Buying_a_home_with_contingencies_v3
00:00:00.000 | Hello everybody, it's Sam from the Financial Samurai Podcast.
00:00:03.800 | And in this episode, I wanna talk about buying a home
00:00:06.980 | with contingencies, whether it's financing contingencies
00:00:10.200 | or home inspection contingencies.
00:00:12.520 | There are actually many types of contingencies.
00:00:15.160 | And the reason why I am talking about this specific topic
00:00:19.100 | is because I think it was overlooked as one of my posts.
00:00:23.560 | Maybe it's summertime or maybe I just didn't write the post
00:00:27.800 | insightful and entertaining enough.
00:00:30.360 | But this is one of the most important posts you can read
00:00:33.560 | if you're looking to buy a home ever, okay?
00:00:37.260 | Ever, I'm not just talking about right now, but ever.
00:00:40.620 | For most people, I think they go into a home
00:00:44.280 | and buy it with contingencies.
00:00:45.960 | But for me, I haven't bought a home with contingencies
00:00:49.000 | in I would say the past three homes.
00:00:51.120 | So that's a long time.
00:00:53.000 | The last time I bought a home with contingencies
00:00:54.720 | was my very first home
00:00:55.800 | because I didn't really know what to look for.
00:00:58.060 | But now that I've remodeled,
00:00:59.920 | gut remodeled multiple homes before,
00:01:03.220 | I've met with multiple inspectors, plumbing,
00:01:06.060 | electrical, building, and city inspectors.
00:01:09.640 | I know what to look for when buying a home.
00:01:12.360 | Therefore, having a home inspection contingency
00:01:15.520 | is not as necessary in a competitive market.
00:01:19.240 | Now, markets turn, real estate cycles go up and down.
00:01:23.480 | And currently, there's a lull on the coast,
00:01:26.800 | at least here in San Francisco.
00:01:28.760 | And so I'm trying to take advantage and upgrade homes
00:01:31.800 | because I love real estate.
00:01:33.060 | I love to enjoy the house that I live in
00:01:36.040 | and potentially make money.
00:01:37.240 | I think it's the best usage of your funds.
00:01:40.620 | Whereas stocks, yeah, it goes up, but then it goes down.
00:01:43.620 | You never really gain any utility.
00:01:45.240 | So I'm in the process of buying a home
00:01:47.400 | and I was able to get into contract with a contingency,
00:01:51.200 | a home inspection contingency.
00:01:53.880 | And it's very eye-opening for me
00:01:56.080 | because I haven't written about this in the past
00:01:58.120 | and I wanna help you think as a real estate investor
00:02:01.280 | how you can really profit when you have a contingency.
00:02:05.560 | All right, once your offer is accepted with a contingency,
00:02:09.720 | you must send an earnest money deposit
00:02:11.560 | equal to one to 3% of the value of the home
00:02:14.200 | to an escrow company.
00:02:15.520 | This is to protect both parties.
00:02:17.620 | The escrow company holds the money
00:02:19.160 | until all contract conditions are met on both sides.
00:02:23.280 | And please know before wiring any money,
00:02:25.560 | call the escrow company
00:02:26.880 | and confirm the wiring instruction before sending.
00:02:29.440 | I've seen horror stories about folks wiring money
00:02:33.240 | to wrong accounts because the emails,
00:02:36.980 | the emails were getting intercepted by some hacker.
00:02:39.940 | So just be careful, call ahead, confirm, confirm, confirm.
00:02:44.320 | And then contingencies are conditions
00:02:46.220 | written in your real estate offer letter
00:02:48.040 | to protect yourself from losing your earnest money deposit.
00:02:51.320 | It's usually about 3% earnest money deposit.
00:02:53.960 | So for example, if for some reason
00:02:55.360 | the bank decides not to lend you money,
00:02:57.920 | if you have a financing contingency,
00:02:59.760 | you have a penalty free out.
00:03:01.480 | So in other words, you can not buy the home
00:03:03.760 | and you can get all your 3%
00:03:05.880 | or whatever percent earnest money deposit back.
