Nothing reduces the risk real estate investor contacts are exposed to quite like a good contingency. A proper contingency, for that matter, is absolutely imperative to have in place the next time you go to acquire a deal. Anything less could leave your deal open to unnecessary risk.
You could argue that today’s best investors are not those with access to the most capital, or even those with the most extensive network of like-minded professionals. While both “tools” are of the utmost importance for realizing success, there is one skill that transcends them all: the ability to mitigate risk. If for nothing else, it’s those that can reduce their exposure to risky scenarios that stand to realize the best odds to complete a timely and profitable transaction.
It’s a sad truth, but a reality nonetheless: there isn’t an investor out there capable of eliminating risk altogether. There will always be an element of risk associated with every real estate deal. It is worth noting, however, that it’s entirely possible to mitigate risk to a point that the odds of success greatly outweigh those of failure.
If you want to reduce your risk exposure, there are plenty of things you can do. A sound education and due diligence are a great start, but there are some things that deserve your undivided attention: contingency clauses.
For those of you less familiar with the idea of a contingency clause, at least as they pertain to real estate investor contracts, they are — more or less — your single, best option for backing out of a deal in the event unforeseen circumstances arise. As the name would suggest, contingencies are just that: a provision for an unforeseen event or circumstance. In the case of real estate investor contracts, they are nothing more than a safety measure to protect buyers, and even sellers, from committing to a deal they may regret in the future.
If you are interested in mitigating risk in your next deal, look no further. While contingencies aren’t going to eliminate all risk, they are a great way to protect yourself from many unforeseen circumstances.
1. Appraisal Contingency
I maintain that no real estate contract is complete without the addition of an appraisal contingency. The appraisal of a particular property plays a large role in the asking price, and can’t be ignored. In fact, you could argue that the appraisal is the single, greatest influencing factor in determining a home’s value, and, therefore, the asking price one will be expected to appease. It’s only fair that the price you are willing to pay is contingent on what the appraisal says.
As the name would lead you to believe, the typical appraisal contingency can help investors two-fold. On the one hand, a proper appraisal contingency offers savvy investors a backdoor out of a deal in the event the appraisal price on a property is not as high as the purchase price. On the other hand, it’ll give those that were smart enough to include such a contingency the ability to negotiate a better deal on their behalf if the appraisal comes in at less than the agreed upon purchase price.
It’s also worth noting that professional appraisals help determine the amount banks are willing to loan borrowers. In the event the appraisal comes in much lower than the asking price, it stands to reason that the buyer will need to come up with the difference, and therein lies the true benefit of a proper appraisal contingency: it keeps the asking price in line with the appraisal value, and gives otherwise unsuspecting buyers a way out in the event of a discrepancy.
2. Financing Contingency
As perhaps one of the most popular ways out, financing contingencies have become a stalwart in the investing community, and for good reason: few things are more volatile than financing. It only make sense that real estate contracts would account for one’s access to capital, or lack thereof. That said, I am a huge proponent of financing contingencies. A proper financing contingency will make certain that an impending deal is contingent on whether or not you can obtain financing — simple enough, right? Not only that, but a good financing contingency will state the type of financing, terms, and the amount of time in which you have to apply and be approved for the loan. The more detailed it is, the better.
More often than not, financing contingencies are put in place to protect prospective buyers in the event their financing doesn’t come through. Rather than incurring a penalty or losing earnest money, this safety measure allows you to back out of a deal if you can’t secure funding in time without any repercussions.
3. Home Inspection Contingency
The home inspection contingency is far and away the most popular contingency strategy used by investors. If for nothing else, it’s the one contingency that makes the most sense. While each contingency on this list is important, the home inspection contingency is the only one that will confirm whether or not a property is up the the standards you deem acceptable, and that said standards are met at the time of purchase. In short, the home inspection contingency grants prospective buyers a way out in the event the home inspection comes back with unsuspected news.
If the home inspection does come back with red flags, a great contingency will award potential buyers one of three options: It’s entirely possible to ask for a discount to atone for the newly found issues, continue with the deal, or even back out of the deal. Which path you choose will depend on the contingency, so be sure to iron out the details before you add it to your next contract.
4. Home Insurance Contingency
Lesser known, but nonetheless important, home insurance contingencies are a crucial part of any good real estate contract. And, as you would expect, a good home inspection contingency will give buyers a way out of any deal in which they aren’t able to secure the necessary home insurance.
The home insurance contingency seeks to protect a buyer’s new purchase from disasters, as different home in different locations require different types of insurance. Seeing as how property damage, fires, natural causes, and other issues are all but inevitable, it only makes sense that buyers would want to protect their asset. However, not everyone will qualify for insurance. It’s a sad truth, but a reality nonetheless: there are those who won’t be approved for home insurance, and that’s where this particular contingency comes into play. In the event you can’t get the insurance you need in a particular area, adding this contingency to your next contract will allow you to exit a deal without penalty.
Risk Mitigation At Its Finest
Today’s most prolific real estate investors are none other than those who can reduce their exposure to risk. It’s worth noting, however, that nobody can eliminate their risk exposure, but it’s entirely possible to reduce it. With a few savvy investment strategies, a sound education and an acute attention to detail, you can effectively mitigate the risk you are exposed to. That said, one of the best ways to do so is by including a number of contingency clauses in your own real estate investor contracts. The addition of the right contingencies makes it entirely possible to back out of a deal without repercussions in the event red flags present themselves. What better way to mitigate risk than by giving yourself an out in unpredictable circumstances?