Look out for these three most common conditions in your real estate contract:
- “Subject to finance”
- “Subject to pest inspection”
- “Subject to building inspection”
The spotlight now is on the first of these conditions, the finance clause, since obtaining finance is becoming more difficult in the current market (Sept 2015 — learn more here).
What the finance clause means
Should the buyer in a real estate transaction be unable to obtain finance, the finance clause sets out a procedure for the buyer to end the contract. It’s a protection mechanism for the buyer. Generally a rejection letter from the nominated lender is provided, the buyer gets their deposit back and then both parties move on.
The finance clause is usually set at 7-21 days after the exchange of contracts, so once the clause lapses the buyer must be 100% committed to purchasing the property. Failure to go ahead with the purchase — due to being unable to obtain finance, or for any other reason — usually results in the seller finding new buyer, and then the original buyer losing their deposit and potentially being sued for any shortfall on the new sale price (plus interest, fees and costs) too.
Unless adequately protected failure to go ahead with the purchase means the buyer loses their deposit and potentially gets sued for the losses incurred by the vendor too.
There’s no finance clause when you buy at auction
Note that finance clauses do not apply for auction sales. In the case of auctions serious buyers usually mitigate their risk by obtaining a finance “pre-approval” before bidding. This involves the submission of a loan application to a bank before selecting a specific property. If the pre-approval process is successful then obtaining finance is more certain.
Low valuations don’t get you out of finance clauses (valuation clauses do)
When it comes to obtaining finance, the bank assesses the borrower’s loan application based on the valuation of the security property being purchased.
This valuation is provided by an independent assessment of the property provided by a professional third party valuer. For the loan to be approved the leverage ratio of the borrower relative to this security value must be within allowable parameters and the overall loan size must also be deemed serviceable by the borrower to limit the bank’s risk.
Along with the recent APRA crackdown on investor lending, as well as signs that the property markets in Sydney and Melbourne may be starting to soften, many valuers are beginning to take a more conservative approach. In the current market it’s not uncommon to see property valuations come in below contract prices — and these scenarios can be awfully stressful as the inference is that buyer has overpaid.
When faced with a low valuation, the buyer has tough decisions to make:
- consider going to a new lender, in the hope the new lender provides a more favourable valuation (and also approves the loan);
- borrow a larger sum from the original bank (if possible) to complete the purchase; and/or
- contribute additional funds with the original bank (if possible) to complete the purchase
If due to the low valuation the original bank is unwilling to provide the loan (e.g. options ‘2’ and ‘3’ above are not possible), then the finance clause protects the buyer and the real estate contract can be ended without penalty.
However in options ‘2′ and ‘3’ above the bank may still be in a position to make the loan (if the buyer can still afford it) in which case the buyer will still be on the hook.
So finance clauses serve a good purpose however the real protection against a low valuation is having a “valuation clause” (not a finance clause) in your contract. We will discuss valuation clauses in a separate post but be sure to ask your solicitor about them.
It pays to get the right wording
Signing a contract with wording provided by the seller’s real estate agent can place you at risk. The seller’s agent acts in the best interests of the seller, so as a buyer it’s important to get legal advice on the right wording before you sign.
Buyers should pay particular attention to loose wording around finance clauses like “the finance clause expires X days after the purchase is accepted”. This is ambiguous because verbal acceptance may come well before a signed contract (formal acceptance) — so it’s unclear when the purchase is actually accepted. The buyer won’t be able to obtain finance without a signed contract so not having a signed contract may create undue pressure for the buyer to commit to the purchase prematurely.
Be smart about your finance
Certain operators hold the view that finance clauses limit a buyer’s negotiating power and therefore should be avoided. This may be true to a degree however finance clauses are clearly useful from a risk mitigation standpoint and they are becoming more widely accepted as a standard contract item now that obtaining finance is becoming more difficult.
If you’re working with a buyer’s agent a good agent should be able to work around finance clauses anyway and still negotiate effectively on your behalf.
If you’re unfortunate enough to receive a low valuation first speak to your solicitor and see whether finance can be extended.
Time permitting it usually pays to seek finance from an alternative lender who hopefully values your property more favourably (e.g. at the contract price, see option ‘1’ above).
If the valuation provided by the second lender is stronger it’s possible to take the new valuation back to the original lender and ask them to match it. The new valuation usually introduces new comparative sales which assist this process.
You should only commit to contributing more funds towards your purchase as a last resort.
When buying at auction finance clauses aren’t relevant however risks can still be reduced by obtaining a finance pre-approval before bidding.
To go about your next purchase sensibly make sure you have a team of experts around you who will guide you through these processes. At the very least you should have a good solicitor reviewing your contract before signing and a good finance broker ensuring your loan structures are optimised.
