Understanding Mortgage Contingencies in Single Family Real Estate Investment

Here's the basic definition of a contingency: it's a condition or event that must be fulfilled before a real estate contract is binding on all parties involved.

There can be many contingencies in contracts. A typical example involves inspection of the property: "This contract is contingent upon a satisfactory inspection of the home being completed by January 16 that reveals no significant defects. If defects are discovered, the Seller will correct them or provide compensation to correct them."

As you'll see later, buyers often have contingencies for mortgage financing, the sale of another property, appraisals and many other items.

Contingencies exist for a very good reason; they provide protection against potential or hidden legal or structural problems for both buyers and sellers.

For buyers, it's good way to make sure everything is place before making an offerfinancing, good property condition, etc.

Sellers, on the other hand, want to qualify buyers so they know they're serious about the purchase of the property and can meet all necessary obligations. Before a contract is signed, both parties must agree on all contingencies.

Generally speaking, there are three results as a result of contingency negotiations: The contingencies are met. If all contingencies are agreed upon, the sale proceeds; it's no longer subject to cancellation or modification of those items. The contingency is waived or removed. These two actions can be done by either the buyer or the seller, depending on who the beneficiary is. Example: a 1031 tax deferred exchange contingency by a seller. Originally, she indicated the property would be identified as a replacement one, but later decided not to do an exchange. So, the seller notifies the buyer that she's waiving that particular contingency. The contingency is rejected or fails. For example, assume an appraisal reveals there's serious damage to a property's foundation. Receiving this information, the buyer decides he's no longer interested in the property because the repair costs are too high. In this case, the contingency fails, and the buyer receives his earnest money back.

Contingencies will vary with the type, size, and location of the property and the needs of the buyers and sellers. However, the following contingencies should be included in every agreement (depending on whether it's a residential or commercial/industrial property):

Property appraisal.

Require that a licensed independent professional conduct property appraisal. Naturally, the appraisal should show that the property is at a value equal to or greater than the proposed purchase price. If you're the buyer, this keeps you from overpaying for the property.

Books/records inspection.

This contingency is especially important for multi-unit, commercial and industrial properties. As a buyer, you need to know the income and expense statements as well as the nature of the lease. To make sure the seller is giving you real and accurate numbers, request their IRS Schedule E statement. He or she isn't legally obligated to provide those numbers, but you're putting them on notice for future legal action if the numbers are misleading or false.

Contracts.

If you're the buyer, be sure you get copies of all current service agreements and contracts associated with a commercial/industrial property. Unless they're especially attractive to you, you may request that the seller cancel or end all non-essential contracts at the end of escrow. That way you have the option of bringing in your own vendors.

Financing.

The terms of the loan should be spelled out in detailtype of loan, maximum interest rate, etc. If you plan on assuming existing financing, get copies of the current loan documents and the most recent loan statement.

Marketable title.

If you're the buyer, get a preliminary title report. It should have copies of each and every exception. Have your attorney review these documents carefully.

Physical inspection.

As a buyer of a residential or commercial property, you should always have a physical inspection of the property done. In the case of commercial/industrial properties, your team of property inspectorsroofing, plumbing, electrical specialists, etc.--should have unlimited access to the interior and exterior. They should conduct a complete inspection so you can use this information to negotiate with the buyer to do one of three things: make the necessary repairs, adjust the purchase price or terminate the purchase agreement.

Property survey.

Often required by lenders, an ALTA property survey shows all the boundaries of a commercial/industrial property as well as the site plan for existing improvements. In addition, it should include any easements and restrictions.

Additional contingencies:

Testing for lead, radon, mold and other toxic substances. Inspections for termites and other wood destroying insects. Testing of private well water to make sure it meets health standards.

When dealing with contingencies, it's important to make sure they're written in clear and specific terms. Otherwise, misunderstandings, misinterpretations, and a lot of expensive aggravation can occur. Here are two examples of badly written contingencies:

"Contingent on a water test"This doesn't specify what kind of water test; e.g. should it test for bacteria levels or heavy metals or pesticides? If you don't specify, it may not get tested and you could end up with clean-up costs you don't need. "Contingent on a septic permit"This doesn't specify the type of septic system requireda conventional one or one specified by local laws. From these two examples, you can see that it pays to know all regulationslocal, state and federalconcerning real estate.

Key Point: As either a buyer or a seller, it pays to know federal, state and local regulations concerning properties so you can handle them in contingencies. A lot of knowledge can keep repair dollars from flying out of your pocket after purchasing a property!

Jack Sternberg