Contingency-free contracts can be dangerous
Originally appeared in Bay Area News Group publications on March 8, 2013
“It’s like deja-vu, all over again.”
– Yogi Berra
Unbalanced markets lead to unbalanced behavior that buyers often later regret. Today, extremely low inventory combined with record-low interest rates have buyers scrambling to be one of a horde vying to buy a home or condo.
The rules change when a substantial number of buyers compete for one property. This could result in five offers or over 25, depending on many factors. The compelling question for buyers is, “How can I get this home?” The answer, in my experience, can sometimes be detrimental to a buyer’s financial and emotional health.
As recently as 2006, many buyers felt like you might be feeling now. Prices skyrocketed from 2003 and it was impossible to be sure when a slowdown would occur. Without knowing it, folks who bought in 2006 and early 2007 were experiencing a seller’s market that had already peaked.
2008 was the beginning of a market where buyers, not sellers, were in control. Since then, the market has slowly strengthened. The point is that real estate markets are always cyclical and keeping that in mind might help you make rational decisions.
Contingencies are discouraged in competition
A contingency is a condition that must be satisfied for the contract to continue. Examples are for appraisal, loan and inspection. They create an escape hatch for the buyer, but uncertainty for the seller as to whether they will be removed.
When the market gets overheated, as today, many agents advise their buyers to eliminate some or all of these contingencies to make their offer more competitive. While sellers and their agents may look favorably on this, a lack of contingencies can be dangerous for both buyers and sellers and may not be worth the gamble.
Appraisal and loan contingencies
A contract might be written with a loan contingency, but no appraisal contingency. If, however, the price is bid way up and the appraisal is lower, the buyer, without increasing his down payment, might not qualify for the loan. At that point, the buyer’s deposit may be at risk. Regardless, this is an escrow that might not close.
Some buyers are counseled to eliminate both the appraisal and loan contingencies. There is no problem if the buyer has the funds and intends to pay cash if the loan is not approved. This is rarely the case.
With no loan approval and no loan contingency, the buyer stands a good chance of losing his deposit and, possibly, being exposed to further damages. The seller does not have a closed sale and must start the selling process over.
Failing to have comprehensive inspections is an imprudent choice for buyers who eliminate this contingency and for sellers who do not insist that the buyer have some time for inspections in the contract. The buyer may discover expensive, previously unknown, problems after close and sue the seller for lack of disclosure. This is not unusual and is disastrous for both sides.
Some homes are marketed with pre-sale home inspections that are available to potential buyers. Many lack these reports. Even if available, they might be from unknown inspectors, raising the question as to how much you can rely on those reports. Clearly, having no inspection contingency on a house without pre-sale inspections is even riskier.
There are agents who advise their buyers to do a pre-offer inspection with an inspector of the buyer’s choice. This, they say, will eliminate the need for an inspection contingency. Glossed over is the fact that the buyer may be paying $550 to $750 per inspection on many houses he offers on, but does not get.
From the seller’s perspective, allowing pre-offer inspections creates the possibility that reports from unknown and, possibly, unqualified inspectors might have to be disclosed to all future buyers.
The bottom line is that I do not suggest pre-offer inspections when representing buyers and suggest sellers not agree to them when I am the listing agent.
Standard of care vs. Standard of practice
Unfortunately, especially when the market blazes, some licensees follow the crowd and do what is expedient, even if that can later prove harmful to the client.
A prime example of this is advising buyers in multiple offer situations to eliminate contingencies in their purchase contract, a common practice in our local market. When a majority of agents work in a certain way in a specific area, this is known as the “Standard of Practice.” I know this as a Bay Area real estate expert witness.
“Common,” in this case, does not mean correct. This practice, in my opinion, falls below the “Standard of Care” of a reasonably diligent licensee, who is required to use “utmost care” in his client’s best interests. These offers usually work and no one is harmed, but I wonder whether agents understand and fully explain the risks to their buyers.
Even in the hottest markets, I recommend that my buyers maintain their contingencies, although I suggest tight time frames. Contingencies protect the buyer and must not be waived lightly.
As a seller, keep in mind that the lack of a written contingency such as loan does not signify the buyer will perform without this financing. It just means he took the risk of not having the contingency in writing.
As a buyer, slow down and manage your emotions. Do not let the fear of missing out cause you to make massive mistakes you will later regret.