Navigating the real estate market involves understanding various financial components; among them, the concept of earnest money. Earnest money signifies a buyer's genuine intent to purchase a property. This deposit is a crucial part of the transaction, contributing towards the down payment. However, what sets transactions apart is the nature of this earnest money — whether it's refundable or non-refundable.
The earnest money — also referred to as an earnest deposit, escrow deposit, or good faith money — is a deposit made to the seller that represents a buyer’s good faith to buy a property.
The earnest money is usually about 1% of the purchase price and goes towards the down payment. For example, if the contract price is $10 million, the earnest deposit will be approximately $100,000.
Generally, the earnest money is due a few days after the execution of the purchase sales agreement (PSA). The exact timeline is outlined in the PSA.
The earnest money can be refundable or non-refundable. If the earnest money is refundable, the buyer will receive their funds back if they use one of the contingencies to back out of the contract. However, if the earnest money is non-refundable, the buyer will not receive their funds back if they use one of the contingencies to cancel the contract.
For non-refundable earnest money, the buyer can stipulate when the money “goes hard” (i.e., becomes non-refundable). The money can go hard on day 1, after a specific task is completed (e.g., due diligence), or after a certain period (e.g., 30 days).
For this blog post, we will be discussing earnest money that goes hard on day 1.
An offer that includes non-refundable earnest money is stronger than an offer that includes refundable earnest money. In fact, in some cases, a lower offer price with non-refundable earnest money is stronger than a higher offer with refundable earnest money. If a buyer is willing to put down non-refundable earnest money, it is an indication that they are extremely confident in the deal and conveys their intention to close. If they don’t close, the seller gets to keep the earnest money.
In today’s competitive market, you may need to submit an offer with non-refundable earnest money to be awarded an on-market deal or, in some instances, even to be considered for a deal. However, if you plan on submitting an offer with non-refundable earnest money, your confidence level in the deal needs to be extremely high. To have an extremely high level of confidence, you should spend a lot more time on due diligence before submitting an offer.
During the underwriting and bidding process, spend time understanding the deal, evaluating the market, and creating the business plan. This should entail an extensive market analysis, touring competitive properties, and discussing loan options with potential lenders. However, these tasks should be performed whether you are submitting refundable or non-refundable earnest money.
If you are considering submitting non-refundable earnest money on day 1 after completing the tasks above, take your pre-contract due diligence to the next level. The goal of this next-level due diligence is to be as confident as you can be that you won’t discover any big surprises during the formal due diligence period. To do this, perform the following tasks:
During the formal due diligence process after executing the contract, you’ll be able to perform a full, detailed inspection. You will likely find at least a few unforeseen items during this process. Still, your goal should be to make sure the impact of those findings is minimal, especially when you are putting down non-refundable earnest money.
This is accomplished by completing the five tasks listed above. Additionally, to avoid these unforeseen items affecting the projected returns of your deal, create conservative underwriting assumptions that can withstand potential findings. In your capital expenditure assumptions, always include a contingency fund to account for anything you discover. Also, you should leave a cushion in your income and expense assumptions.
Overall, when you want or need to put up non-refundable earnest money, your pre-contract goal should be to limit the number of surprises!
About the Author:
Joe Fairless is the co-founder of Ashcroft Capital, a fully integrated multifamily investment firm with more than $2.7 billion in assets under management, and the founder of Best Ever CRE. His podcast, the Best Real Estate Investing Advice Ever Show, is the world's longest-running daily real estate podcast with more than 500,000 monthly downloads.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.