Locking tens of thousands of dollars in escrow is not a gamble if you understand when and how earnest money is refundable.
Here’s a question with no straight answer: Is earnest money refundable?
The short answer is that, yes, buyers can typically get their earnest money deposit or EMD back. The long and honest answer, however, depends entirely on the circumstances in which you’re hoping to get that deposit back.
Also called good faith deposits, earnest money is a deposit potential buyers make to show serious intent to purchase a property. EMDs typically range from 1-5% and up to 10% of the property's total purchase price – but the required earnest money amount can vary wildly based on things like the property's value, location, and market conditions.
In today’s competitive market with rising cap rates, as media firm Institutional Real Estate Inc. (IREI) show, sellers want to see that kind of commitment to differentiate genuine buyers from those who aren’t. As a result, earnest deposits have become the norm in many of the regional CRE markets in the US.
That’s why understanding when earnest money deposits are refundable is important for both buyers and sellers in the CRE market – because what if the deal falls through in the final negotiations or the buyer backs out because they weren’t able to secure financing? Can a buyer back out of a contract before closing?
Source: IREI
Buyers who understand when an earnest money deposit is refundable can strategically use EMDs in CRE deals and protect their investment rather than lose a hefty sum of money. Sellers need to understand the ins and outs of EMDss because it impacts their ability to negotiate a competitive price for their property.
In this guide, we explore when an earnest money deposit is refundable and when not.
We talk to experts to get their take on earnest money and briefly delve into Duckfund's innovative soft deposit solution, which offers a unique approach to securing earnest money deposits without tying up personal funds or undergoing lengthy credit checks.
So is earnest money refundable? Read on to find out.
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In today’s competitive commercial real estate market, earnest money deposits play a crucial role in the negotiation process. As Stash Geleszinski, who is Managing Director of the Cincinnati office at CRE firm Capstone, emphasizes, "The deposit is an important thing. It says, 'Okay, I'm here to play.'”
Geleszinski focuses on multi-family and has helped facilitate the transfer of all types of properties, from class-A urban infill projects to high-rises throughout the Midwest and Northeast. In his experience, “It's part of every deal. It's part of every transaction.”
Once you make an earnest money deposit, the paid amount is held in an escrow account by an escrow agent through a title company. It is held in escrow until the transaction is either completed or terminated.
If the commercial real estate deal is completed successfully, the EMD is then paid directly to the seller as part of the purchase agreement process – unlike down payments that are made to lenders towards a mortgage loan.
With the property sale finalized successfully, the earnest money deposit gets credited towards the buyer's closing cost. But what happens to earnest money if the buyer cancels? Can a buyer back out of a contract before closing and still get their earnest money back?
And is earnest money refundable if financing falls through? Let’s delve into these and other scenarios.
When negotiating a multi-million CRE deal, an earnest money deposit that is a few percent of the sale price represents a sizable chunk of an investor’s liquidity and is, in turn, a big financial commitment. No buyer wants to see that kind of money go to waste. Especially not in a dynamic real estate market where liquidity is everything.
But earnest money deposits aren’t automatically forfeited by an escrow company if a transaction goes south. If a deal falls through because of contingencies outlined in the purchase agreement, the buyer is entitled to a full or partial earnest money refund.
Contingencies are conditions that must be met in order for the transaction to proceed. They protect buyers by allowing them to walk away from a deal without penalty if certain conditions are not met.
Contingencies in commercial real estate contracts are essential for creating a level playing field during the real estate transaction process for both buyers and sellers, mitigating unforeseen challenges and risks that can arise during the transaction.
Contingent contracts can get complex. Zeno Lancaster, Managing Attorney at Lancaster Law Firm, comments that, “As a North Carolina real estate closing attorney, I often witness clients grappling with the complexities of contracts, and one crucial aspect that demands attention is contingencies.”
As a buyer, do you get earnest money back when specific contingencies outlined in the terms of the contract aren’t met? While that ultimately depends on the real estate contract terms (read the fine print!), here are some common contingencies that can trigger an earnest money refund:
When written into a property sale contract, physical inspection contingency allows buyers to conduct an inspection of the property before finalizing the purchase.
