What Are Contingencies in a California Real Estate Contract ?
UNDERSTANDING THE MOST COMMON REAL ESTATE CONTINGENCIES
WHAT YOU NEED TO KNOW
Most Real Estate contracts in California are contingent upon specfic factors.
These contingencies are typically for inspection, appraisal, and loan but may also include the sale of the Buyer’s property.
Each contingency has its own timeline and requirements.
One of the most common questions Buyers and Sellers have is about the “contingencies” in the CA Residential Purchase Agreement (RPA) which is the standard contract used in over 95% of residential property sales in California. (Often builders may use their own contracts as do some others.)
This post discusses how contingencies work in the current purchase agreement and is not intended as legal advice. As each transaction is different, it is best to consult with the licensed agent representing you and where appropriate an attorney. If you don’t have an agent, use this contact form if you have questions.
Hopefully this over view can point you in the right direction so you know what to look out for and what questions to ask.
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WHAT IS A CONTINGENCY IN A REAL ESTATE CONTRACT?
The RPA as drafted by the California Association of Realtors (C.A.R.) has a number of standard contingency clauses which give the parties the right to cancel and back out of the contract under specified circumstances that are pre-defined between the Buyer and Seller.
Think of a “contingency” as a condition that must be met in order for the sale to go through. Please note - lenders also use the term conditions and a lender condition is different than a buyer (or seller) contingency.
Buyers will typically have an inspection contingency, an appraisal contingency and a loan contingency. They also may have a contingency for the sale of their current home. If any of those contingencies can not be satisfied, the Buyer can cancel the contract and in most instances have their earnest money deposit (EMD) returned.
Once all contingencies are removed, the buyer may be at risk of losing their deposit (typically 3%) if they default (as defined by the contract) and do not close escrow. Also, once a contingency is removed, you can not go back and un-remove it. Contingencies have to be removed in writing (there is a specific contingency removal form) and there is a pre-defined timeline for when those contingencies are to be removed or extended.
Sellers have fewer contingencies but some contracts do include a contingency for the Seller to cancel the contract if the Seller can not purchase a replacement home. If the Seller cancels under that contingency that does not entitle them to the Buyer’s EMD.
Let’s take a deeper dive into each of the contingencies.
Buyer Investigation - aka the “Inspection Contingency”
This is what is commonly called the “inspection contingency” but what it really covers is the Buyer’s investigation of all matters related to the property including insurability. Beyond the physical inspection of the property, Buyers investigate the neighborhood, the CC&Rs or HOA if applicable, and any other of a number of factors.
As an example, the home under contract may not have any specific physical issues but a Buyer may discover that there are HOA rules preventing them from leasing the property out, having a pet over a certain size or even making some modifications or improvements to the subject property.
As part of the disclosures Buyers receive they may discover many things that may make them change their mind on a specific property. In CA the “Buyer Beware” disclosures are numerous but often not filled out by the Seller in a thorough or forthright manner.
Sometimes Buyers do discover things during a home inspection that are wrong with the property and sometimes these are serious such as a leaky roof, foundation or other structural issues, sewer line (or septic) problems and mold. Often things come up during inspections that are more routine and attributable to deferred maintenance. These shouldn’t be deal killers and should be negotiated. Other common things that may come up during inspections are room additions made without permits or insurability issues if a property is in a flood or high fire hazard area.
Buyers can request a Seller to make certain repairs or compensate them in another way such as lowering the purchase price or providing credits in the form of off setting closing costs.
Request for repairs (RR) is another misunderstood aspect of the purchase contract. Before we get into that, let’s diverge for a second and discuss how the “inspection contingency” as it appears in the current version of the RPA works.
The default time allowed for the Buyer investigation is 17 days. But as this is the most subjective and easiest out of the contract, and we’ve been in a low inventory seller’s market for quite a while, it is more common to see the number of days typically lowered to 10 or less.
The RPA states that the Buyer may “within the time specified” request the Seller make repairs. The RPA further states that by the end of the time specified, the Buyer shall deliver to Seller a removal of the applicable contingency or a cancellation. This paragraph is entirely misinterpreted by most agents.
Here’s what often happens.
On day 10 or whatever the end of the investigation contingency period is up, the agent representing the Buyer sends a Request for Repair (RR). The mistaken interpretation is that they have made the request within the time specified - which they have. But that does not modify the subsequent paragraph that states that by the end of the time specified the Buyer shall remove the contingencies or cancel the contract.
In other words the contract does not state that the Buyer gets an extension of time on that contingency if the Buyer submits a Request for Repair.
I’ll discuss the RR and how that is handled in a separate post.
