I blame math! Why this crazy market is about to get ugly.

It’s a crazy market, and it’s about to get ugly.

Some buyers are waking up to the realization that they overpaid for their property.  Specifically, they overpaid compared to a similar property being sold today in this market of less intense buyer demand and increased inventory. If the first three rules of Real Estate are location, location, location, then certainly the fourth rule is Timing!

Imagine a scenario where a buyer signs an Agreement back in April for $800,000, with a July 15th closing date.  Come June 1st, they read an article from Trebnet that sales volumes are down, and prices are being pressured downward. Houses on the street are now signing contracts for $750,000.  As a result, the mortgage company is going to lend less based on the appraisal of $750,000, and the buyer now has to come up with the difference, which they would have to borrow at credit card rates which they can’t afford.

They have a tough choice to make:

Scenario 1: Do they walk away, and leave the vendor to fend for themselves?; or

Scenario 2:  Do they beg, borrow and steal to close the deal and just resell it before the carrying costs drive them into bankruptcy?

“Of course they should close!” I hear you saying (maybe even yelling as you slam your fists on your keyboard). They signed a contract. They are committed. You can’t just break a contract! The Vendor will sue! And that’s true. The Vendor may sue.  The Vendor may, nay: likely will, be victorious.

But not so fast. There is a problem with “doing the right thing” and that problem is, simply put, math.  The Purchaser, faced with having to resell the property, can’t close the deal. If they can’t afford the property to begin with, they certainly can’t afford to flip it at a loss. That would actually be financially insane. Here’s why:

Why deals fail to close

The Buyer is presented with an impossible decision.  To walk away is to agree to compensate the Vendor for their losses. In this example, likely in the $60,000 range. That’s a bitter pill to swallow for a softening market.

But to close the deal, just to end up reselling for even a slight loss, the buyer has to carry the mortgage for 3 to 4 months while they market and sell the property in the down market, they also have to set up utilities (and cancel them after 4 months), they have to insure the property with a new policy for 3 to 4 months, they will have to pay lawyer’s fees, land transfer tax, registration fees, title insurance and closing costs to both buy and sell the property, there will be real estate commissions payable, and the sale will be complicated by the apparent flip (as will their income tax filings). On top of everything else, they will invariably be paying a pre-payment penalty on that mortgage that isn’t factored in the above math at all, ranging from 3 months simple interest to the “interest rate differential” which could be $10,000 or more. A total direct loss exceeding $100,000 if they are lucky.

When faced with a financial decision between “Compensating the Vendor $60,000” on the one hand, or directly “losing $117,000” on the other, the decision becomes a very easy one. The buyer will save $50,000 or more by simply walking away and letting the chips fall where they may. There is a built in cushion of $67,000 to cover the risks of lower than expected resale price or higher than expected transaction costs due to the Vendor. Frankly, how can they not walk away?

Added to all this: the ability of lawyers to make it hard for the Vendor to collect, which can save the Buyer even more money if the Seller doesn’t have the resolve for prolonged litigation.

We are starting to see this in my practice.  Buyers trying to get out of deals, looking for a price abatement, and some just flat out walking away without so much as an apology.

The only lesson here, of course, is that the Seller must be diligent about reviewing the buyer’s qualifications to purchase the property, starting with insisting on more than just a meager $5,000 or $10,000 deposit.  The consequences of a failure to close in today’s market pricing are just to severe to accept less than an adequate deposit towards a purchase price exceeding $500,0000.

Sellers should also ensure they have the resources set aside to fund a failure to close. In other words, a cash reserve to enable them to pay the movers, lawyers, and other out of pocket expenses of not closing the deal, extension fees and costs for delaying whatever purchase they were going to make (assuming they don’t have bridge financing in place) is a good idea, so that a failure to close doesn’t end up going on your credit cards to make cashflows work during the remarketing phase of selling your home to the next buyer in line.

Sellers also need to be represented by competent counsel who ensure they are ready, willing and able and in legal conformity with the Agreement of Purchase and Sale to preserve their rights to forfeit the deposit and to sue for damages where there is a failure to close, since finding out that a lawyer’s error means you wont’ get any of your losses compensated would truly be the greatest injustice of them all.

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