Negotiating Due Diligence
A complete understanding of the Due Diligence provisions of the standard Offer to Purchase and Contract is a huge negotiating advantage. Use it. Even if they have read it, most people, including many real estate brokers, do not understand it.
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Today, many states use a standard form offer and contract which includes some type of due diligence provisions. The simplest way I know to describe this is to say that the contract, when fully executed is an option to purchase contract. The standard form contract grants the buyer an option to purchase the property with the contractually agreed-upon terms, for some negotiated period of time. During this period, the buyer can decide if he wants to move forward with the purchase, or not.
In return for this option, the buyer pays the seller a nonrefundable option fee, most often labeled the Due Diligence Fee. And the time period for making this decision is labeled the Due Diligence Period. If during this period, the buyer decides to terminate the contract (typically for any reason or no reason), the seller keeps the fee. And if the buyer does not terminate and therefore moves forward with the transaction, the fee is applied to the Purchase Price.
I would argue that other than the Purchase Price itself, this option fee, the Due Diligence Fee, is the most important term in the offer and contract. I might even go so far as to say, because everything is subject to re-negotiation during the Due Diligence Period, including the Purchase Price, that actually, the Due Diligence Fee is even more important that the Purchase Price itself.
While the parties may agree to change any other term of the contract, and while the Due Diligence Fee is sometimes increased (say for example if the buyer is asking for more time for his Due Diligence Period or more time to close), I have never seen an instance where the Due Diligence Fee is reduced. Why? Well, this fee is not escrowed; it is paid directly to the seller. There’s no point in reducing it if the transaction moves forward because it applies to Purchase Price. And if the transaction is halted for any reason, there’s not much chance the seller will give it, or some of it, back to the buyer. So as a practical matter, this figure can only go up.
Point is, pay the Due Diligence Fee to the seller…and it is gone. And this is exactly where people, including many real estate brokers, lose the plot. Both sides, buyer and seller, should ask themselves: What are the ramifications of this nonrefundable payment? And the answer to that question is, mostly, a function of how much the payment is. Exactly how much money did the buyer give the seller? Or in the negotiation itself, how much money is the buyer proposing to give the seller?
Because the amount paid determines who controls the transaction. Stop and think about that. If the buyer and seller negotiate some small amount, the buyer has very little to lose by terminating the contract, and therefore the buyer is in control. If the buyer and seller negotiate some large amount, the buyer has a lot to lose by terminating the contract, perhaps even more than he can afford to lose, and therefore the seller is in control.
Now we’ll stop here and ask: Surely there is some amount that can be negotiated which would equalize the parties transactional control? And the answer is clearly yes, there is, in theory. But it is difficult to know that figure ahead of time. And of course, a party knows his number, but not the other side’s. And because so few people understand the previous paragraph, they end up accepting the wrong amount. Or an amount which later fails to protect their interests. As buyers, they pay too much; as sellers, they accept too little.
The consequences can be grave. The buyer may find many expensive and necessary repairs that need to be made, and of course, ask the seller to make them. But if the buyer gave the seller a large Due Diligence Fee, which the seller knows or suspects that the buyer will not walk away from, the seller may decline to make any repairs. Nothing requires him to do so except a desire to consummate the transaction. Alternatively, if the seller accepts too little as the Due Diligence Fee, the buyer may request these same repairs and say to the seller, either spend money on these expensive repairs, or I will just walk, because I don’t have much to lose.
And it is not just repairs. Because the due diligence process most often gives the buyer the right to terminate for any reason or no reason, during the Due Diligence Period, the buyer can re-open any terms for re-negotiation. And worse still, the buyer can inject new terms into the transaction. Yes, out of thin air. Remember, the contract grants the buyer a unilateral right to terminate; the seller enjoys no such privilege. While the seller can refuse any new or altered terms, he does so at the risk that the buyer may exercise his right to terminate. So in their desire to move forward with the transaction, many sellers will ultimately accede to the buyer’s new or additional terms.
Is this fair? I know, what a question, right? But indulge me: Is it fair that the buyer has the ability to, basically, re-negotiate the whole deal, and if the seller does not agree to the new terms, the buyer can walk? And, should the buyer not be held somewhat accountable for the terms previously agreed-upon, supposedly in good faith, by both parties? The fact that the buyer can terminate, sometimes means that his original terms were not, in fact, made in good faith. Should the seller have no means of enforcing these terms?
So let me answer this way: The reason a seller would find himself in a position of not being able to enforce the original terms, is that he or his broker failed to properly negotiate the Due Diligence Fee. That is to say, the Due Diligence Fee is the enforcement mechanism available to the seller. And other than simply refusing the new terms, it is the seller’s only means of control.
So if a broker tells you that during the Due Diligence Period of the contract, the seller has no control whatsoever and the total jeopardy is on the seller, I assure you, she has failed to properly negotiate the Due Diligence Fee. Is it not our job as competent brokers to insure that our clients do not suffer total jeopardy and are treated fairly? In fact, as fiduciaries, it is our job to (ethically) represent them to the best of our ability. As an aside, this is so much easier to do when one represents one side or the other, and certainly not both.
Now there are those who argue that the Due Diligence Fee should always be a small amount. Their rationale seems to be: The buyer will also be spending money on other due diligence and closing related expenses. So for example, the buyer is also paying for inspections, and paying for an appraisal, and perhaps paying a lender’s application fee, and to have the water tested, etc. So the buyer’s total out-of-pocket expenses might be high, and so the negotiated Due Diligence Fee does not need to be very much. Why? Because the actual figure that matters is not the Due Diligence Fee itself, but rather the total out-of-pocket expenses of the buyer which include the fee. That total is the real amount the buyer loses if he decides to terminate.
