One of the things that I get to do from time to time is to teach classes to real estate agents. It is an opportunity for me to provide the insight of one who does not actually negotiate or broker real estate sales to those who do (it's that old saw - those who can't - teach).
This class is my favorite - things that listing agents should do, but don't. I have to preface this post by saying that I have been practicing law for twenty years. Ten of those years as a litigator, and ten as a real estate transactional attorney. The perspective I have is legal - what happens when contracts don't close? This leads me to an investigation of why it did not close. The final part of the inquiry is what to do to prevent the issue from causing a contract failure again.
There are three general things that listing agents can and should do to prevent a contract from failing. This post will deal with one - demanding substantial earnest money.
Think about trying to sell real estate from the seller's perspective. The first thing is pretty obvious - the seller wants to obtain the most money he or she can for the property. Next, the seller needs to sell the property as quickly as they can. Third, the seller needs to conserve cash to buy the replacement property.
These three motivations are always in a state of flux. Sometimes a seller is willing to take a lower offer than he otherwise might in order to close the sale more quickly, or not to have to put cash into the property for repairs. A seller might demand a premium to accept a contract that has more contingencies for financing than one that does not. This list is not meant to be exhaustive, but rather to show that the decision whether to accept a particular offer is usually the product of weighing many conflicting factors.
The biggest thing that listing agents can do is to require more earnest money. Why do we have earnest money anyway? The common wisdom is that a real estate contract is not enforeceable without earnest money. However, this is not true. The mutual promises to buy and sell are sufficient, if in writing signed by those making the promise, to support enforcement of a real estate contract. Earnest money is just what the name implies - a show of good faith. Thus, in order for a buyer to show true intent to purchase and the financial ability to consummate the transaction, the buyer puts up a substantial sum of cash.
Something happened to earnest money though - it seems that with the advent of easy credit and 100% financing, the amount of earnest money got smaller and smaller. This was true even in a market where there was fairly strong demand for housing. Credit was so easy, sellers simply did not care about the amount of earnest money the buyer put down. It seemed that almost anyone or anything could get financing!
Which brings me to my first observation - if a listing agent wants to give her client confidence that the contract will close, demand significant earnest money. A good rule of thumb is to demand an amount of earnest money that will compensate the seller for his carrying charges (either rental value or interest payments, taxes, insurance and upkeep) for the property during the time it takes to close the contract.
This is important - if a property is off the market for a month and then the buyer defaults, $500.00 dollars will not come close to reimbursing the seller for what he had to pay to carry the property for that period of time. In addition, there is little or no security for the broker's commission if the deal does not close due to the breach by the purchaser.
The usual objection that I hear to my suggestion that listing agents demand more earnest money is that buyers won't pay it - they too need to conserve cash to close, and will simply move on to the next property. I would respond that if the buyer moves on, then you have done the seller a valuable service. You saved your seller from having to endure the emotional stress of waiting for a month and then not closing the deal. - Or worse, getting strung out through a series of missed closing dates while the buyer struggles to obtain financing.
The other big advantage of asking for substantial earnest money is that it filters out the people who won't be able to close the deal from those financially able to consumate the transaction. This is truly important because at the end of the day, while it is nice to be fairly compensated for the time value that the property has been off the market, the objective is to close the sale. Financial qualification of buyers is another whole topic of things listing agents should do - but earnest money is big part of that.
Finally, substantial earnest money gives the seller leverage to close the deal. It prevents buyers from making superficial contractual commitments to buy your clients' house. The amount of money involved should be an amount that the buyer won't walk away from on a whim. It also allows you some wiggle room in the negotiation. It is something to "give away" when the buyer asks for financial concessions in a counter.
Too conclude, be bold. Listing agents, ask for three month's mortgage payments as earnest money. You will make your clients happy, and frankly, in this day and age, it will be nice to know that the buyer has some skin in the game. But then, what do I know? I just close the deals!
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