Many people confuse the due diligence fee vs. earnest money deposit. While they seem similar, the first is different from the second.
- Due diligence fees enable a time frame for the buyer to investigate the property and cancel the property without penalty
- Earnest money shows good faith, and it protects the seller if the buyer backs out without cause
There is an important distinction between the two, as the first is a fee paid to the seller and the second is a down payment held in escrow.
What Does Due Diligence Mean in Real Estate?
The first area to look out in this study of due diligence vs. Earnest money is that period where the buyer should thoroughly examine the property. According to Roofstock, due diligence in real estate is when the buyer performs inspections on the property that they want to buy to ensure that the house is properly valued and in good condition. This is important because these transactions are complex and involve large amounts of money. Therefore, any real estate transaction requires careful planning. This process begins before you even bid on a property. For any real estate transaction, due diligence begins with learning the neighborhood before you even consider bidding.
Due Diligence for Residential Real Estate
While Residential real estate is relatively simple compared to other land deals you still should proactively learn as much about your financial situation and the property you want to buy. The first steps in the process should be:
- Learn what your budget is for buying a house
- Learn all you can about schools, transportation, and other infrastructure
- Make a list of important features and make sure the house includes those requirements
You should do these before you even begin looking for a house. The second phase of due diligence begins after you submit the contract. These steps include:
- Hire a licensed professional to perform a thorough inspection of the house
- Your lender appraises the property’s value, but if you pay cash, still take this step
- Order a title search of the home
These last 3 have deadlines, usually 10 – 15 days. The seller wants to finish this phase quickly, but if you need more time, you can negotiate before you sign the contract.
Due Diligence for Rental and Commercial/Industrial Properties
Rental properties are more complicated than residential. They are usually larger, more expensive, and may involve multiple investors. Therefore, these contracts are less generic. You need to perform all the same steps you do for residential properties, but you have added steps to ensure the financial health of the investment.
After you select a property, you need to:
- Perform physical inspections
- Review financial statements
- Deal with legal and loan issues
For simple investments it may not be much more complicated than buying a residential home. For large transactions, you need a team of professionals to help. In fact, there are companies, like Deal Room, that specialize in due diligence for complex investments.
For commercial real estate, you have the same due diligence concerns that you do with rental properties, but these transactions are even more complex. This is because you have the added concerns of the business for which you are buying the property. There are many other concerns specific to each individual venture. Commercial and industrial land deals are always very complicated and require a team or professionals to navigate the due diligence process.
What is a Reasonable Due Diligence Fee?
A reasonable due diligence fee depends on the market conditions and where you live. Most areas, except North Carolina and a few other places do not use these extensively. Even in an area that does use them, they are not mandatory. Therefore, they are negotiable. In a seller’s market (when there are few houses available) they can go as high as 5% of the purchase price. In a seller’s market (when there are many homes for sale) you may not have to put down a deposit at all. Sellers want this because:
- The seller agrees to not show the home for the duration of the period
- They may lose good potential buyers during this time
- Stagnant (been on the market a long time) properties tend to sell for less money
There can be a substantial risk for sellers, so some compensation may be reasonable. Usually, this money is credited back to the seller at closing. They may only recover this money if the seller breaches the contract. Raleigh Realty points out that sellers rarely breach the contract, and if they do it is usually because of a substantial physical problem with the property (like a fire), or they cannot provide clear title.
Do You Get Due Diligence Money Back?
You can only get due diligence money back if the seller breeches the contract, and that rarely happens. Therefore, it functions like a payment for a period for the buyer to perform due diligence activities. During that time the buyer may back out, but the seller is locked into the contract.
What Does Earnest Money Mean in Real Estate?
A buyer puts forward money to show good faith about the contract. It may also be called a good faith deposit. While the due diligence fee guarantees a period where the buyer may perform home inspections, the good faith deposit holds the buyer into the contract. It:
- Acts as a deposit
- Is refundable if the deal falls apart because of a contract contingency
- Is held in escrow
The seller credits the good faith deposit toward purchase price or closing costs at the closing.
Earnest Money and House Appraisal
Rocket Mortgage points out that you do not lose your earnest money if the house does not appraise when this clause is in your contract. Do not worry too much, though, because this is standard for real estate transactions. It is important protection because:
- You do not want to pay more than the house is worth
- The lender does not will make a loan for more than they can recover if they need to foreclose
Does this happen? Yes. Sellers often have inflated concepts of their homes’ values. Buyers, also, may be emotional. Furthermore, real estate agents make mistakes, and so do mortgage representatives. Appraisals are important because an independent appraiser can objectively value the home.
Earnest Money and Loan Approval
You do not lose earnest money if they bank does not approve your mortage. Many people believe that once they have a preapproval they are set, and they will get a loan. This is not true. A preapproval only tells you what you may afford based on your stated income.
Once you put a contract on a house, then the underwriting process begins. And that can be an arduous process. Your lender checks all aspects of your financial history to determine if you really have the money, debt to equity ratio, and credit history to be able to afford a house. Many things can go wrong in this process from missing documents to making unwise purchases during the process. In fact, the bank runs a last credit check just before the closing, just to make sure everything is good.
At any point they may deny the loan. If that happens then a mortgage approval clause becomes very important. Without it you lose your earnest money. However, it is a standard clause in most real estate contracts.
Who Gets Earnest Money When the Buyer Backs Out?
If the buyer backs out as a breach of contract, then the seller gets the earnest money. While there are many contingencies in the contract to protect the buyer, the one thing you cannot do is just walk away without a good reason. If you do, then you forfeit the money to the seller.
On the other hand, if the deal falls apart because of contingency, then you may recover your earnest money. That is why the attorneys keep these funds in escrow accounts until the closing.
Final Thoughts about Due Diligence Fee VS. Earnest Money Deposit
There is a distinction between a due diligence fee vs. earnest money Deposit. Due diligence is an investigation to verify the accuracy of a seller’s information and appraise value, while earnest money is a deposit to show the good faith of the buyer.