00:03:08.560 | Now let's say you have a home inspection contingency
00:03:11.620 | and you find during your due diligence,
00:03:14.020 | there's a leak, a damaged part of the roof
00:03:16.600 | and the seller isn't willing to fix it or pay for it
00:03:20.240 | or negotiate a lower price.
00:03:22.200 | Well, you have the option, penalty free,
00:03:25.160 | of withdrawing your offer
00:03:26.720 | and getting your earnest money deposit back.
00:03:29.580 | Such contingencies have expiration dates, note that.
00:03:33.200 | And when that date comes,
00:03:34.560 | the prospective buyer must sign a document
00:03:37.800 | that releases the contingencies.
00:03:40.120 | It's not a, oh, we got to that date,
00:03:42.160 | it automatically expires,
00:03:43.840 | the earnest money deposit is mine if you don't buy it.
00:03:45.880 | No, no, no, no.
00:03:47.000 | You have to look at the document and sign.
00:03:50.720 | It's usually a docusign, electric signature,
00:03:53.320 | where you say, I release contingencies.
00:03:55.960 | So then after that,
00:03:57.660 | your earnest money deposit is at risk.
00:04:00.660 | Therefore, it is vital, vital, vital
00:04:03.660 | that before you release any contingencies,
00:04:06.080 | you get all your ducks in order,
00:04:08.400 | you do your due diligence thoroughly.
00:04:11.760 | So obviously from a home seller's perspective,
00:04:14.040 | they prefer not to have any contingencies in the offer,
00:04:16.720 | no financing, no home inspection contingencies.
00:04:19.400 | In a hot market, they could afford that.
00:04:21.920 | People just wanted to get in.
00:04:23.880 | And if you offered contingencies,
00:04:26.160 | well, it made your offer uncompetitive.
00:04:28.920 | But now, finally, if you've been renting all these years,
00:04:31.960 | if you've been waiting for the right time to buy,
00:04:34.840 | well, because mortgage rates are averaging,
00:04:37.840 | supposedly 7% for an average 30-year fixed,
00:04:41.160 | the demand has waned because affordability has decreased.
00:04:45.960 | 7%, it's not super high in a historical context.
00:04:49.640 | I remember getting a 6.5% mortgage rate
00:04:52.200 | in, what's that, 2003, 2004, 2005.
00:04:55.440 | I thought I was fine.
00:04:56.840 | And home prices still went up before, of course,
00:04:59.400 | the 2008, 2009 crash.
00:05:02.720 | But from a historical perspective,
00:05:04.280 | mortgage rates are not high.
00:05:06.320 | But from a recency perspective,
00:05:08.240 | given we could have all refinanced under 3%
00:05:10.640 | for a 30-year fixed, it does feel high.
00:05:14.040 | So demand is softer in some regions of the country,
00:05:17.560 | most notably on the West Coast.
00:05:20.040 | And so, therefore, homebuyers have an opportunity
00:05:22.560 | to buy if they have the down payment
00:05:24.760 | or if they have a lot of cash to pay cash, all cash for a home.
00:05:28.560 | Now, why do I say buying a home with contingencies
00:05:31.040 | is like getting a free call option?
00:05:33.000 | Well, call options are financial contracts
00:05:36.280 | that give the option buyer the right
00:05:39.440 | but not the obligation to buy a stock, a bond, a commodity,
00:05:43.520 | or other asset at a specified price
00:05:46.600 | within a specific time period.
00:05:49.680 | A call buyer profits when the underlying asset increases
00:05:53.080 | in price.
00:05:54.360 | And in this case, this podcast episode,
00:05:57.160 | the underlying asset is a house.
00:05:58.800 | And I want you to click over to the post,
00:06:00.560 | and you can just see a chart that
00:06:02.400 | highlights how you make money through buying a call option.
00:06:07.480 | Once you send in your earnest money deposit
00:06:09.560 | and get your offer accepted with contingencies,
00:06:12.960 | you don't have much downside risk
00:06:14.800 | at all until the contingencies are removed.
