If you’ve ever been through a real estate purchase (or watched any show on HGTV…) then you’ve probably heard the term “contingency.” This is another one of those real estate terms that gets thrown around a lot and used in different contexts… so it can be hard to pin down exactly what it means! In this article, we’ll unpack what contingencies actually are, and how they can affect your real estate deal.
What is a Contingency?
In the context of a real estate transaction, a “contingency clause” is a condition or action that must be met in order for the contract to become binding. Essentially, contingencies act as “walk-away” clauses in the contract that give parties a way to back out of the deal without consequences. Contingencies are usually associated with specific aspects of the real estate sale, such as inspections, financing, and appraisal. They can exist for the protection of the buyer, the seller or both. But generally speaking, contingency clauses benefit the buyer and offer them specific protections and opportunities to back out of the deal without putting their earnest money deposit at risk.
Each contingency has a specific period of time to complete the associated action. When the deadline is reached, the buyer can choose to remove the contingency altogether – this indicates that they are approving the items related to that contingency, and are moving forward with the deal. If the buyer does not approve, does not wish to move forward, or needs more time to investigate, they can:
Contingencies are generally included in the purchase contract. When making an offer on a property, the buyer will need to decide which contingencies to include, and what the time periods will be. Your buyer’s agent can walk you through the different types, and strategize on how to optimize your contingencies to present a strong offer while still protecting yourself. Here we will look at the most common types of contingencies that are used in real estate transactions.
Inspection / Buyer Investigations
The home inspection contingency gives the buyer the opportunity to inspect the condition of the property. This is often expanded and combined with other items that the buyer may want to review, and can be called the “buyer investigations” contingency. This is the most broad contingency in the transaction, and is the buyer’s best form of protection. This contingency period gives the buyer the chance to investigate ANYTHING that may materially affect their decision to purchase the property.
While other contingencies are designed for a specific purpose (such as loan or appraisal), the buyer investigations contingency is very general and can often be used for the buyer to investigate and negotiate on a variety of issues.
Beyond just the physical condition of the house, this can include investigating factors like the neighborhood, schools, crime, traffic, noise; the title to the property and ability to obtain title insurance; environmental hazards and the availability of homeowner’s insurance; as well as reviewing any disclosure information provided by the seller.
** Note that it is important to make sure ALL disclosures have been received from the seller and reviewed by the buyer BEFORE this contingency is removed.
If the seller sends a new disclosure after the buyer has removed contingencies, it may trigger a new contingency for the buyer to review that item. Check your contract language and consult with your real estate broker or attorney for specifics. **
Before the inspection contingency is lifted, the buyer may have the opportunity to negotiate with the seller to make repairs, to give a credit, or to adjust the purchase price before moving forward.
The loan contingency (also called a financing contingency or mortgage contingency) gives the buyer a specific period of time to apply and be approved for a loan for the purchase of the home. This provides the buyer with a safe way to back out of the deal within that time period, in the event that the financing is not approved.
Loan contingencies generally state a specific number of days for the buyer to obtain financing. Often, this section will also include language which specifies certain terms for the financing – for example, it might state that the buyer has 21 days to obtain a conventional loan at an interest rate not to exceed 4.00%, and with points not to exceed 2.00%. With language like this in place, the buyer may also safely back out of the deal if they are not able to get the loan they need with terms that are acceptable.
The appraisal contingency gives the buyer (or the buyer’s lender) the opportunity to order an independent appraisal on the property to determine its value. It is used to ensure that the home is valued at or above the contract price.
If you are obtaining a loan, your lender will almost always require an appraisal to assess the fair market value of the home. If the appraised value comes in lower than what the buyer agreed to pay, the lender will be reluctant to move forward. Because the home is the collateral for the loan, the lender wants to make sure that they can recover their investment in case the borrower defaults.
When an appraisal comes in too low, the parties are at a crossroads. The buyer’s lender will not allow the transaction to move forward with an appraisal gap, but there are a few possible solutions:
If the parties can not overcome the appraisal gap, then the buyer can use their appraisal contingency to safely back out of the purchase and move on to another property.
Title Contingency (often combined with inspection)
Most standard contracts require that the seller is able to deliver a clean and marketable title to the property. In some areas, there is a separate contingency for the title. This gives the buyer or the seller the chance to investigate the title to the home, to find if there are any clouds or outstanding liens, and to make sure that a title company will be willing to issue a policy of title insurance.
However, in most instances the title (along with most other investigations) will be wrapped into the buyer inspection contingency. In this case, the buyer must use their time for “buyer investigations” to research the property title, while simultaneously conducting any other necessary inspections and due diligence.
