Entering the real estate market as a new investor can be very intimidating. That's why so many people are tempted to add contingencies to their purchase contracts that allow them to escape from an offer unharmed. Not that there is anything wrong with this line of thinking. Protection is good and necessary. The error is found in the use, or should I say “abuse,” of these contingencies when the buyer uses false contingencies, or “weasel clauses,” to secure his or her protection at the expense of the seller.
For those of you unfamiliar with the concept, weasel clauses say things like, “This offer is subject to the approval of buyer's partner,” when the buyer doesn't really have a partner or, “This offer is contingent upon the inspection of the property by my spouse,” when your spouse has already seen and approved of the property. The real reason for these contingencies is to provide the buyer with a bogus reason to back out of a deal by later claiming that their “partner” (possibly his dog) or their wife/husband didn't approve of the purchase. The problem with these contingencies is that the buyer is deceiving the seller and, even worse, if the buyer exercises a weasel clause, other events in the seller's life (bill payment, purchase of another house, helping a relative, etc.) may be significantly delayed when the settlement doesn't occur as expected.
Just the description of “weasel” never sat well with me. I didn't ever desire my reputation to be that of someone who “weaseled out” of a deal every time the chips were down, so I made a pledge to myself when I began investing to see every deal through to completion whenever a seller accepted my offer. My sole condition was that I had to be able to obtain sufficient funds in order to settle. Such funds would either come from lenders, my own bank account, or a combination of the two.
Believe me when I tell you I can relate to many of you who offer tens of thousands of dollars for a home with little to (in my case) no money in the bank. This seems so illogical, however, like you, despite my lack of funds, I knew I had two choices, make offers or go home. Not being the “quitting” type, I found a solution to my problem, a financing contingency that would allow me to purchase an investment property by borrowing ALL of the required funds while informing my seller of my cash position. My standard contingency (certainly nothing new or magical) read as follows:
“This offer is contingent upon the buyer obtaining financing from ABC Lenders. A prequalification letter from such lender is attached.”
The difference between this financing contingency and a “weasel clause” is that it discloses truthfully to the seller upfront that I am dependent upon my hard money lender to provide me with enough money to purchase their property. I'm not hiding anything or creating an escape hatch.
Financing Contingencies In Practice
As I quickly discovered when making offers on bank REO properties, weasel clauses were unacceptable even if I did intend to use them. Banks had been burned by weasel clauses time and time again, and they weren't accepting contracts containing them. In fact, they were selling their properties “as-is,” so inspection contingencies were out of the question as well. My only choice was to make truly clean offers (no contingencies) or offers with a financing contingency. Since I didn't have my own cash, I had to make offers with financing contingencies.
As with many of you, my goal when I first started was not want to buy homes but rather to wholesale them, pick up my check, and move on to the next deal. Now, if I purchased a home at the right price, wholesaling was not a problem as I always had buyers waiting in the wings. However, if my offers were too high, it was difficult to find a wholesale buyer since I had paid too much.
Chances were if I paid too much for a house and couldn't wholesale it, then my hard money lender wouldn't give me enough money for the purchase either. They might have agreed to finance a portion of it, but if I didn't have the rest of the funds required to settle, I couldn't buy the home and they didn't have any choice but to turn down my loan request. If they turned me down, I could exercise my financing contingency to release myself from the contract.
Now, I'm not suggesting that anyone should attempt to wholesale properties by haphazardly making offers that may or may not be too high knowing that the financing contingency can legitimately bail them out. Whenever you start to exit a lot of deals, however ethically or gracefully, sellers will still be upset and word will start to spread that you can't be trusted to settle and your offers won't be accepted. Plus, you risk losing your earnest money deposit, depending upon the language in your contract.
What I do recommend is that you to go into every deal with the intent of closing if at all possible. Even the “cash poor” among you should take heart. It won't be long before you have some cash to assist you in those situations where your hard money lender comes up short. In my case, I was only three months into my investing career before I had made $23k and was able to put away some cash which enabled me to purchase and rehab some of my “bad” wholesale deals on my own, even when my hard money lender couldn't finance the whole purchase.
Hidden Problems Not A Problem
While you might not be able to insert an inspection clause into your contract, you will still be protected from material defects in the property by your financing contingency. For example, let's assume that after signing a contract to purchase a home, you discover some major repair issues that weren't disclosed or uncovered prior to your making an offer (by major, I mean significant structural damage, a dry well, etc. Most little things don't make a difference since you are buying properties at such reduced prices). Upon discovering this problem, you have an obligation to your lender to call them so they can make an educated decision regarding the loan. They will reevaluate and probably reject your loan request, protecting themselves and preventing you from getting involved in a bad deal. As a result, you will be able to exercise your financing contingency and exit the deal.
On the other hand, you could keep the problem to yourself. But why? There isn't anything wrong with informing your lender of the problem. In fact, it's your duty and what they expect. How do you think they would feel if they discovered the problem later? Furthermore, how do you think they would feel if they discovered you knew about the problem? Sure, you could hide the problem and involve both of you in a deal that you shouldn't be doing, but in the process you would jeopardize your relationship and prevent them from making an educated decision about how they invest their money. No question about it. You should be honest with your lender and move on to another deal.
Now, just as with your offering price, you should exercise care in doing your due diligence and arriving at a realistic repair estimate so you don't back out of too many deals. Don't get stuck in the details, but talk to an experienced investor and obtain a good understanding of the general repair costs in your area. When in doubt, estimate high, but try to remain in the ballpark. Otherwise, your offer will be too low to be competitive.
So, whether you need protection from high offers or significant repair issues, if you use your financing contingency correctly, it is the only clause you will ever need. Personally, I have only needed it twice. On both occasions, I was off the mark with my offers and could not obtain enough financing from my hard money lender as a result. In both cases, I was released from my contract through my financing contingency. As I said before, it's the only contingency you'll ever need.