Any purchase contract that includes an EMD agreement should include a property inspection contingency. In fact, these clauses are standard practice in real estate transactions. After all, who doesn't want to have a look at what they’re buying before they sign?
Allowing for a physical inspection before the property purchase gives potential buyers the opportunity to identify issues that may affect investment cost and the overall viability of the project they’re trying to realize.
Let’s say the inspection reveals major problems that weren’t previously disclosed by the realtor. If you’re not willing to accept these defects as a buyer, you can choose to walk away from the deal and have your earnest money deposit returned from the escrow account without incurring penalties.
Here’s another essential clause. The appraisal contingency allows the buyer to back out of the deal and retrieve their EMD if the property appraises for a lower value than the purchase price.
Appraisals are independent, third-party estimates of a property's value made by licensed professionals. These appraisals are different from their counterparts in residential real estate purchases because commercial appraisals are more detailed, comprehensive, and data-heavy due diligence reports that provide valuable information for all parties involved, like lenders, property owners, and other stakeholders.
Appraisals are crucial when financing a property with a traditional bank loan, as they help determine the property's value, influencing the loan-to-value ratio and the lender's decision on the loan amount.
Appraisals are equally essential for property owners looking to sell or understand the value of their property before placing it on the market or accepting a buyer’s offer.
Is earnest money refundable if financing falls through? That depends on whether you included a financing contingency in the sales contract.
A financing contingency is another common clause in CRE deals. Buyers whose financing isn’t yet finalized should negotiate this clause into the contract terms, as it allows buyers to back out of a deal if they are unable to secure financing.
If specified in the purchase contract, a financing contingency can even let buyers leave a purchase if they get a loan but it is on less favorable terms than stated in the terms of the contract.
This clause typically comes with a deadline by which the buyer must have secured funding. If the deadline passes without the buyer having obtained financing, the buyer’s earnest money is refunded as per the terms of the contract — that is, entirely or partially.
A financial records contingency is a clause in a CRE contract that allows the prospective buyer to review the income and expense records of the property before finalizing the purchase.
This could be important if, as a buyer, you’re looking to obtain an existing commercial operation with a positive cash flow. By including a financial records contingency in your real estate contract, you get to take a look at the financial records of the property.
A variety of documents can be of help, like vendor records and operating statements, to figure out whether the property is truly turning a profit.
A zoning contingency is a clause in a CRE purchase agreement that allows for the termination of the contract when a certain zoning condition cannot be met. This is extremely relevant for when commercial development is subject to zoning permits, like when building a new structure or opening a particular type of business.
This contingency is especially handy when the property’s zoning is not clearly defined and/or when there is a risk of zoning changes.
Including this clause in the terms of the contract shields buyers from the financial risk of losing their earnest money deposit when the deal falls through due to zoning issues. More importantly, it ensures buyers don’t get stuck with a property they can’t use as intended.
In commercial real estate contracts, environmental contingencies allow for environmental due diligence or assessment before closing the deal. Depending on the specific terms outlined in the environmental contingency, a buyer can get their EMD back when backing out of a deal where certain environmental conditions aren’t met.
Environmental due diligence identifies environmental hazards or liabilities related to the property. Depending on the location, use and history of the property, environmental due diligence takes all kinds of environmental hazards into consideration. From the flood risk and nearby endangered species, to the costs to abate asbestos during reconstruction.
The environmental contingency can protect the buyer from financial obligations arising from environmental issues, such as cleanup costs or legal liabilities. The contingency can be negotiated between the buyer and seller, and the specific terms of the contingency will depend on the individual transaction.
Sometimes a CRE investor negotiates a property sale contingency into the commercial real estate contract. More often seen in residential real estate as a home sale contingency, this clause allows buyers to make the purchase contingent on the sale of another property in their portfolio.
In other words, the buyer is allowed to terminate the contract if they fail to sell their current property within a specified timeframe.
