Perils of a hot market: Contingencies are in a real estate purchase contract for a reason

With high demand, low inventory, and unprecedented appreciation, the hot California residential real estate market we’ve experienced for the last several years has resulted in a fact pattern that we’ve now seen on many occasions: Homebuyers, eager to get into the market, have been outbid on several other properties.

They then find another potential “dream home” and receive from the seller’s agent a disclosure package with a short fuse for offers to be received and for escrow to close.

Not wanting to lose out again, the buyers make an over-asking offer with a short close. And, relying entirely on a visit to the property and the disclosure package (sometimes without fully understanding the package or even reviewing it in detail), and against the written advice of their agent, they waive all contingencies with their offer.

The offer is accepted, the buyers put a 3% initial deposit into escrow, and the buyers and sellers are now in contract.

After the parties are in contract, however, something happens that causes the buyers to want to renegotiate or cancel the deal.

In the past, that “something” has typically been that the buyers discovered something about the property that wasn’t disclosed.

Even with a contingency waiver, the seller still has a legal duty to disclose all facts that might materially affect the value or desirability of the property. Buyers in that situation therefore could take the position that they would not have entered into the deal if they had known the true facts.

At that point the typical result was that the parties would renegotiate the price, or agree to cancel the contract and return some or all of the deposit. The sellers would then re-list the property, with supplemented disclosures, and in a rising market they would typically be able to sell the property for more than the price of the canceled contract.

More recently, however, the “something” that has changed for the parties after entering into the contract is related to rapidly-changing financing and market conditions.

With interest rate hikes beyond what we’ve seen in recent history and more on the way, buyers are now finding themselves either unable to get the financing they were counting on to close the deal, or fearful that they will be able to sell their current homes at the price they were counting on to close on the new one.

And sellers, fearful that they may not be able to sell their property at the same price to someone else, are less motivated to let their buyers out of the deal, or to release their deposit.

If the buyers have waived all their contingencies, there isn’t much that can be done to help them from a legal standpoint.

To understand why, and why the contingencies are there in the first place, it’s important to grasp these:

1. What are the contingencies, and why are they there?
2. What are the bases for a buyer to cancel a purchase contract?
3. What happens if a buyer wants to cancel but the seller won’t agree?

What are the contingencies?

Assuming the parties are using the standard California Association of Realtors form Residential Purchase Agreement (December 2021 revision (PDF sample); “agreement”), the contingencies spelled out in paragraph 8 are these:

• Loan
• Appraisal
• Investigation of property
• Review of seller documents
• Preliminary title report
• Common interest disclosures (if applicable)
• Review of leased or liened items (if applicable)
• Sale of buyer’s property (if both sides agree).

In rare cases, there may also be a seller’s contingency for the acquisition of a replacement property.

From the buyer’s standpoint, these contingencies are there for a simple but important reason: To make sure the buyer knows what he or she is getting into, and to have a contractual way to end the deal if things change after the parties go into contract.

If a buyer is for some reason (such as a change in job status, or a change in available interest rates) unable to obtain appropriate financing, or if the property doesn’t appraise high enough to support the needed financing, the Loan and Appraisal contingencies give the buyer a way out.

If something that wasn’t known going into the deal is discovered about the title to the property, or about its physical condition, the contingencies for Title, Investigation, and Review of Seller Documents allow the buyer to call the deal off. In short — the contingencies are there to protect the buyer from having to complete a deal that turns out to be different from what was expected going into it.

What are the bases for a buyer to cancel the purchase contract?

Depending on the circumstances, and if the buyer hasn’t waived the contingencies, there are potentially both contractual and non-contractual bases for a buyer to cancel the purchase contract.

Under paragraph 14D of the agreement, the contractual bases fall into two categories:

1. The seller hasn’t removed its contingencies or performed its contractual obligations.
2. The buyer in good faith hasn’t removed all of the buyer’s contingencies.

But here’s the problem: The first category typically won’t help a buyer cancel the contract because there usually aren’t any seller contingencies — and even if there were, under the agreement, the seller must first be given three days notice to perform (either by lifting the seller contingency or fulfilling a contractual obligation such as providing disclosure documents).

That means that, as a practical matter, the only contractual basis for a buyer to cancel is by way of the buyer’s contingencies — which in turn means that, if the buyer has waived all contingencies, there typically is no contractual basis to cancel the contract.

The only other way a buyer might be able to cancel the contract is, as mentioned above, if he or she is able to prove that there was a material misrepresentation in the disclosure documents, and that they never would have entered into the deal in the first place had the true facts been known.

But going down that road can be expensive, with an uncertain outcome.

What happens if the buyer wants to cancel and get its deposit back, but the seller refuses?

Under the agreement, the deposit cannot be released by the escrow officer without the written consent of both the buyer and seller, or by order of an arbitrator or court.

That means that the only way to change the status quo is for the parties to reach an agreement on their own, or, failing that, to resolve the dispute through mediation (which is required by paragraph 20 of the agreement), or through binding arbitration (if both parties have initialed paragraph 31 of the agreement) or court trial.

These processes can be expensive, and depending on the amount of the deposit, can sometimes exceed the amount at stake. Importantly, the agreement (paragraph 22) also provides that whoever wins in arbitration or court trial is entitled to recover their attorney’s fees from the other side (if the prevailing party had previously agreed to participate in the required mediation process).

Why waiving contingencies isn’t a good idea

Conclusion and take-away message. The agreement is a legal contract, with important terms that may direct the outcome of a dispute, depending on the circumstances. It’s important that buyers — and sellers — know and understand those terms before signing on the bottom line. That’s especially true as to the buyer’s contingencies. It was never a good idea from a legal standpoint to for buyers to waive their contingencies — and that is especially true now, with rising interest rates, an uncertain economy, and the potential for a changing real estate market.