00:06:17.760 | You now have the free call option
00:06:19.800 | to buy the property at an agreed upon price at no cost to you.
00:06:24.840 | You're in escrow period, right?
00:06:26.560 | And the average escrow period is something around 30 to 45 days.
00:06:30.080 | But I've seen it go to 90 days or even longer.
00:06:34.080 | At the same time, you have the upside profit potential
00:06:37.280 | as time goes on.
00:06:38.640 | Time here is a huge variable in a call option.
00:06:43.680 | So in order to potentially make the most money off a home
00:06:47.320 | as possible, you want to have as long of an escrow
00:06:51.000 | period as possible.
00:06:52.200 | So that's time.
00:06:53.520 | To do so, one strategy is to input long contingency
00:06:57.320 | durations.
00:06:58.400 | And then another strategy is to extend the escrow period
00:07:01.560 | as many times as possible.
00:07:03.960 | So now you're asking, well, why?
00:07:06.080 | Why is the free call option more valuable the longer
00:07:10.440 | the contingency duration, the longer the escrow period?
00:07:14.160 | Well, it's because the more time you have,
00:07:16.560 | the more time you get to make a more informed home
00:07:19.440 | buying decision.
00:07:21.000 | So imagine getting into contract to buy
00:07:23.640 | $1 million worth of the S&P 500 index at a strike price of $4,500.
00:07:29.000 | If the contract lasts only 30 days, that's not a lot of time.
00:07:33.360 | You wouldn't be willing to pay a lot for that contract
00:07:36.160 | to buy $1 million worth of the S&P 500 index.
00:07:39.240 | I calculate maybe it's worth $8,000, or 0.8%
00:07:43.600 | of the value of the purchasing power.
00:07:46.440 | All right, now, let's say you have a call option
00:07:50.080 | to buy $1 million of the S&P 500 index at a strike price of $4,500,
00:07:55.040 | but the duration is 10 years.
00:07:58.080 | You have 10 years to decide whether you want
00:08:00.720 | to buy $1 million at $4,500.
00:08:02.840 | At a 7.2% annual rate of return, the S&P
00:08:05.800 | will have doubled in 10 years.
00:08:07.720 | So that $1 million will have gone to $2 million.
00:08:12.320 | Hence, the value of the contract is much greater
00:08:15.120 | than the previous example of $8,000,
00:08:17.120 | because it only lasted 30 days.
00:08:18.800 | With a 10-year option, you might be
00:08:20.600 | willing to pay $500,000, $600,000, $700,000
00:08:25.440 | to have the option to buy $1 million at $4,500,
00:08:29.280 | because the probability, based on historical returns, 7.2%,
00:08:34.160 | it's kind of in the realm.
00:08:36.040 | And if it's below that, well, you
00:08:37.720 | can calculate your break-even cost.
00:08:39.720 | And if it's above that, you're going to make a lot more money.
00:08:42.720 | So you can extend this type of thinking to buying a home.
00:08:46.960 | Let's say you put down a $30,000 earnest money
00:08:49.320 | deposit to buy a $1 million home, 3% earnest money deposit.
00:08:53.520 | The contingency duration is 45 days for buyer's investigations.
00:08:59.000 | And after the contingency duration expires,
00:09:01.600 | you then have another 15 days to come up with all the funds
00:09:05.200 | to close, because that's what's written for the close
00:09:07.720 | of escrow target date.
00:09:09.760 | Now, without an extension, the total escrow period is 60 days.
00:09:14.080 | Now, let's say during this 60-day process--
00:09:16.920 | or let's just say 45-day process for the contingencies--
00:09:21.080 | that there's peace in Ukraine.
00:09:23.200 | In addition, the federal government
00:09:25.040 | announces it's going to do another quantitative easing
00:09:28.000 | for some reason with a surprise $3 million stimulus package
00:09:32.120 | to create more jobs.
00:09:34.120 | After all, it's election year coming up.
00:09:36.160 | You've got to buy your votes, right?
00:09:37.800 | So due to these two factors, the S&P 500 rises by 10%.
