Contract Contingencies and 4 Rules for Using Them
Before I get into some of the rules for using contingencies in your contracts, I wanted to review the most common contingencies you’ll find in a real estate purchase offer:
Financing Contingency
This is one of the most common types of contingency. Basically, it says that your offer is contingent on you being able to procure financing for the property. It will often be specific about the type of financing (FHA, Conventional Loan, etc), the terms (interest rate, down payment, etc), and the time period.
Any Buyer who is planning to use the financing to purchase a property should include a Financing Contingency; worst case, your financing will fall through, but you’ll still have the option to back out of the deal without penalty.
Appraisal Contingency
This contingency basically says either:
* If you can’t get an appraisal on the property that is at least as high as the purchase price, you can back out of the deal; or
* If you can’t get an appraisal on the property that is at least as high as the purchase price, you can ask the Seller to drop the price, and if he refuses, you can then back out of the deal.
The appraisal contingency often goes hand-in-hand with the financing contingency, as the lender will not fund the loan above the appraised price.
Inspection Contingency:
Also known as a “Due Diligence Period” or a “Due Diligence Contingency,” this contingency says that the Buyer has a set amount of time (often ranging from 3-14 days), where he can do whatever he needs to do to ensure that he wants to buy the property. This might include inspections, appraisals, contractor walk-throughs, etc.
If at any time within that inspection period the Buyer chooses to back out of the deal for any reason, he can. This is a common contingency for anyone who is not intimately familiar with inspecting properties and coming up with rehab cost estimates. The Buyer can use this time period to get a full property inspection and get bid from contractors to do any necessary work. If any surprises turn up, he can then either ask for a discount (or repairs) or just back out of the deal.
Now that you hopefully have a good idea of what contract contingencies are, in the second half of this post, I want to discuss the 4 rules for using contingencies (or not) to improve your investing success…
First, let me start with the first and most important rule of using contingencies when making offers:
Rule #1: The fewer contingencies used in your offer, the more attractive your offer will be to the Seller.
Perhaps this is obvious; perhaps not. Let’s look at it from the perspective of the Seller:
He wants to sell his property as quickly and as efficiently as possible, and any contingencies you put in your offer is an opportunity for you to back out of the deal before it closes.
So, as a Buyer, you want to limit your contingencies to only those that are absolutely necessary. I’m certainly not saying to never use a contingency — sometimes they’re very important — but don’t use more than necessary to protect your interests. And, if you have the ability to use no contingencies in your offer, that’s makes your offer much stronger than any competing offers.
Of course, unless you have had the property inspected (or have done it yourself) and are absolutely sure that you want to move forward, you take a risk by not have a contingency in your offer.
Rule #2: If possible, limit your offer to a single contingency.
While it may be more reassuring to you to have lots of contingencies in your offer — it means you have more leeway to change your mind, right! — the truth is, that a single contingency often provides all the protection you need. In fact, for 80% of the offers I make, the only contingency I use is the Inspection Contingency (the other 20% of the offers I have no contingencies at all).
The inspection contingency will give me a fixed period of time — generally 5-10 days, depending on how much I think I need — to get everything in order to ensure that I want to — and can — buy the property. During that inspection period, I will get my property inspection completed, I will ensure that I have my financing lined up, I will create my Scope of Work, I will have my contractors come out to the property to give me bids, I’ll contact my insurance agent to get quotes, etc.
By the time I’ve used up that inspection period, I’m pretty sure of whether I’m ready to move forward on this property or not. If I’ve come across anything concerning (structural issues, mold, missed repair costs, etc), I might go back to the seller to request a lower price, and worst case, I might back out of the deal.
Rule #3: Only execute a contingency if absolutely necessary.
I know plenty of investors who will make lots and lots of offers, each with contingencies. They won’t even bother looking at the properties unless they get their contract accepted. While this is a perfectly reasonable way to make lots of offers in a short period of time, it also increases the probability that you’ll end up having to back out of one or more of those offers using your contingency.
Perhaps you find that there is more repair work than you needed. Or maybe you find that there is the structural issue that will be costly to fix. Or maybe you determine the layout of the property will make it difficult to sell. Regardless, if you’re not careful, you’ll find yourself backing out of deals.
And if you back out of too many deals, you run the risk of getting a bad reputation. If you work with the same listing agents over and over (for example, if you buy REO properties), and you have a reputation for backing out of deals using your contingencies, you’ll find that you start getting many fewer offers accepted. Remember, Sellers are interested in getting rid of their property as quickly and efficiently as possible, and if they think you’re just going to waste their time by backing out of the deal, they won’t even bother to accept your offers.
If you intend to use your contingency, consider alternative uses:
Rule #4: Contingencies can be negotiating tools.
Just because you find that the deal isn’t working out for you, doesn’t mean that you need to use your contingency to back out. You can use that contingency to reopen negotiations with the seller instead.
For example, let’s say that during your inspection you find that there are some major plumbing issues in the property that will require an extra $3000 in plumbing work that you hadn’t factored in. Instead of using your contingency to back out of the deal, use it as an opportunity to ask the Seller to drop his price by $3000. Not only do you keep the deal alive, but the Seller would likely face the same issue with the next buyer, so one way or the other, he’s going to end up eating that $3000 cost.
Or, let’s say your financing falls through — instead of using the contingency to back out of the deal, perhaps you can use it to reopen negotiations around seller financing, especially if the Seller is a bank.
The key is that even when you use a contingency, you don’t have to use it to back out of the deal; you can instead use it to revisit the original deal and try to come to a reasonable compromise that resolves the issue(s) and makes both parties happy.