This contingency protects buyers from the financial risk of having to service the debt and operational cost of two properties. Furthermore, it frees up cash with the sale of one property – cash that can be used towards the purchase and development of the commercial property that the buyer has agreed to purchase.
Another circumstance in which buyers are usually entitled to an earnest money refund is when a seller fails to uphold their end of the purchase agreement. Typical breaches of contract include:
So what happens if the seller breaches the real estate contract? Is an earnest money deposit refundable in that case?
Chad Johnson, who is an experienced real estate attorney and Founding Partner of Minneapolis law firm Hellmuth & Johnson, and who often receives inquiries from aggrieved real estate agents, explains that, “Statutory cancellation may be commenced by the buyer in response to the seller’s breach of the purchase agreement, which requires the buyer to serve a legal notice on the seller.”
Johnson further explains that, “If the seller fails or refuses to cure the default within the fifteen or thirty-day time period required by the notice, the purchase agreement is canceled and the buyer will generally be entitled to a refund of the earnest money.”
So much for legal procedures in Minnesota. But when a seller breaches the sale contract, is earnest money refundable in Texas, too?
While specifics differ across states, earnest money should generally be refunded to buyers when a seller breaches the contract, mitigating financial loss.
Yet, investors incur a loss even when their full EMD is returned. That’s because a contract breach after painstaking market research, contract negotiation, and due diligence still counts as a loss of opportunity. Johnson notes that, “The buyer may seek money damages for a seller’s breach of the purchase agreement by suing the seller.”
Having gone through the scenarios in which earnest money is returned to the buyers’ account, let's look at situations in which the buyer does the contract breach and backs out of the deal. Is earnest money refunded in that case? Likely not. But is that a bad thing?
Geleszinki argues in favor of non-refundable earnest money deposits: “We're telling the buyers that, if you want to get the deal, you've got to put non-refundable earnest money up day one. And what that means is that the deposit is non-refundable, subject only to title and environmental [contingencies].” According to him, this type of commitment fosters the right climate to close deals.
So is earnest money refunded when you back out of a purchase agreement without contingencies that aren’t met? Generally not — but that doesn’t mean you necessarily lose your whole earnest money deposit.
Apart from the terms of the contract, how much earnest money you lose is dependent on state regulations.
For example, California law limits the amount of earnest money that can be awarded to the seller if a deal falls through, capping it at a maximum of 3% of the purchase price.
It’s important for CRE investors to understand whether earnest money is refundable in specific circumstances – not just to prevent financial loss, but to stay liquid in a competitive market.
Good cash flow management and forecasting are key to collecting the funds for one or multiple earnest money deposits. For first-time investors it’s even more important to set aside funds specifically allocated for earnest money, to avoid straining liquidity during the transaction process.
In today's dynamic commercial real estate landscape, having a reliable lending partner can be a game-changer. This is especially true when it comes to securing funds for earnest money deposits without compromising your capital reserves.
Anna Kogan, CEO of soft deposit provider Duckfund explains their process: “If the deal does not go through, Duckfund’s customer notifies Duckfund about it two days prior to the closing date of the due diligence period and is then free to go without any additional actions or fees.” She further explains how Duckfund retrieves the EMD: “Duckfund terminates the PSA and gets the deposit back from escrow. The LLC registered for the acquisition may be used for another property.”
With careful planning, market research, legal counsel, and innovative financing solutions, real estate investors and developers can effectively protect their investments and earnest money while maintaining a competitive edge.
As Kogan states, "The key in navigating current market fluctuations is to be open-minded to new opportunities and have strong in-house analytical and financial skills to ensure every investment is well-evaluated."
With some knowledge, a well-crafted purchase contract, and a reliable soft deposit lender, earnest money deposits boost your ability to capitalize on lucrative commercial real estate opportunities.
[Use EMDs to your advantage. Explore options like Duckfund's soft deposit financing to secure the funds you need while retaining the flexibility to walk away if a deal doesn't meet your criteria.]