00:09:43.440 | 10% in 60 days is huge.
00:09:45.640 | That's a raging bull market.
00:09:47.840 | Now, with a lot more wealth created in the economy
00:09:50.880 | during this 45- to 60-day period,
00:09:55.040 | the value of your home might have appreciated
00:09:56.960 | by another 3%.
00:09:59.400 | Now, if that's the case, you absolutely
00:10:02.520 | want to buy that house.
00:10:04.040 | It's a free call option to buy it at 3% below market value.
00:10:09.280 | Now, let's look at it the other way.
00:10:12.040 | During the 45-day contingency period,
00:10:14.200 | let's say China decides to invade Taiwan.
00:10:16.880 | In addition, a major employer near the house's neighborhood
00:10:21.080 | you want to buy decides to shut down, and 5,000 jobs are lost.
00:10:26.880 | As a result, the S&P 500 declines by 20%
00:10:30.120 | during this 45-day contingency period.
00:10:32.560 | In this situation, the value of your house
00:10:36.040 | may have depreciated by 5% to 7%, or $50,000 to $70,000
00:10:42.240 | on a million-dollar house.
00:10:44.160 | So what are you going to do now?
00:10:46.200 | Well, if you choose not to drop your contingencies,
00:10:49.040 | you can walk away.
00:10:50.640 | You can also negotiate for a lower purchase price.
00:10:55.000 | There are no standard contingencies
00:10:56.960 | for exogenous variables like war,
00:10:59.080 | although you could write one into the contract.
00:11:01.000 | Anything is negotiable.
00:11:02.640 | But if you have a contingency in your offer,
00:11:04.600 | you can always find an excuse not to move forward,
00:11:07.360 | not to buy the house, or not to pay the price you agreed upon.
00:11:11.920 | Everything is negotiable.
00:11:14.480 | These examples should help illustrate,
00:11:16.760 | from a financial perspective, why sellers want faster closes
00:11:21.080 | and why buyers should want longer closes.
00:11:24.840 | The more time a buyer has to survey market conditions,
00:11:27.880 | the more ammunition buyers have to make an optimal home
00:11:31.720 | purchase decision.
00:11:33.520 | Now, technically, there is some opportunity cost
00:11:36.120 | after sending in your earnest money
00:11:37.800 | deposit to get into contract.
00:11:39.840 | That opportunity cost is the income
00:11:41.720 | or returns you could have made if you had invested down
00:11:44.760 | payment instead.
00:11:46.200 | And with rates at 5-plus percent,
00:11:48.360 | that opportunity cost is significant for a large down
00:11:51.400 | payment.
00:11:52.520 | Some states do require escrow to pay an interest
00:11:55.080 | on the earnest money deposit, but the rates are very low.
00:11:58.400 | I checked here in San Francisco, California,
00:12:01.000 | and escrow is required to pay something like 0.1%.
00:12:05.240 | So who cares?
00:12:06.120 | That is a PITA.
00:12:08.440 | Although there is minimum financial downside risk
00:12:10.880 | if you make an offer with contingencies,
00:12:13.040 | there's also the cost of your time
00:12:15.360 | and the added stress you may feel in buying a home.
00:12:19.520 | So if you're not one to like contract negotiations,
00:12:23.720 | negotiating, making people sweat,
00:12:27.200 | and dashing your dreams and hope,
00:12:29.200 | well, this sort of buying strategy,
00:12:32.880 | of buying with contingencies and extending and negotiating,
00:12:37.280 | isn't going to be very pleasant.
00:12:38.840 | But if you're like me, who loves to write about real estate,
00:12:41.720 | who loves to buy real estate, who loves to get a good deal,
00:12:44.900 | and who loves to understand the various strategies involved
00:12:47.720 | to help y'all, listeners and readers,
00:12:50.720 | get a better real estate deal for yourself,
00:12:53.640 | well then, this to me is a goldmine process that I love.
00:12:57.680 | Let me share a real life example of my escrow process.
00:13:02.240 | Back in April 2020, I stumbled across my primary residence.
