I’m currently purchasing a new house and I want to share some insights. Baseline knowledge: Houses are unique goods on multiple margins that are imperfect substitutes. Let’s assume that both a buyer and a seller have real estate agents in the USA. The opportunity cost to the buyer is selecting another house that is not quite as desirable or finding a comparably desirable house after a wait (due to time searching and the appearance of new listings). Legally, the seller is not allowed to lie about the property details (though they can claim ignorance). The lending process makes it difficult for the buyer to lie.
Step 1: List and Bid
The seller chooses a price low enough that will permit a sale within their preferred timeframe, and high enough so that they earn a commensurate return. There is a tradeoff.
The buyer makes an offer. Before buying, I thought that the offer was, more or less, just bidding a price. That would make the problem nice and 1-dimensional. It would fit nicely into the auction theory that I learned in grad school. But that’s not the whole story. As it turns out, an offer specifies other details too. It specifies:
- The price.
- Earnest money. This is the amount that the buyers pays immediately in order to signal legitimate interest in the property. It’s often held in escrow by a 3rd party in order to improve credibility.
- The number of days until closing (signing the final contract).
- The number of days for ‘due diligence’. This is the period during which inspections must/can be done. The seller or their agent must make the house reasonably available for inspection during this period.
- The appraisal period. This is the length of time during which an appraisal of the property determines the value of the home insofar as a lending institution is concerned. Without a loan, this number can be zero is irrelevant.
- A lender’s pre-approval letter specifying the permitted size of the loan and the down payment. This is a signal of credibility that the buyer is able to pay. The buyer can request to be approved for a smaller loan in order to signal unwillingness to pay more.
- Any contingencies, such as whether another property must sell first, or a delay is requested. Really, this can be almost anything that the buyer wants. Some people get creative in their offers, like paying a higher price in exchange for a later closing date or rent-to-own contracts.
Given the above details, a potential buyer would like to craft the offer to meet the seller’s preferences while also acknowledging the scarcity of the buyer’s resources. As it turns out, not all resources are instantly convertible. One may be willing to move quickly but have a lower budget. Or, be willing to pay a higher price, contingent on the sale of another property.
Step 2: Active Bidding
Once offers have been made, the seller is likely to provide a notice of multiple offers to the bidders. This is the seller’s opportunity to shape the offers to better align with their preferences. They are likely to give priority to the offer which already most closely gives them what they want. Therefore, knowing some details about the seller early on can be valuable info for a bidder. Real estate agents, by experience and research, make a habit of investigating and intuiting a seller’s priorities. So far, this process seems pretty good insofar as market efficiency goes.
Step 3: Due Diligence
Congratulations! You’ve won the bid. Both buyer and seller sign a contract specifying assent to the now-curtailed offer. You’re both under contract. All of the details above are specified. This is where things start to get messy. Up until now, there were multiple bidders and a buyer might bid on multiple houses. Now, things are starting to get real… and intimate. Now, we’ve moved from bidding in a competitive market to bargaining between two parties (for simplicity).
During the due diligence period, the buyer can investigate almost whatever they want so long as they don’t damage the property.* If they want, they can walk away from the transaction during this period. If there is a loan, then a standard home inspection is required by law. Inspectors are trained and licensed to encourage objectivity and uniform standards, though skill and experience vary. The buyer can be present during the inspection and can ask specific questions that the inspector may entertain and address in the final report (which is furnished to both buyer and seller). The inspector may encourage additional inspections by experts in plumbing, roofing, a structural engineer, electrical work, etc. The buyer may or may not choose to employ these other experts.
Step 3: Renegotiation
Here’s the rub. An inspector may find something wrong or worrisome about the property. While the price is already legally defined, the bidding and bargaining isn’t over. The buyer can request a ‘seller’s credit”. This is essentially a transfer of money from the seller to the buyer at the time of closing. It’s a way of affecting the net price of the property without affecting the legal price. Back at the bargaining table, the seller can choose to concede, balk, or counteroffer.
This is tricky. From the seller’s perspective, they chose the best offer already. Now it’s 10-20 days later. The other bidders are gone, though they could still be interested. It’s hard to say. If the seller balks and the buyer walks, then they have to start collecting bids again. That’s frustrating generally, but downright painful if the seller’s priority was to sell quickly. Further, if there was damage found by the inspection, now the seller is legally required to disclose it to future buyers. Therefore, a hard-nosed buyer could request just below the discount that the seller would have to take due to the newfound damage being made public. Add to the request the value that the seller places on closing 15-30 days sooner, and we’ve got a moment that smells ripe for extortion.
