Help a Reader: New Home Construction Deposit

Here's a question I recently received from a reader:

We need advice on a new home construction deposit. 

In early 2007, we deposited a 10% binder on new home construction in northwest Florida.

At the time, we thought the price of the new home was reasonable but as we've seen prices have continued to drop and probably will continue to drop in the near future.  We are scheduled to close on the property in the fall. 

The market value of the still in construction property has decreased about 10%, so we are already in the hole.  We are currently debt-free and live in a house that's paid off.   We were thinking of renting out our current house.

My question is at this point should we consider just walking away from the deposit? ....or continue with the purchase and hope that the value doesn't drop much more and hope that it will eventually rise in the future.  The builder has offered  to help buyers who are having financial trouble but this doesn't apply to us ...yet.....we're just worried about catching the falling knife......We know at this point our deposit is non-refundable, has any body there in this position before and any suggestions??

What are your thoughts for him?

Comments

[Robert D> Ashby]

One question I would ask is if the house is a house they see themselves wanting to live in for a long time, ie a retirement location. If he truly wants to live there, the gain or loss is a moot point in reality. If he can afford it, wants to live there, etc., then go ahead with plans to buy and don't worry about the rest, whether gain or loss.

If it is an investment property, my advice may be different. Feel free to have him contact me if he would like to review his entire situation and I would gladly give some free advice, no strings attached.

[Dedicated]

Before even toying with the idea of walking - why not give the builder a call and discuss the market issues. I'm sure there is a business decline for him as well and a new price adjustment, might be put into play. It can't hurt to ask.

[7million7years]

My advice always differs a little from the convetional:

Money is also very cheap right now, so if you love your new home and want to close, borrow (and, lock in for as long as possible!) enough money against either/both properties such that you can:

a> Have no more / no less than 20% equity in the new home that you intend to move into

b> Have your rental property neutrally-geared i.e. such that the rents coming in (less 25% for contingencies) match you mortgage payments

c> Use the balance of the borrowed money to do the same as b> in more rental properties until you run out of deposit monies ... or until you are outside of your comfort zone.

If you can do this with a 10 to 20 year outlook, you will be well on your way to a MUCH MORE comfortable retirement.

BTW: Use a mortgage broker and accountant to help with the calcs in b>[why accountant: to make sure you are also taking into account any depreciation / tax-breaks that may help produce a positive cashflow].

[No Debt Plan]

These questions are always so hard. My question would be, why are you purchasing the new home? Is it just to upgrade? Is it a place where you are going to stay long term?

If it is a long term purchase, then you shouldn't worry about the value of the house today. If you are just trying to make money in real estate... then it gets more difficult.

[Mike S]

In the past, I would say this "tongue in cheek", but now I'm serious.

My advice- forget about living debt-free. Borrow as much as you can against your current home. Then go borrow more- again, as much as you possibly can. All loans should be adjustable rate and interest-only, of course. While you're at, borrow or cash-out your all of your retirement savings.

With all this cash and tons of debt...now go out buy as much house as you can; then go on a spending spree- new cars, extravagant vacations, etc.

Don't worry about paying anything back. Just stick out your bottom lip like a 3-year old and tell everyone you are a victim. Soon enough, the government will make certain that responsible citizens like myself will pay your debts for you.

It's a shame, but prudent people like me are the real smucks! Now, if you choose to reject my advice and continue to be prudent and responsible like you have in the past, then you can join me in paying other people's debt.

[Matt]

Assuming you do want to live in the new house and you weren't just making a speculative investment:

Find a comparable house for sale, ideally one in the same neighborhood built by the same builder. Let's call the price of this house "C".

Now, let's call the amount of additional money you would need to close on the deal you already made "A". Finally, let's call the amount of the deposit "D".

So walking away from the existing deal and buying the comparable house will cost you C + D, and obviously completing the deal costs you A. So if C + D < A, walk away or negotiate with the builder to lower A so that it equals C + D.

That's the simple version. Make sure you account for any other differences in cost when you make the comparison.

Read your contract carefully though. I've heard of builders in Florida suing people who tried to walk away from deposits.

[Matt]

So I did the math wrong. That's good news though, because it turns out it's even simpler (and cheaper). D is a completely sunk cost. D is the fee you paid to make A available to you as an option. All you have to compare is A and C. If A > C, tell the builder you're walking unless they make A = C.

BTW, @Mike S: LOL!

[wallace]

Hello all. Reason for purchase is an upgrade. Family of five have always lived in a small house. Waited many years to purchase bigger new house (about 2100 sf) Plan on staying there for at least 10+ years if not longer. Thanks for all the advice!