00:13:07.240 | It was listed, I think it was in mid-April, right?
00:13:10.600 | And I said, "Wow, this is a great house.
00:13:12.960 | "Panoramic ocean views on all three floors,
00:13:15.360 | "nice space, good for work from home.
00:13:17.820 | "What a great house, I wanna buy it."
00:13:20.160 | And I talked to the listing agent over a course
00:13:22.800 | of maybe five sessions, private sessions, 12 hours,
00:13:26.880 | and we developed a working relationship.
00:13:29.320 | And ultimately, I let him represent me through dual agency.
00:13:33.480 | And he really fought for me.
00:13:34.680 | It was pretty amazing, because he convinced the seller
00:13:38.320 | to go with my offer, which was $100,000 lower
00:13:42.120 | than a competing offer, for various reasons too.
00:13:45.760 | And so I got into contract, and I just realized
00:13:49.320 | I did have a contingency.
00:13:50.960 | I had a financing contingency.
00:13:53.200 | And the financing contingency was that I would get financed
00:13:56.760 | by a bank for the rest of the payment of the house.
00:14:00.160 | I put down, I think it was 40%, and I financed 60%.
00:14:04.720 | And that was a strong down payment that went in my favor.
00:14:07.600 | And I was going with a big bank,
00:14:09.440 | which also went in my favor.
00:14:10.680 | So the seller was like, "Oh, big bank,
00:14:12.520 | "you got a good down payment.
00:14:13.640 | "We're gonna go with you, not this other potential buyer."
00:14:17.600 | So we got into contract in June, beginning in June 2020,
00:14:22.120 | and it was a 30-day close.
00:14:24.360 | 30 days is reasonable if you have financing contingency.
00:14:28.440 | And about the last week of the 30-day close,
00:14:31.220 | I started to get cold feet, because if you can recall,
00:14:35.080 | June 2020, things were still under lockdown.
00:14:38.920 | Things were still uncertain.
00:14:40.640 | I think many of us hoped we would have one week,
00:14:43.080 | two week lockdown, maybe one or two or three months max,
00:14:47.720 | but not April, May, June, third month of lockdown, right?
00:14:51.320 | So I was thinking to myself,
00:14:52.400 | man, is this the right move to spend more money on a home
00:14:56.680 | we don't really need, although we were going through
00:15:00.160 | a gut me remodel process with our existing home
00:15:02.880 | on the downstairs floor?
00:15:04.980 | Is this a good idea to spend this much money on a home
00:15:07.220 | while we're still under lockdown?
00:15:09.120 | And so I said, "Well, let me see if I can extend escrow."
00:15:13.420 | So essentially, that's what I did for another 30 days,
00:15:16.600 | because I wanted to buy myself time
00:15:19.480 | to get the right financing,
00:15:20.920 | but also to see if the stock market and the economy recover
00:15:25.120 | and if the government would step in.
00:15:26.840 | And so every single week, the market started rebounding
00:15:31.200 | after, what was it, March 18 meltdown, right, for 30 days.
00:15:36.160 | And then after that, so at the end of April
00:15:38.760 | and then May, June, things started to recover,
00:15:41.320 | especially since the government stepped in
00:15:43.560 | with their bazookas with economic stimulus.
00:15:46.120 | So this time, buying more time
00:15:48.400 | gave me more confidence to buy this house.
00:15:51.320 | And as a result, it ended up being a optimal,
00:15:54.840 | or at least a good financial decision,
00:15:56.840 | because home prices increased since mid 2020.
00:16:00.800 | So if you're planning to buy a house in this lull,
00:16:04.080 | I would suggest buying one with a contingency
00:16:06.960 | and have the longest contingency possible.
00:16:09.440 | You need to calculate the probabilities
00:16:11.520 | of a couple things as well.
00:16:13.080 | One is the probability the home will close
00:16:15.400 | by a certain date, your escrow closing date.
00:16:18.640 | And then two, the probability
00:16:20.000 | of you actually purchasing the home.