But even if it is the total buyer expenses that matter, this simply becomes part of the due diligence negotiation which will determine control. I would only adjust my advice by saying, sure, when negotiating the Due Diligence Fee, you can take into account how much money the buyer may spend in addition to the Due Diligence Fee. But sometimes the buyers will spend heavily on these items, and sometimes they will not. So this figure is most often unknown, even to the buyer, himself. But I will tell you what is known: The Due Diligence Fee itself. My advice: Regardless of which side you are on, negotiate the Due Diligence Fee to your fullest advantage paying as little regard to other possible buyer expenses as you can.
Now, how much? How much should you be looking for? Well, if you are the buyer, it is rather straightforward: You want the Due Diligence Fee to be as small as possible, and certainly as small as the seller will let you get away with. Personally, I like to start negotiations with a nominal amount. Say $100. If I get asked about it, I refer to the discussion above about all the buyer’s other expenses. It is surprising how often this works. But note, for more expensive houses, $500 may well be a nominal amount, right? But it is rare for me to start above $250. Work the other expense argument as much as you can before you begin any real negotiation.
Don’t forget, the refundable Earnest Money is a separate contract term, and often much more than the Due Diligence Fee. Even though it is refundable, this larger figure often helps the buyer get away with a nominal Due Diligence Fee. This should not be true, but it is. It should not be true because the Earnest Money is completely refundable and the buyer can terminate during the Due Diligence Period for any reason or no reason. So essentially, the Earnest Money is meaningless. (It is only important in the case of breach after the Due Diligence Period). But nevertheless, it is a nice, large, pretty figure, just sitting there. People don’t understand this and many brokers don’t either, so they allow the Earnest Money to make an impact. My advice: Initially, be overly generous with Earnest Money to help secure a nominal a Due Diligence Fee. If this does not work, you can always back it down as negotiations proceed.
I’ll tell you something else that often happens: The seller says, you know, we’re gonna need more Due Diligence than that (referring to the fee). And representing the buyer, I ask: Well, okay, what if we double it? You would also be quite surprised just how often that works. So now we’re at $200; still a rather nominal amount. God bless real estate brokers.
Advanced Buyer Tip. Let’s say you are in a tight seller’s market, and the property you want will undoubtedly receive multiple offers. But you like it a lot, and by golly, you want it no matter what. Besides, you’ve already lost out on several other properties. Very common in today’s market. Bump your Due Diligence Fee up to an extreme level, say $5,000. And go ahead an attach your $5,000 check, payable to the seller, to your offer. It’s like magic. Even though your offer may not have the highest Purchase Price, that’s $5,000 directly and immediately into the seller’s pocket. Magic. Be aware, the seller will make no repairs, and there will be NO further negotiation after contract. If you exercise your right to terminate, you kiss your $5,000 goodbye. But in a tight seller’s market, this is often okay with the buyer. You got the house!
So, on the seller’s side, how much Due Diligence Fee should we be looking for? Well, here it is a little more complicated. Obviously, we are not going to even consider the $100 or $200 figure that some brokers will try to get away with. Oh no.
No, the figure must be high enough to cause pain16 to the buyer, if the buyer ultimately decides to walk away from the contract. Ideally, the figure should be an amount that the buyer simply cannot afford to walk away from. And this is often a judgment call, based on the buyer, your house, and the price point. For first time home buyers and starter homes, you know $500 may well be enough, considering their other expenses, to get the job done. Think about it, if they walk away from that $500, they may not have another $500 for the next house they find.
For our typical $500,000 house? That’s more difficult. But I can promise you $500, does NOT get the job done. No, here you start at four-figures. But it is more of a judgment call.
Now stop: What does: Getting the job done mean? For me, it mostly means: If there is any reason that comes up during the Due Diligence Period, where the buyer is even just considering termination, that the buyer will promptly stop and reconsider, because the Due Diligence Fee is nonrefundable and therefore is (really) a penalty for termination. Or even after the Due Diligence Period, it becomes an added penalty for breach. Like I said, the figure must be high enough to cause pain. And clearly this is different for a million dollar home and a one hundred thousand dollar townhouse.
So for example, the buyer asks for a bunch of repairs that the seller does not want to make. As the seller, we want them to accept that not all, or perhaps not any, repairs will be made. That is, without the buyer exercising his right to terminate. Or if the buyer is having a difficult time getting their financing in place. As the seller, we want them to work their lender hard.
So sellers, get as much as you can, regardless of what either broker says (because too often, even the brokers don’t understand). But don’t try to get so much that the buyer (or his broker) says, you know, I wonder if there is anything wrong with that house? Like I said, it is more of a judgment call.
Now I gave the buyers an advanced tip above. Let me end this longish chapter with a little trick for sellers. You receive an offer with (and I’ll just make up some numbers) a $500 Due Diligence Fee and $2,000 in Earnest Money. Very common. That’s a total of $2,500 immediately out of the buyer’s pocket. So take a reasonable approach and say: You know, we’re quite happy with the $2,500 total and we don’t need any more, thank you so much. But could you simply reverse the figures?
My friends, you will be surprised at how often this works. And even if the buyer does not make a complete inversion, they will often come close or close enough to get the job done. Why? Because neither they nor their broker understand the ramifications of our modest little request. Now I know, you find that just incredibly difficult to believe. But give it a try.
Optimize the Due Diligence Fee, control the transaction.
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16. Let’s define pain: In a real estate negotiation and transaction, a financial loss that the counterparts are unable to endure or are unwilling to accept. Or perhaps ultimately do accept, but only after all else fails. Pain is a harsh word, and may even be offensive to some who perhaps feel it turns negotiation and business into a blood sport. I appreciate this concern, but use pain only as a technical and financial term.