How Not to Back Out of a Contract
Buying an investment property is a big decision. With hundreds of thousands of dollars at stake, it’s no wonder investors sometimes get cold feet.
There are ways for buyers to legally back out of a contract of sale, but be careful. Although real estate sales contracts often tend to favour the buyer, contract provisions still give considerable power to sellers.
Back in April, 2014, two property investors agreed to purchase a home in the Melbourne suburb of Richmond for $4.48 million. The property was located across from Epworth hospital and came with a permit for medical rooms, meaning it was technically a commercial property.
A few days later, the investors got cold feet, and since they were within the cooling off period of three business days, they notified the vendor’s agent in writing of their wishes to pull out of the contract. The agent replied the following morning, on day four, to say the cooling-off period had expired, and suggested they take the matter up with the vendor’s solicitor.
The seller refused to return the $350,000 deposit to the buyers, and instead relisted the property for sale. Four months later, another buyer came along and paid $4.07 million.
The investors filed suit against the seller to recover their $350,000 deposit. The seller filed a counter suit. He demanded the buyers pay an additional $98,000, being the remainder of the 10 percent deposit, plus the vendor’s $410,000 loss on the resale of the property, plus his sales costs for reselling.
This was quite the standoff. So, who do you think was in the right?
In the end, the judge ruled in favour of the seller, demanding the buyers pay up in full, plus reimburse the vendor for all his legal costs. In total, these unwitting investors could end up paying out over $1 million for their mistake.
Where did the buyers go wrong? The judge ruled that a cooling-off notice must be served to either the vendor directly, or the vendor’s solicitor, but never to the vendor’s agent, unless the contract specifically gives that liberty.
This story highlights the importance of buyers understanding the rules of the game, and most importantly, thoroughly understanding the terms of the contract.
Here’s how to make sure you never find yourself on the wrong side of a legal standoff:
1. Carry Out Thorough Due Diligence Before Over Committing Yourself.
Never rush into signing a contract when you have doubts. Unless you’re 100 percent sure the deal stacks up, don’t make an unconditional offer.
Many investors rush into deals for emotional reasons. Sometimes they get caught up in the hype of a euphoric market are afraid they’ll miss out on an opportunity. Other times, they make rash decisions without looking at the deal from every angle.
I’m not sure why these Richmond investors decided to pull out. Perhaps they decided they had paid too much. Maybe their circumstances changed and they could no longer justify the purchase. Likely, they overlooked a vital aspect of their due diligence and needed to change course. Either way, they over committed themselves.
2. If Possible, Include a Get-out Clause.
You may need to secure a property for purchase before your due-diligence is completed. It’s okay to enter into a contract when you still have doubts, as long as you leave yourself a way out.
A “subject to due diligence” clause is a time-limited, catch-all clause that buys you time to carry out a more thorough due diligence before going unconditional. Depending on the market, you may not be able to get the vendor to agree to accept such an open-ended clause, but giving the vendor more favourable terms can soften the blow.
I’ve written more about other “subject to” clauses in the article, “4 Simple Rules for Submitting Offers on Investment Properties.”
3. Cancel the Contract Within the Cooling-off Period.
Many residential contracts include a cooling-off period. The terms of the cooling-off period depend on the laws of each state, as well as the specific pre-contract negotiations between the buyer and seller.
Here’s a basic overview of the cooling-off laws for real estate purchases in each state:
- Victoria: Three business days, with a financial penalty of 0.2 percent of the purchase price.
- New South Wales: Five business days, with a financial penalty of 0.25 percent of the purchase price.
- ACT: This is the same as NSW.
- Queensland: Five business days, with a financial penalty of 0.25 percent of the purchase price.
- South Australia: Two business days, with refund in full of purchase deposit over $100, but forfeiture of holding deposit.
- Western Australia: No mandatory cooling-off period.
- Northern Territory: Four business days, with no financial penalty.
- Tasmania: No mandatory cooling-off period.
As the story above about the Richmond investors illustrates, there is a right way and a wrong way to exercise a cooling-off right. Be sure you thoroughly understand the terms of your contract.
4. Walk Away From Your Deposit.
The final way to back out of a contract is to simply walk away from the deposit. This option would seldom make financial sense, unless the costs of continuing with the purchase become greater than the costs of pulling out.
Some have speculated that investors who are now buying off-the-plan apartments in Melbourne and Brisbane could end up walking away from their purchases. Many have put down 10 percent deposits, but most lenders have recently changed their lending criteria to require an 80 percent LVR for investors. The problem could be compounded if prices fall and valuations don’t stack up.
It’s important to be mindful. Before walking away from your deposit, keep in mind that the saga may not be over. The vendor may come after you for their losses if the property sells to another buyer for less than your contract amount.
Back to the Richmond investors: In hindsight, walking away from the transaction would have brought them a much better financial outcome than taking the seller to court. The judge had little choice but to honour the sales contract to the letter of the law.
If you end up having to walk away from a purchase and forfeit your deposit, you likely haven’t done your homework before entering into an unconditional contract. By using a thorough due-diligence system, you should not have to resort to drastic measures.
The greatest protection is to arm yourself with thorough education, so you never find yourself on the losing end of standoff with a vendor. In Steve McKnight’s Property Apprenticeship course, the entire third module is dedicated to analyzing and buying properties. Steve includes a thorough due diligence system that empowers you to buy on fact, rather than on opinion, speculation or emotion.