00:16:22.640 | If you're like me, you like to look at a lot of properties.
00:16:26.000 | You sometimes spray and pray and make offers
00:16:28.320 | on overpriced or underpriced properties.
00:16:31.140 | You never know unless you give an offer
00:16:33.480 | and you see what happens, right?
00:16:34.620 | I've seen many homes sell for below what I thought.
00:16:38.080 | And I was kicking myself thinking,
00:16:39.240 | man, I should have put an offer on the home
00:16:41.120 | for a competitive price.
00:16:44.220 | Anyway, the reason why you need to calculate
00:16:46.800 | your probabilities of when the home will close
00:16:49.360 | and whether you will actually purchase the home
00:16:50.840 | is because you've got to figure out
00:16:52.240 | how you're gonna invest your down payment.
00:16:55.160 | For most people, your down payment
00:16:57.720 | is your sacred down payment.
00:16:59.700 | If it's 20%, you should probably have
00:17:02.000 | the vast majority of it in cash.
00:17:04.120 | 80 to 100%.
00:17:06.340 | But for other folks who like to take
00:17:07.640 | a little bit more risk, you can have some of it
00:17:10.280 | in liquid stocks, index funds, whatever it is you want.
00:17:15.280 | It just depends on your risk tolerance.
00:17:17.360 | Because the higher the probability you plan to buy the home,
00:17:20.600 | the lower the percentage of your down payment money
00:17:23.400 | should go to risk assets.
00:17:24.860 | And then vice versa.
00:17:25.960 | If you think there's only like a 20% probability
00:17:28.840 | you're gonna buy the home
00:17:30.600 | because the seller has to go through a lot of hoops
00:17:32.360 | due to the contingency as well,
00:17:34.160 | you can invest more like you normally would with your money.
00:17:37.560 | After all, let's say 2023, S&P 500 is up 20%.
00:17:42.560 | You don't want to just be twiddling your thumbs
00:17:45.120 | and having it all cash while the market is up so much.
00:17:48.440 | You would miss out on a lot,
00:17:49.600 | especially if you're paying all cash for a home.
00:17:52.080 | So these are some things to think about
00:17:54.320 | as you manage to buy a home with contingencies.
00:17:57.560 | The more stocks and other risk assets
00:18:00.520 | go up for your down payment fund,
00:18:02.560 | the cheaper the home and vice versa.
00:18:05.680 | Don't forget to calculate your future cash flow
00:18:09.200 | as well as how many other assets you can move around
00:18:13.020 | in terms of shifting assets from stocks
00:18:16.360 | or other investments to buying your home.
00:18:19.520 | The more assets you have, obviously,
00:18:21.840 | the more risk you can take on the down payment of your home.
00:18:25.080 | Alrighty, folks, I hope you enjoyed this episode.
00:18:28.400 | It really helps if you can think about buying a home
00:18:32.400 | like an investor with a lot of money at stake.
00:18:36.360 | Yes, we mostly buy homes to enjoy,
00:18:39.480 | create memories, raise our children,
00:18:41.400 | take care of our parents and our family members,
00:18:44.400 | but let's be frank here.
00:18:46.160 | A home is likely the most expensive asset
00:18:49.560 | you will buy in your life.
00:18:51.400 | So it behooves you to think like a rational, savvy investor.
00:18:56.480 | And this is part of the reason why I'm recording this podcast.
00:18:59.320 | It's actually the main reason why.
00:19:01.120 | I don't want y'all to lose money on a home.
00:19:04.080 | I want y'all to enjoy your home
00:19:05.840 | and make money in the future.
00:19:08.600 | Thanks so much, everyone, for listening.
00:19:10.320 | If you'd like to subscribe,
00:19:11.680 | check out financialsamurai.com/news.
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00:19:20.560 | And please share, rate and review this podcast.
00:19:25.000 | I'm just a one man band,
00:19:27.160 | but I'm trying to help you guys succeed
00:19:29.400 | because financial independence is worth it.
00:19:31.760 | Take care.
00:19:32.600 | [BLANK_AUDIO]