January 4, 2015

Bigger Bids Aren’t Always Better Bids

Read the article on Washington Post.

Bidding wars among would-be home buyers, once a rarity, seem to have become almost routine this frenzied spring. But even now, it’s not all about money, money, money.

What both buyers and sellers should understand is that the highest offer is not necessarily the strongest. There are many other terms in a contract that can come into play. Understanding how all these items relate is critical to putting together a successful bid, or choosing the strongest offer.

As real estate agents, we routinely counsel our buyers that they need a strategy to approach bidding wars: Analyze the available information; identify their key concerns; and then structure an offer that is as aggressive as possible yet still protects their interests and keeps the sales price within the range of reason.

Here are some of the most important terms that appear in the “Regional Sales Contract,” the Washington area’s most common standard contract form, and how would-be buyers and sellers should deal with them.

Price

· Description: This is the amount the buyer is offering to pay for the property. The amount can be more than, less than or equal to the seller’s asking price. A common misconception is that a seller is obligated to accept an offer that is at or above the asking price. This is not true: A seller’s listing of a property in the multiple listing service (MLS) is a solicitation of offers and not an offer itself. Another common misconception is that in a competitive situation, the offer with the highest price is the one that wins. However, this often is not the case.

· From the buyer’s perspective: Price is obviously a major factor in determining the strength of an offer. As a general rule, the higher the amount offered, the more likely the offer will be accepted. To determine what to offer, it is critical to do as much research as possible. At a minimum, a buyer’s research should include a thorough examination of comparable sales data, local, regional and national market trends, and, to the extent available, information about the seller, such as motivations for selling, preferred settlement date or the need for a rent-back. The buyer’s financial situation and level of interest in the property must be considered, too.

There are two things a buyer should remember when determining how much to offer in a competitive situation.

First, there is no one “right” price for a property. Because a buyer does not know what other prospective buyers will offer, he is operating with imperfect information.

Therefore, we advise clients to think about pricing an offer in terms of a “reasonable price range” for a property. Once the reasonable price range is established, the buyer can determine where in that range he wants to be. The higher the price offered within the range, the greater confidence we have that the seller will accept the offer.

A buyer should never write an offer that has a 100 percent chance of being accepted because that means the buyer is overpaying. By establishing a reasonable price range before determining what to offer, buyers can remain rational.

Second, in a competitive situation, prices are not compared in a vacuum. Sellers will frequently take a less risky, lower priced offer over a riskier, higher priced offer.

· From the seller’s perspective: Assuming that a seller has received multiple offers, there are a number of factors, in addition to price, that he should consider.

First, the seller should weigh the likelihood that the price offered will yield his anticipated net amount at the closing table. In other words, the more contractual rights the buyer retains to reduce the price (appraisal language) or to force the seller to have to pay for things (repairs or credits), the less certain the seller is that his profit will be unaffected.

Second, the seller should consider the financial ability of the buyer making the offer to close on the closing date — just because a buyer says he will pay $30,000 more than the asking price doesn’t mean that he can do it.

Finally, the seller should consider the nonfinancial terms of the offer (settlement date, rent-back offered, earnest money, etc.) to determine which works best given the seller’s situation.

Escalation Clause

· Description: An escalation clause is a common addendum to the contract in multiple-offer situations. This clause typically provides that if the seller receives one or more additional offers to buy the property that result in net proceeds to the seller equal to or greater than the net proceeds of this buyer’s offer, then the sales price in this buyer’s offer will automatically increase by a stated amount up to a capped price.

· From the buyer’s perspective: An obvious weakness of an escalation clause is that it tips the buyer’s hand to the seller. That means an escalation clause is not always in the best interests of a buyer.

We advise our buyer clients to use an escalation clause only if a certain combination of factors is present: The seller has established a deadline for presenting offers; we know that there will be at least two other offers; and our buyer client is willing to offer a price greater than the seller’s asking price.

If all of these factors are present, then we believe it’s generally advisable to use an escalation clause. That allows the buyer to offer the seller’s asking price with an escalation clause capping at the price that the buyer would have otherwise offered outright.

If the buyer just offers the higher price outright, he essentially creates a situation where the seller either accepts or rejects the offer at that higher price. However, by using an escalation clause, our buyer has a chance that his offer will be accepted at an amount below the higher price.

For peace of mind, when using an escalation clause, the buyer should think of the cap in the escalation clause as the amount he is offering.

· From the seller’s perspective: A common misconception is that a seller is not allowed to make a counteroffer for more than his asking price. This is not true. An escalation clause ostensibly tells the seller the maximum price a buyer is willing to pay for the property. There is no reason why the seller cannot counter a buyer’s offer at a price equal to or greater than the cap in the buyer’s escalation clause.

Of course, by countering the offer, the seller loses some control of the situation and risks having the buyer walk away. Another option for the seller is to ask the buyer to resubmit his offer at a desired price. By asking orally, as opposed to countering in writing, the seller is not rejecting the buyer’s original offer. If the buyer says no, then the seller still has a valid offer from the buyer.