Sale of Buyer’s Property (Home Sale Contingency)
Many buyers find themselves in a catch 22 – they need to collect the proceeds from selling their current home before they can afford the down payment on the next home. If you are selling a home and buying a replacement property, you may need to use a Contingency For Sale of Buyer’s Property.
Essentially, this contingency allows the buyer a certain amount of time to close escrow on their previous home so that they can move forward with the purchase of their next home. If their previous home doesn’t sell in time, then they can use this contingency to safely back out of the deal with their deposit intact.
However, this type of contingency is extremely unpopular with home sellers, and would almost never be recommended in a competitive market environment. When accepting an offer contingent on the buyer selling their previous home, a seller would be taking their home off the market for a long period of time, with very little certainty that the buyer will ultimately be able to close. This would substantially weaken your offer, and is only effective in very particular circumstances.
To avoid this, one option might be to sell your previous home first, collect the proceeds, and rent a temporary home until you can purchase your next property. Alternatively, a buyer can use an all-cash offer company – these companies will put up cash on the buyer’s behalf to purchase the new property, which will then be repaid when the buyer’s previous property eventually sells. A few companies that are doing this today are Homeward, Reali, and Accept.inc.
Special / Custom Contingencies
A buyer (or their agent) can write custom contingencies into their offer covering any number of items. This may be for the review of some specific piece of information, for example the status of building permits or the availability of insurance. Just be aware, though, that contingencies like this are usually for the protection and benefit of the buyer; as such, the more contingencies your offer has, the less desirable it will appear to the seller.
Subject to interior inspection
This is a contingency that can be used in certain situations. If a property is tenant occupied, for instance, it may not be possible for a buyer to tour the home in person before making an offer. In a case like this, the buyer can add an extra clause which makes it so their offer is subject to interior inspection. This basically means that once their offer is accepted, they will have the chance to visit the interior of the property in person, and can make a thumbs up / thumbs down decision on whether to move forward at that point.
The seller in a transaction usually doesn’t have many (or any) contingencies or clauses to back out of the deal. However, there are very few instances where a seller may have contingencies of their own.
Contingency for seller to locate replacement property
One example would be a seller’s contingency to purchase a replacement property. This contingency would be designed to ensure that the seller has time to locate and close on their next home, before closing escrow (and having to vacate) their current home. In a hot seller’s market, especially if a seller has multiple offers, a buyer may have to give a concession like this just to curry favor with the seller and get the deal done. This type of arrangement could also be accomplished with a seller leaseback.
How timelines work – running concurrently vs. back-to-back
The way that contingency timelines are handled will depend on your specific contract language, the type of real estate (residential / commercial), as well as the customary practices in your area. Timelines are generally tracked one of two ways: running concurrently, or back-to-back.
Keeping track of deadlines
No matter what, it is always crucial to closely track your contractual deadlines. Often the real estate brokers, lenders, and escrow officers will each have their own calendar of escrow timelines. However, it is always recommended for the buyer and seller to keep a calendar with reminders to stay on top of all timelines, since missing a contract deadline will likely have consequences.
How contingencies are removed – proactive vs. automatic
The manner in which a contingency is removed will also depend on the customary practice in your area, as well as the language in your specific purchase contract. In some cases, contingencies are lifted automatically. This would mean that once the time period is up, unless the buyer takes some specific action, the contingency is automatically deemed to be removed and the transaction moves forward.
In Southern California, the standard practice is that contingencies must be proactively removed. This means that the party who is responsible for the contingency (usually the buyer) must take action to remove the contingency in writing, regardless of when the deadline occurs. This practice primarily favors the buyer. Just be aware, though, that if you miss a contingency deadline the other party will have the option of sending a “Notice to Perform” which could put your position in jeopardy.
Wrapping it all up
In real estate, contingency clauses are conditions of the sale which need to occur or be approved before the transaction can move forward. Contingencies can benefit any party in a contract, but are primarily used to protect the buyer and allow opportunities for the buyer to cancel the escrow for specific reasons without risking their entire deposit.
As the buyer, there are many different contingencies you can choose to include with your offer contract. However, keep in mind that too many contingencies attached to your offer makes it less desirable to the seller. Sellers always prefer all-cash buyers, because they often have fewer or no contingencies attached to their offer. Your buyer’s agent can help you decide which contingencies should be used in your specific situation.
To achieve a quick sale and the highest possible price, it’s crucial to polish your home’s image to make it as inviting as possible to potential buyers! In this guide, we lay out a step-by-step process to make sure you are covering all your bases when preparing your home for sale.
Part 2 – The continuation of our podcast-style interview with a lender! In this interview we dive deep into the topic of loans to answer some of the biggest questions, including what mistakes you should avoid!