What prevents pervasive extortion? First, it’s probably happening a lot and we don’t hear about it. Renegotiations happen behind closed doors, usually between the real estate agents at the behest of the buyer and seller. And that’s where markets get efficient again.
Real estate agents have a reputation to uphold. If an agent becomes known for unreasonable renegotiations, then you can bet your britches that word gets around to selling agents. Future offers from bidders who use the sly agent are less likely to have their bids selected for contract. Seller agents hold ransom the future contracts that the buyer’s agent desires. So, the buyer’s agent may dissuade the buyer from being extortionary with the renegotiation. Ironically, the market is made to work better because the buyer’s agent *doesn’t* perfectly serve the buyer. They also have their own reputation and future earnings to worry about. Therefore, they try to keep the renegotiation and request for credits in the realm of reasonable. If not by design, agents function to find a happy medium between the buyer, seller, and agents in order to enable successful transactions. In the end, there is another contract to sign.
Step 4: Appraisal Period
There is no more room for explicit bargaining. The appraisal will be completed. If it’s consistent with the buyer’s pre-approval, then the lending institution verifies that there are available funds and this step is a non-event. Nothing happens between the buyer and seller.
If the appraisal results reflect a low property value and the buyer doesn’t have adequate funds to purchase the property, then they must notify the seller by the end of the appraisal period.** The contract is dissolved after investing time and resources, but at least the buyer gets to keep their escrow deposit. This period gives the buyer another chance to walk away. They just need to have finances that “don’t work” (by accident or design).*** This is where the features of the initial offer matter again. More earnest money and a larger down payment indicate better financials. The seller wants to ensure that the buyer is not at risk of failing the financial health test that the appraisal and contract impose.
Step 5: Closing
Completing a contract for a residential property sale is expensive. By default, the seller pays the real estate gent fees (about 5-6% total). There are a bunch of taxes and fees. The buyer must also pay property taxes, property insurance, and HOA fees for the balance of the year – all at the closing. Closing costs differ by state and circumstance. The consequence is that your closing costs are a mysteriously large number. This part is strange to me. Because the closing date affects the closing costs, and because renegotiations happen, the closing costs are not known at the time of making an offer, going under contract, or even by the end of the due diligence period. Really, we just become increasingly certain about the costs as the date approaches. The title company (that’s another story) and the lender estimate the closing costs early on assuming that everything runs smoothly. But it doesn’t always work that way. A delay of even 1 day changes the closing costs. Not to mention that the real estate agents can adjust their fees and provide credits to the buyer or the seller.****
So, closing costs are ball-parked ahead of time. That feels wrong to me because it’s all calculable, given some assumptions. The reality is that they can be very well forecasted, but that the details change throughout the process and each detail affects the cost. Rather than create a new estimate on a daily basis, the loan processor typically just updates the estimate at milestones in the process. If you’re a savvy buyer, then there is no reason that you couldn’t keep track of and update these fees yourself. It must not pay the lender to expend resources on precise estimates. Most people know that they need a bunch of money based on market comparisons, and they become increasingly confident as the process progresses. Finally, if borrowing, at no fewer than 10 days prior to closing the buyer must have funds to cover their down payment and all closing costs. At closing, everyone sign a boatload of paperwork.
Congratulations. If you stuck with it, then you just bought a house and you need a drink.*****
*The seller can prohibit damaging, dangerous, or risky activity, such as tearing up some flooring or climbing the roof.
**The buyer may appeal the appraisal result and the buyer’s agent can provide their own market analysis of comparable properties. The lending institution may acquiesce and we’re back on track.
*** There is no more room for renegotiation above the table. This would only be an opportunity for off-the-record requests. Real estate agents don’t legally entertain this round of renegotiations.
**** They don’t want to be known for doing this because it makes them a potential bargaining adversary with their client or the other agent. An agent’s credit wouldn’t be included in the closing cost estimate ahead of time (it would be documented elsewhere).
***** Also, if you made it this far in the post, then you probably need a drink.
I didn’t know half of this. Now I understand why “all cash offers” matter. I wonder if you had a difficult time getting a house you wanted. The market has been brutal for buyers in northern Virginia ever since the pandemic.