Appraisal Language

· Description: A standard condition for a lender to lend money for a home purchase is that the property receives an independent appraisal at or above the purchase price. Because the purpose of the appraisal is to determine the fair market value of the property, this condition assures the lender that there is sufficient collateral for the loan. If the condition is not met — that is, the appraised value comes in less than the purchase price — then the lender may reduce the amount of the loan or even deny it.

The regional sales contract anticipates this possibility and includes protective language for the buyer. The contract language says that if the property appraises below the purchase price, then the buyer can ask the seller to lower the price to the appraised value. If the seller and buyer cannot agree on a new purchase price, then the contract provides that the parties can walk away from the contract and neither party is in breach.

In multiple offer situations, buyers sometimes “waive the appraisal language,” meaning that they strike this protective language from the contract. By doing so, the buyer is saying that he will proceed with the transaction no matter what value the appraiser determines. If the buyer has waived the appraisal language and the property appraises below the purchase price, the buyer may need to come up with additional funds to make up the difference between the appraised amount and the purchase price.

· From the buyer’s perspective: Examining comparable sales data can provide a fairly good idea whether a property will appraise at or above the purchase price. However, an appraisal is an independent assessment and, sometimes, more art than science. There are no guarantees that a property will appraise at or above the purchase price. An offer that includes the appraisal language poses a real risk to the seller.

Waiving the appraisal language can be an effective way for a buyer to make his offer more attractive. Most homes appraise at or above the purchase price. However, a buyer should consider waiving the appraisal language only if he is financially able to come up with the additional money necessary to close even if the appraisal comes in low. If a buyer is going to waive the appraisal language, he can maximize the impact by providing the seller with verification of the funds to proceed with the transaction if necessary.

· From the seller’s perspective: Anyone can cross out a paragraph in a contract. Just because a prospective buyer has waived the appraisal language does not mean that the buyer is financially capable of going through with the transaction if the property appraises below the purchase price. A seller must consider the buyer’s ability to come up with the money needed to close. A high-price offer that waives the appraisal language is good from the seller’s perspective, but a high-price offer that waives the appraisal language and also includes verification of the buyer’s funds to close is better.

Earnest Money

· Description: Earnest money is the money that the buyer puts into an escrow account at the time he makes an offer; the idea is to demonstrate good-faith intent to go forward with the transaction. An earnest money deposit is not an additional cost of doing a transaction, but rather an advance payment toward the buyer’s closing costs and down payment. An earnest money deposit will be held in escrow until it is released at settlement, by mutual agreement of the parties or upon court order. If a buyer walks away from a transaction without a contractual right to do so, he risks forfeiting the earnest money to the seller.

· From the buyer’s perspective: There is no fixed rule for how small or large an earnest money deposit a buyer should make. Of course, the more earnest money, the more serious the buyer appears. Earnest money deposits of anywhere between 2 percent and 5 percent of the purchase price are typical in this area. In competitive situations, however, the percentage can be much higher.

· From the seller’s perspective: The bigger the earnest money deposit, the less likely the buyer will walk away from the transaction. In addition, in general, the larger the earnest money deposit, the more likely that the buyer will be able to get financing.

As-Is Offer

· Description: An “as is” offer means that buyer accepts the property in the condition that it is in — usually determined as of the date the contract is accepted — and that the seller has no responsibility to make any repairs.

· From the buyer’s perspective: In most cases, a buyer will not know the property condition when he makes an offer. However, in many competitive situations, buyers are making as-is offers. These buyers are taking on unknown risk.

For a cooperative or condominium, the potential risk is not as great because the owners association is generally liable for the structure and sometimes some of the mechanical systems.

There are many ways for a buyer to structure an as-is offer to protect himself from these unknown risks. For instance, one way to reduce this risk (if time allows) is to conduct a “pre-offer” home inspection. Most sellers welcome a pre-offer inspection because it increases the likelihood of getting an as-is offer from a buyer who will not get cold feet later. Another way to reduce the risk is to use other contractual rights to achieve the same purpose as a home inspection contingency.

· From the seller’s perspective: An as-is offer is appealing to a seller because the seller will not have the inconvenience or expense of repairs. In addition, an as-is offer is attractive because the buyer does not have a contractual right to walk away from the deal because of structural problems. Everything else being equal, an as-is offer from a buyer who has done a pre-offer inspection is a more solid choice than an as-is offer from a buyer who has not done one.

Other Terms

The deal terms above are just some that come into play in a multiple offer situation. There are a host of others including settlement date, the settlement company, whether the buyer offers the seller a “rent-back,” contingency for the sale of the buyer’s home and contingency for the seller’s ability to find a new home. Every deal is different and it may be that a seemingly trivial item could be the difference in whether an offer is accepted or whether the seller gets what he expects at the closing table.

In putting together a bid, a buyer who focuses just on price is doing himself a big disservice. All the terms of the offer should be crafted to make an intelligent offer given the buyer’s abilities, circumstances and desires. In evaluating multiple offers, a seller must compare the strengths and weaknesses of each and choose the one that best meets the seller’s needs.