In my quest to upgrade homes, I've come to realize that buying a home with contingencies is like getting a free call option. Your likely worst case scenario is that you make nothing. But your best case scenario is that you buy a home at a price that is below market.
For the last three homes I purchased, I did not make real estate offers with contingencies. One of the reasons why was because at that time, the San Francisco housing market was strong. Hence, writing an offer with a financing contingency or home inspection contingency would have made my offer uncompetitive.
However, thankfully, the housing market has taken a breather after a strong run-up in prices since the 2020 pandemic. With move-up homes becoming more affordable and a huge rebound in tech stocks, I have decided to put in an offer with inspection contingencies to buy a home.
Earnest Money Deposit And Contingencies
Once your offer is accepted, you must send an earnest money deposit equal to 1% – 3% of the value of the home to an escrow company. To protect both parties, the escrow company holds the money until all contract conditions are met on both sides.
Please note, before wiring any money, call the escrow company and confirm the wiring instructions. There have been cases of e-mail scammers intercepting your communication with an escrow officer and getting unsuspecting buyers to wire money to a fraudulent account!
Contingencies are conditions written in your offer letter to protect yourself from losing your earnest money deposit.
If, for some reason, the bank decides not to lend you money, with a financing contingency, you have a penalty-free out. If you find the roof has a lot of damage beyond the disclosures, with an inspection contingency, you can also pull your offer and get your earnest money deposit back
Such contingencies have expiration dates. When that date comes, the prospective buyer must sign a document that releases the contingencies. Once all contingencies are released, the earnest money deposit is at risk if the buyer doesn't follow through with the purchase.
Home sellers prefer not to have any contingencies in the offer. But during a soft housing market, sellers may have no other choice. For homebuyers who have no experience remodeling or buying a home, having at least a home inspection contingency is highly recommended.
A Free Call Option To Make Money On A Home
So why do I say buying a home with contingencies is like getting a free call option?
Call options are financial contracts that give the option buyer the right but not the obligation to buy a stock, bond, commodity, or other asset or instrument at a specified price within a specific time period. A call buyer profits when the underlying asset increases in price. In this case, the underlying asset is a house.
Once you send in your earnest money deposit and get your offer accepted with contingencies, you don't have much risk until the contingencies are removed. You now have the free call option to buy the property at an agreed upon price at no cost to you. At the same time, you have upside profit potential as time goes on.
In order to potentially make the most money off a home as possible, you want to have as long of an escrow period as possible. To do so, one strategy is to input long contingency durations. Another strategy is to extend the escrow period as many times as possible.
Have a look at part of an offer document below regarding the various types of real estate contingencies in an offer.
The Various Types Of Real Estate Contingencies
Real estate offer contingencies include: Loans, Appraisal, Leased or Liened Items, Title Review, Buyer's Investigations, HOA Disclosures, Rental Leases, Rental Property Accounting, Seller's Statutory Disclosures, SF Seller Disclosure, Other Seller Disclosures, Other.
There are default duration days for each contingency, ranging from 15 to 21 days in California. Your goal is to get the seller to accept as long of a duration as possible. In this example, the buyer inputted 45 days for Buyer's Investigations, as opposed to the default 15 days.
Usually, the maximum contingency duration sellers are willing to accept is 60 days. Remember, as a buyer, once you have your contingency in place, you can extend for legitimate reasons.
Extending is not what a seller wants to see. However, if a seller wants to sell the home to you, they may have no choice but to comply.
Why A Longer Contingency Duration Is More Valuable To The Buyer
The longer the contingency duration is, the more valuable the free call option because time is valuable. The more time you have, the more time you get to make a more informed home-buying decision.
Imagine getting into contract to buy $1 million worth of the S&P 500 index at a strike price of 4,500. If the contract lasts only 30 days, the contract might be worth 0.8% of the value of the purchase amount, or $8,000.
In other words, investors might be willing to buy the contract for $8,000. If the S&P 500 rises by more than 0.8% in 30 days, the investor makes money. If the S&P 500 rises by 3% after 30 days, the investor will make a net profit of $22,000 ($30,000 – $8,000).
Related: Examples Of How Structured Products work And Perform
Long Duration Call Option Example
Now let's say the real estate purchase contract has a 10-year duration with an option to buy $1 million of the S&P 500 index at a strike price of 4,500.
At a 7.2% annual rate of return, the S&P 500 will have doubled in 10 years, and so will the $1 million. Hence, the value of the contract is much greater than the previous example. Some investors might be willing to pay $500,000 for such a contract!
$500,000 is clearly greater than $8,000. However, as the potential homebuyer, you get a free call option because you don't have to pay (and lose) any money to get into contract due to your contingencies.
The hardest part may be convincing the seller to get into contract with you so you can have a free call option.
Example Of A Free Call Option To Purchase A Home At A Lower Than Market Price
Let's say you put down a $30,000 earnest money deposit to buy a home for $1 million. The contingency duration is 45 days for Buyer's Investigations.
After the contingency duration expires, you then have another 15 days to come up with all the funds to close because that's what's written for the close of escrow target date. Without an extension, the total escrow period is 60 days.
Now let's say during the following 45 days there's peace in Ukraine. In addition, the Federal Government also announces a surprising $3 trillion stimulus package to create more jobs. Due to these two factors, the S&P 500 rises by 10%.
With a lot more wealth created in the economy, the value of your house may have appreciated by 3%, or $30,000 in this 60-day period! As a result, you are encouraged to exercise the free call option and buy the house at below market value.
Example Of A Free Call Option To Let The Purchase Contract Expire At No Cost
Now let's say during the 45-day contingency period, China decides to invade Taiwan. In addition, a major employer near the house's neighborhood decides to shut down.