[Joe]

If the value of the house is going to be less than 90% remaining on the agreed price. Consider walking away or using the option of walking away to renogotiate.

Look at the 10% down as spent money (sunk cost). It is gone with no way to get it back. If the price delines such that the remaining 90% of the agreed price is 110% of the market value of the house, it would be nuts to pay that. You could walk away from the first contract and start fresh negotiations with values that reflect the market at the time you will be taking over the house.

~joe

[Mike S]

Wallace,

Seriously, your really only "lose" the 10% deposit if you walk away. You said you thought the price was "reasonable" when you made the deposit in early 2007. If you live in the home for 10+ years, that's plenty of time for things to rebound.

If you walk away, you lose the 10% deposit, and will need to come up w/ more cash if you plan on buying another home. What if the same thing happens the second time? You buy and the market drops another 10%? Then what?

Will you know when the market hits bottom? Buying at the bottom is fantastic but, I'm not smart enough to pick the bottom of the market.

Congrats on owning a paid for house! Good luck!

[Natasha]

I was in the same situation with a builder in Northwest Florida. I went back to the negotiating table with my builder and got the price reduced. When the construction is finished, the builder will not be able to sell it at your contract price. The builder wants to sell and more than likely, the builder will not let a qualified buyer walk away. Everything is negotiable. Re-NEGOTIATE!

[AdamCO]

7million7years:
thanks for the advice. i would have to say, however, that your advice is very conventional and sounds like a lecture from my accounting 101 class.

over leveraging a bunch of rental properties is placing a bet on the success of the real-estate market. it just doesn't make sense at a time when most properties in this country are significantly overvalued.

to the buyer: renegotiate and if the seller doesn't budge, walk away. the easiest way to build a down-payment in this market is to simply wait. if i buy a house in 2009 instead of 2008, i've saved an easy $35,000, way more than i could actually save in a year.

[Fred]

RE Mike S.
Your comment makes me laugh and weep at the same time.

[Kevin]

Wallace - no harm in asking the builder for a price reduction. If he's hurting for work, he may be willing to work with you. Otherwise, I would stick with it as that is probably a good chunk of change you would lose.

Good luck and congrats on paying off your home.

[Amelia]

Am I the only one who is bothered by the fact that when you made a deposit, it was making a promise to the builder? How does he figure into all of this? He has bills to pay too. Negotiate, surely, he's probably more than willing, but in my mind, it seems unethical to walk away.

[Mike S]

Good point Amelia; What if the builder wanted to re-negotiate the price in a rising market! But I guess that's the purpose of the deposit.

I'd be careful to negotiate too hard. Otherwise, good luck getting the builder to come back for warranty repairs after closing.

[fathersez]

I think that buying a completed house, even if it costs a little more, is better than contracting with a builder. (Unless, of course, you have a whole set of special specs).

And if prices of houses in the region are dropping, have a look around, and see if you can get one at a price cheaper or equal to what you would pay the builder.

At least you can see and check what you are buying.

And if the completed house option is better, then walk away from the deposit. Like others have said, it is sunk costs.

[AdamCO]

Amelia:

If you and me were sitting in a room, you would be the only one who would be bothered about the promise to the builder.

It's a business transaction, plain and simple. If I put a Playstation 3 on layaway and pay 10% down, then the Playstation drops in price by $100 the next week, should I be expected to pay the original price from when I put it on layaway? Of course not! The store understands it is a business price and the Playstation is worth what it's now worth.

Shame on builders for making buyers pay yesterday's prices.

[Foobarista]

Renegotiate. The builder wants your money and will do anything to sell the house to you instead of building it and having to sell into an awful market. A deposit isn't a promise; it's a call option contract on the house at a 10% discount off the "face value", paid for with the 10% deposit. If you walk away from your deposit, you are surrendering your call option.

The math as to whether it's worth exercising the call option is simple: if the strike price has dropped by more than 10%, it isn't worth exercising from an economic point of view. If the market price has dropped 25%, it isn't worth exercising your option unless you get at least a 15% discount.

For more on call options: http://en.wikipedia.org/wiki/Call_option

[JK]

Will the rental market see an increase in demand due to the number of people that will be unable to buy a home after their foreclosure? I have considered renting out property also, and I wonder if this is a possibility.

I realize there is a glut of housing on the market, but I think you have to wait anywhere from 2-7 years to qualify after a foreclosure. Where will all of these people live in the meantime? Are we going to see another period of intense speculation when these previously irresponsible buyers are allowed to buy again?

I'm getting a little carried away here, but I would be interested in hearing others thoughts.

