Contingency clauses are some of the most important components of a real estate purchase contract, and can provide significant protections to buyers of real estate. A contingency clause typically states that a buyer’s offer to buy property is contingent upon certain things. For example, the contingency clause may state , “The buyer’s obligation to purchase the real property is contingent upon the property appraising for a price at or above the contract purchase price.” Under this contingency, the buyer is relieved from the obligation to buy the property if the buyer obtains an appraisal that falls below the purchase price. Because contingency clauses provide the buyer a way to back-out of a contract they can be excellent tools for real estate investors who make numerous offers on properties. Here are some contingency clauses to consider in your real estate purchase contract.
1. Financing Contingency. A financing contingency clause states something like, “Buyer’s obligation to purchase the property is contingent upon Buyer obtaining financing to purchase the property on terms acceptable to Buyer in Buyer’s sole opinion.” Some financing contingency clauses are not well drafted and will provide clauses that say simply, “Buyer’s obligation to purchase the property is contingent upon the Buyer obtaining financing.” A clause such as this can cause problems as the Buyer may obtain financing under a high rate and thus may decide not purchase the property. However, because the contingency only specified whether financing is obtained or not (and not whether the terms are acceptable to buyer), the clause can be unhelpful to a buyer deciding not to purchase the property. Some financing clauses are more specific and, for example, will say that the financing to be obtained must be at a rate of at most 7% on a 30 year term and that if the buyer does not obtain financing at a rate of 7% or lower then the buyer may exercise the contingency and back out of the contract.
2. Inspection Contingency. An inspection contingency clause states something like, “Buyer’s obligation to purchase is contingent upon Buyer’s inspection and approval of the condition of the property.” Another variation states that the Buyer may hire a home inspector to inspect the property and that the Seller must fix any issues found by the inspector and if the Seller does not fix the items specified by the inspector then the Buyer may cancel the contract. Inspection clauses are very important as they ensure that the Buyer is obtaining a valuable asset and not a money pit full of defects and repair issues.
Other important contingency clauses are clear and marketable title clauses, approval of seller disclosure documents, and rental history due diligence information (e.g., rent rolls, lease copies, financials, etc.).
When using contingency clauses buyers should pay attention to a few key terms. I’ve personally seen many disputes arise as a result of one of the following issues.
1. What Happens to the Earnest Money. One important consideration that is often vague in real estate purchase contracts is what happens to the buyer’s earnest money when the buyer exercises a contingency. Does the buyer receive a full return of the earnest money? Does the seller keep the earnest money? If the contract is silent and if you as the buyer exercise a contingency, don’t count on the seller agreeing to a release of the earnest money as they are often upset that you are not going to purchase the property. Make sure the contract clearly states something like the following, “If Buyer exercises any contingency, Buyer shall receive a full return of any earnest money deposit or payment to Seller.”
2. Contingency Deadlines. Another important contingency clause issue is the date of the contingency clause deadline. Most contingency clauses have expiration dates that occur well before closing. Those dates should typically be somewhere from 2 weeks to 2 months from the date of the contract, depending on the purchase and seller disclosure items and the type of property being purchased. For example, single family homes will typically have a shorter window as financing and inspection can occur more quickly than would occur under a contract to purchase an apartment building. Whatever the deadline is, make sure that the deadline is set far enough out so that you can complete your contingency tasks. You need to make sure you have enough time to obtain adequate financing commitments, to properly inspect the property, and that you have enough time to review the seller’s disclosure documents. Setting a two week deadline is sometimes done but two weeks is usually not enough time to complete financing commitments, inspection, and due diligence activities that are necessary to determine whether you are going to commit to purchasing the property. If contingency deadlines are approaching and you need more time, then ask the seller for an extension before the deadline arrives. If the Seller refuses an extension, then exercise the contingency you need more time to satisfy.
3. Exercise You Contingency in Writing. If you do exercise a contingency and decide to back-out of the purchase of the property, make sure you do it in writing. Don’t rely on telephone calls or even e-mails (unless the contract permits e-mails as notice). Additionally, make sure that the reason for the contingency and that the date of the contingency are put in writing and are sent to the seller in a method where the date can be tracked in accordance to the notice provisions of the contract. For example, if the contract requires a contingency to be noticed by fax or hand delivery, don’t rely on an e-mail to the seller or the seller’s agent as such communication will not invoke the contingency.
Once the deadline to exercise a contingency has passed, the buyer is obligated to purchase the real property and may be sued for specific performance (meaning they can be forced to buy) or at the least the buyer will lose their entire earnest money deposit. Contingency clauses are the best defense mechanism to a bad deal and should always be used by real estate buyers. Keep in mind that until you close on the property, the only investment you have is a contract and if you have a bad contract, then you have a bad deal.