As a result, the S&P 500 declines by 20%. In this situation, the value of your house may have depreciated by 5% – 7%, or $50,000 – $70,000 before the contingency duration expires.
In this case, you could choose not to drop your contingencies, negotiate to get a lower price, or walk away from the deal. There are no standard contingencies for exogenous variables like war (you could write one in as everything is negotiable). But if you have a contingency in your offer, you can always find an excuse not to move forward.
These examples should help illustrate, from a financial perspective, why sellers want faster closes and why buyers should want longer closes. The more time a buyer has to survey market conditions, the more ammunition buyers have to make an optimal home purchase decision.
Opportunity Cost, Time, And Stress
Technically, there is some opportunity cost after sending in your earnest money deposit to get into contract. That opportunity cost is the income or returns you could have made if you had invested the down payment.
Some states do require escrow to pay an interest on the earnest money deposit. But even if they do, the interest rate is usually pitifully low, e.g. 0.1% in California.
Although there is minimum financial downside if you make an offer with contingencies, there is also the cost of your time and the added stress you may feel in buying a home. If you find real estate contract negotiations overly stressful, then you might not appreciate the validity in my argument.
On the other hand, if you are infatuated with finding real estate deals, like I am, then going through escrow is not a problem. You know what the process entails and you can use your negotiating skills to get the best price possible.
Given I have a platform, I like to share my financial experiences, both good and bad, to help as many readers as possible make optimal financial decisions.
Example Of An Escrow Extension With My Current House
During my current primary residence purchase, I extended the escrow period by 30 days because I was worried about the economy. It was June 2020 and everything still seemed so uncertain due to the pandemic.
To be competitive, I offered a 40% down payment and a 30-day close. I then got to know the listing agent through over a dozen hours of conversation. I convinced him to work with me to save at least 2.5% off the purchase price. More importantly, I got the listing agent to convince the seller to accept my offer.
By extending escrow for 30 days, I was able to gain more confidence about buying my house because the stock market continued to recover during this time period. In addition, the government announced an economic stimulus plan to save us all.
Ultimately, I made the decision to close on July 31, 2020 after two months. I wanted to extend escrow further, but I received a Notice To Perform letter from the seller's lawyer with some threatening language. So I decided to negotiate with the listing agent's brokerage to get a $5,000 credit to close and they complied.
Time is valuable. If you can find a way to buy yourself more time for free, then do so.
Analyze The Probabilities Of Closing
If you have a real estate offer accepted with contingencies, you will feel more calm. The next step is to analyze two probabilities to help you determine how you will invest your remaining down payment or all-cash offer beyond the earnest money deposit.
- The probability the home will close by a certain date.
- The probability of actually purchasing the home
For example, for this house I want to buy, I assign only a 40% probability the home will close by the date in the offer document. The reason is because the seller must fix a couple of important things as written in the contingencies.
I assign a 65% probability I will go through the purchase. The main reason is because I'm not entirely confident the seller will be able to fix the issues to my satisfaction, as written in the offer. I want to buy the house. But I don't want to buy a house that will cause me maintenance problems in the future.
The Probabilities Will Help Determine How You'll Invest Your House Fund
Based on these probabilities, you must then decide how to invest your house fund before and during the escrow period.
In general, I recommend keeping the majority of your down payment (75%) in cash if you decide to purchase a house within one year, let alone if you're already in escrow. The stronger your cash flow and the more assets you have outside of your house down payment, the more risk you can take.
In my case, I'm not following my own advice given the low probabilities I've assigned to actually buying the house within a given time period. Given the positive momentum in the stock market all year, I've been inclined to invest a greater portion of my house payment in stocks (~50% weighting, which isn't aggressive).
My decision is like gambling. Every time the stock market goes up, the house gets cheaper. If there is a major sell-off in the stock market, the house I want to buy will become more expensive. But that's the risk I'm willing to take because I have cash flow and other tappable assets.
I hope this article gives you an idea how to think like an options investor. Having the option to buy a house at a specified price can end up making you extra money. Therefore, I highly encourage you to put out as many offers with contingencies as possible.
Reader Questions and Suggestions
Do you see getting into contract with contingencies as a free call option? How have you managed to extend an escrow period? What is the longest escrow period you've had? How has having a contingency saved you?
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Great article!
If you decide not to drop your contingencies, would you lose your escrow money?
Yes, most likely if you don’t follow through. Therefore, be as thorough as possible regarding inspections and everything before removing contingencies.
See: How To Delay The Close Of Escrow To Buy More Time And Money
A few questions:
1) Which contingencies and how long do you recommend make those contingencies for california?
2) How do you explain these extended time periods to your own agent and to the selling party?
3) If one wanted to write an offer with a pre approval letter but are bidding under the ask, do you recommend the initial offer with preapproval letter be the amount of the offer, or much higher than the offer? For example, if looking to bid 3.1mm on a house that is listed for 3.6mm, would you make the pre approval for 3.6mm, or even 4mm to make your financials seem stronger, or just have the lender modify the letter for 3.1mm. Wondering which approach puts you in a stronger negotiating position without compromising the seller’s faith in the strength of one’s financails.
1) Home inspection and financing, as long as you can for the seller to agree. 45 days perhaps.
2) Work in progress. Case by case. Many ways to slow down if you want.
3) Yes, match the lower offer price.
Very helpful article, Sam! Learned a few things. Now is the time to add in some contingencies! I waived all contingencies in the last few years to stay competitive during the seller’s market days. Seems like times are different now. I didn’t know that as a buyer, we could fill in our own (hopefully not random) contingency!
Thanks for the helpful explanation! I’ve always wondered how contingencies work. I’ve heard of people using them before, mostly financing contingencies, but haven’t done it myself before. That’s good to know there are so many different types, even custom ones if needed. Insightful, thanks!