There is a difference in Northern and Southern CA as to how this entire topic is addressed. It is much more common in NoCal for the Seller to post or otherwise provide a lot of the information relative to the property prior to opening escrow. In SoCal things like pre-listing inspections are not as common and more deals fall apart based on the Buyer Investigation than should.
Let’s move on to the…..
Appraisal Contingency
The RPA discusses the appraisal contingency and the time frame for removal. The default is 17 days but it is somewhat common to see this reduced for 14 days or less.
The updated choices in the RPA state that the agreement is contingent on the property appraising for no less than the purchase price or a specific pre-set value. As lenders will base their loan on the lesser of the appraised value or the purchase price, a Buyer would have to supplement any shortfall out of pocket. That makes it very important to decide upfront how this contingency should be handled.
If the property does not appraise for the purchase price, the Buyer can cancel the contract. Often when there is an appraisal shortfall, the parties may renegotiate the sales price.
Unlike the Buyer investigation contingency where a Buyer can cancel in good faith for virtually any reason, to cancel because an appraisal did not meet the purchase price, the Buyer should provide the written appraisal to the Seller.
During the previous Seller’s Market, there was a trend of offers submitted with the box checked off that the sale is not contingent on an appraisal. Unless you are an “all cash” Buyer or have a lot of money to throw at an appraisal shortfall, that is a rather risky strategy for reasons I will discuss elsewhere.
Last comment on appraisals: an appraisal is an “opinion of value” and not an absolute. Two different appraisers may have two entirely different opinions.
Loan Contingency
For most, this is the big one and the last step before all contingencies are removed. A property can check out when you do inspections and it can appraise but without a loan nothing is going to happen if you are financing the purchase.
Even if Buyers have a pre-approval, the operable word there is “pre”. Once escrow is open, the lender will look at other factors such as the title prelim, appraisal, and other conditions relative to the Buyer’s loan. If the property is a townhome, condo, or has any CC&Rs, those all have to be reviewed by an underwriter.
If the lender turns down the loan based on final underwriting approval and the Buyer wants to cancel using that contingency, the written documentation must be presented to the Seller when the contract is cancelled.
Over the last few years, some lenders have started to tell Buyers that their loan has been pre-underwritten and the Buyer does not need a loan contingency. That is not advisable. It is advisable, however, to work with a lender that will do a full underwrite prior to having an accepted purchase contract. When your loan file has been fully underwritten, the offer is much stronger and there is a box to check off on the RPA indicating the loan has been through underwriting.
Contingency for Sale of Buyer’s Property
While the three contingencies discussed above are pretty standard, it is an entirely different challenge to get an offer accepted that is contingent on the sale of a current home. But it is an option.
When the Seller has accepted this term, everything else can go right and those contingencies can be removed but if the Buyer’s current home does not sell, the contract can be canceled.
The contingency for the sale of the Buyer’s property involves adding a form to the standard RPA. There are many options on this form and it will be discussed elsewhere on this site.
What Happens When All Contingencies Are Removed?
After a Buyer removes all their contingencies, they are “all in” meaning that if they do not complete the purchase and default, the Seller may be entitled to their earnest money deposit as liquidated damages. This depends on whether the parties have initialed the liquidated damages clause of the RPA.
Before you ask, it is virtually impossible to get an offer accepted without acceptance of the liquidated damages clause by the Buyer. Without some financial penalty, Buyers could just walk away at the last minute.
If you are a Buyer, before you get nervous about potentially losing your EMD, which is typically 3% of the purchase price, this isn’t something that happens very often. You would have had to removed all of your contingencies and then not closed escrow for some reason. Other than you have decided to move to a desert island, the most usual reason is that the lender can not do the loan. This also doesn’t happen very often but can happen if the something is discovered at the last minute in your credit file such as outstanding liens or judgements against you.
If you are a Seller and your Buyer defaults, retaining their EMD is a lot easier said than done. There is paperwork involved before escrow just hands the money over.
Good Faith Exercise of Your Right to Cancel
If you do cancel your purchase contract and escrow, the form that is used clearly mentions that you are acting in good faith. Without getting into the legal implications of what that means, here’s an example.
If you are canceling because you can’t get a loan but you never submitted the required paperwork to the lender or didn’t do so in a timely fashion, that would not be operating in good faith.
If you are canceling because you made an offer on another property while in escrow, that would not be operating in good faith.
What About Those Seller Contingencies?
The only contingency a Seller can really have is finding an up leg or replacement property. You usually won’t find this very often because it tends to depress the selling price because the Buyer does not know for certain that they will in fact be able to purchase the home. If the Seller cancels, the Buyer can be out the money they spend on inspections and appraisal unless some compensation for those expenditures is negotiated in advance.
Summary
Contingencies are some of the most misunderstood clauses in the RPA. It is best to consult the agent representing you and in some instances a Real Estate attorney to best understand your rights and risks.
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