[Matt]

Mike S: it's not that he loses the deposit only if he walks away. I had the same confusion myself at first. It's a sunk cost, meaning it's lost whether he pays the remaining 90% of the previously agreed price or walks away. Putting down a deposit is basically making a bet that the market price will have gone up by the time the house is ready. It's like a futures contract.

When the house is ready, the buyer has a choice: pay the remaining 90%, or pay the fair market value of a comparable house. So assuming he still wants to buy a house, the rational thing to do is pay whichever happens to be less. To pay the remaining 90%, if it happens to be the higher cost, would only exacerbate the loss.

So suppose the comparable house is cheaper. Even if we can expect the value of the house with the deposit on it to rise in 10 years, the buyer is still better off going with the cheaper house because its value will rise the same way and the gain will be larger. All that matters are the options available at the time of purchase.

[Dennt]

There has been a lot of good advice in the previous posts... That being said, here is my take:
1) Ask yourself why are you purchasing this home. Is it for an investment? Is it for an upgrade? Do you plan on living in this house longterm? If it is an investment, then look at the previous posts that deal with the money calculations and make your decision. If it is an upgrade and you intend on living in that home for 5-15 years, then looking at the monetary side of the issue is moot, as you will definitely see gains in you home's equity over the longterm. Remember, purchasing a home for the right reasons will yield equity gain over the LONGTERM. Homes are not stocks, nor commodities, they are dwellings that provide people with the basic need of shelter.
2) Take you contract to a real estate lawyer to discuss your exposure if you default on your side of the contract. Regardless of what people may say, you entered into a contract. There are repercussions of defaulting on that contract. Most builders have a clause regarding "specific performance", and use terms like "acting in good faith". Look for these phrases in the contract to find the sections and read them carefully. Builders write these sections into the contracts to protect themselves from purchasers that default on the contract. Usually the contracts allow them to a)Let you out, no strings attached, b) Let you out and retain your deposit monies, or c) retain your deposit monies and take you to court to sue you for specific damages. These specific damages can be anything from costs to resell the home, or the entire cost of the home itself. So definitely take the contract to a real estate lawyer to figure out your exposure.
3) Talk to the builder. As people have mentioned, the builder wants you to settle. Builders DO NOT want to have a Spec Home (asset) to resell in difficult market. They WILL work with you. They may not cater to exactly what you want, but they will work with you. If you are using their lender or their "preferred lender" you may want to negotiate all closing costs. That should offset some of the devalue of the property. If not, ask for them to reduce your sales price, but be reasonable and have data on hand to back up what you are asking for. You will need to get past the sales person to get to the decision makers (management) Sales people are savvy and equipped to deal with people in situations such as yourself. Figure out what you want and ask to speak to their manager. If you cannot get to them, start firing off emails to everyone in the profit center or company (depending on the size of the company). Remember, business is a win-win proposition; the builder gets your money for profits, you get a beautiful home. The deal should be structured to reflect the balance of those sides. You should receive a quality product at a fair price.
A side note about builders: Builders are not trying to rip people off. Builders are a business and as a business then need to make profits. They are providing a product (house) and a service (construction and warranty service). Buyers need to understand that builders do not set the market, they serve the market. The price that they sold you the house for was based upon current market value AT THE TIME OF THE SALE. Builders cannot predict the market and thus cannot future-proof pricing. They have hard costs, and soft costs that they need to manage. This does not mean much to the consumer, but it will be reflected in your negotiations with the builder to lower the sales price. I know that this is a long-winded post, but hopefully it helps.

[Teri]

I have to agree with some of the other comments. Certainly ask. They rather re-negotiate the price, then lose their customer, for sure.

We put a non-refundable 3% deposit on our current home and for a time thought we would have to walk away for various reasons. Being persistent the builder was willing to give us back our deposit at one point. So asking, and being persistent does help. In our case, we decided to go through the purchase. We had just had cold feet for a while when our old home wasn't selling. But that was during the boom and hey had 100 people lined up to take our spot. They just didn't really care. They could charge MUCH more for the house if we backed out, since it had appreciated so much in the time since we had reserved the price.

Likewise, you may be in a similar spot. They probably have no buyers, and though they may be less willing to give back the deposit, they may be willing to negotiate to keep you.

[John]

I am in the same situation...possibly walking away from a house we are building. My job situation has taken a turn for the worse and finances are my issue/reason for wanting to walk. Can anyone tell me how this affects credit scores for a future home purchase? I would hate to find a house in the future which would be more reasonable and not be able to get approved because of a credit score collapse. I definitely will try to Re-negotiate with the builder first and foremost, but if I have to walk then I want to know the credit consequences please. Thanks and I enjoyed reading everyone's commments on here so far...very insightful.