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Large Earnest Money Deposits are best for All Involved – Sellers, Buyers, and Agents

Ken H. Johnson, Editor
Journal of Housing Research
Florida International University
College of Business
Department of Finance and Real Estate
11200 SW 8th Street
Miami, FL 33431


July 7, 2011

© Copyright Ken H. Johnson. This material may be freely duplicated and republished in its exact or amended forms under the following conditions: (a) the author’s name must be clearly visible; (b) the author’s journal affiliation must be clearly visible; and (c) the author’s university affiliation must be clearly visible. Otherwise, this material may not be reproduced in any form without the written consent of the author.


Large Earnest Money Deposits are best for All Involved – Sellers, Buyers, and Agents

The negotiation of a sales agreement is a very difficult process. A well drafted sales agreement almost cinches a closing even in the most sluggish of markets. On the other hand, a poorly negotiated agreement typically leads to extra work on the agent’s part and a far greater likelihood that the property will not close, which is not good for either buyers or sellers. Therefore, poorly constructed sales agreements are clearly in no one’s best interest.


Setup

In today’s lack luster residential markets, Sellers face uncertainty over their net proceeds at closing and worry that they might not close and have to remarket their property. Presently, buyers face tremendous uncertainty and pay a premium in markets that have a high percentage of back-on-market (BOM) properties. Economic theory dictates that the bearers of risk receive a premium. In this case, sellers of property in these markets bear significant risk from the possibility that their property may have to be remarketed due to nonperformance. All else equal, this remarketing risk results in higher purchase prices to buyers. Similarly, agents face a lower probability of closing any particular property resulting in either lower expected commission income or greater effort to close poorly negotiated agreements. In short, nobody wins.

There are many things that go into a well negotiated sales agreement. This brief piece is not meant to cover each in detail. Instead, the goal here is to concentrate on the central idea that certainty helps all parties. Said another way, uncertainty kills deals, while certainty provides the best path for all parties. Here again economic theory dictates that when facing uncertainty consumers will over estimate costs and underestimates benefits, which is a prescription for disaster in any transaction.

One item, earnest money deposit,1 can greatly enhance certainty in any transaction. Earnest money is provided by buyers during the negotiation process and is credited towards their funds due at closing. It is forfeit if (and only if) the buyers refuse to perform without a justifiable reason. These reasons typically are tied to contract contingencies such delivery of clear title, financing arrangements, and satisfactory property inspections, among others. Essentially, if all contract contingencies are satisfied and the buyers will not perform, they face forfeiture of their earnest money.2 The only risk to the buyers concerning their earnest money is if they simply refuse to perform as originally promised. Thus, the risk of forfeiture of their earnest money is completely controllable by the buyers and does not lead to any negative consequences. Said another way, if any contingency is not met, the buyers get their earnest money back. If all contingencies are met and the buyers perform, their earnest money deposit is credited towards their funds due at closing. However, if all contingencies are met and the buyers refuse to perform, they forfeit their earnest money. Thus, the size of earnest money deposits signal buyers’ intentions and the amount of remarketing risk in any sales agreement.

Transaction uncertainty (i.e. the likelihood that a negotiated sales agreement will close) is naturally created in a buyers’ market.3 Inevitably, these markets are plagued with a high percentage of BOM properties. This is true especially when the average earnest money deposit is small. Here sellers face significant risk from the expectation of having to market their property more than once. This extra expected marketing effort results in a premium being placed on each property within these markets. Sellers in these markets know that on average they will have to market their properties more than once, and they price their property accordingly.

In this setting, relative large earnest money deposits are the best for all parties – sellers, buyers, and agents.4


How it Works for All

In the case of the buyers, offering a large earnest money deposit to sellers signal that these particular buyers will perform with the only exception being for an unmet contingency. For example, the property might not appraise for enough to justify the loan being made and there is a financing contingency. Thus, remarketing risk is removed from the sellers’ concerns. After removing this risk, as with all financial transactions, the premium associated with remarketing can be removed without loss to the seller. Thus, sellers can afford to slightly discount their property without any real loss by providing a small discount for buyers offering a large earnest money deposit.5 Additionally, in the event of simultaneous offers, sellers seeking to avoid remarketing risk will tend to prioritize (negotiate first with) offers that are accompanied with a large earnest money deposit.

There is one small cost here. Specifically, these buyers incur lost interest income on the earnest money deposit. However, with relatively short closing spans (agreement date to closing date) and today’s low interest environment, this cost is rather trivial.6

In the case of the sellers, they receive near certainty that their property will close. This enables them to more easily proceed with the negotiations on their next property. This alone has value and probably far greater than any discount provided the buyers from offering a large earnest money deposit, i.e. more certainty. For example, sellers accepting small earnest money deposits typically find it difficult to time their next purchase so as to only move once. Often, these sellers must move twice, which is very expensive.

In the case of the agents, they create a working environment which enables them to move on to the next transaction without fear of losing a closing. Negotiated sales agreements with large earnest money deposits require little attention freeing the agent to perform other revenue enhancing activities, i.e. sell other properties. Thus, over the course of a year, an agent’s commission income should be significantly higher.


Summary

Large earnest money deposits are the best for all parties – sellers, buyers, and agents.

Buyers typically are provided with a chance to acquire a small discount by removing remarketing risk from sellers. Additionally, large earnest money deposits typically prioritize offers in the event of simultaneous offers being presented to sellers. Sellers are provided greater certainty and can more easily move on to their next property. Finally, agents create a working environment that allows them a better opportunity to maximize their income and better server consumers.

This is all accomplished due to the increase in certainty that large earnest money deposits bring to sales agreements formed in today’s unsettled residential markets.

 

ENDNOTES

1 Earnest money deposit is known by several names around the country. These include, but are not limited to, binder, deposit, and good faith money.

2 Technically, there are other legal remedies for a breach of contract such as bringing a suit for specific performance. However, in practice, these alternative remedies are rarely sought leaving the sellers with only one realistic solution -- retaining the buyers’ earnest money

3 Conversely, in a sellers’ market, transaction uncertainty is very small, and the outlined strategy has less of an impact because buyers are far more likely to perform. Regardless, this strategy of large earnest money deposits being offered by buyers during the negotiating process is still sound, if only to a smaller degree, in any type of market. For example, in a sellers’ market, the remarketing premium is small providing buyers with only the slightest discount. However, there is always the possibility of simultaneous offers being made, even in a sellers’ market, and large earnest money deposits retain their prioritization effect at the smallest of costs.

4 The question naturally arises, how much is a large earnest money deposit? As a former practicing residential real estate broker, I found, on average, 5% of the agreed upon selling price to be satisfactory.

5 Remember, sellers in markets that have been racked with a rash of BOM properties add slightly to their asking price to compensate for the chance that they may have to market their property more than once.

6 For example, assuming a selling price of $200,000, a 10% earnest money deposit, a 1.5% per annum return, and a 45 day closing period, the cost to the buyers asking for a discount and/or prioritizing their offer over other simultaneous offers is $37.50.