This article explains when a buyer’s breach of a purchase agreement or escrow instructions entitles a seller to recover money losses for failure to close.
To read about how the law is applied through different examples of a buyer’s breach, see Part 2 of this series.
Buyer’s remorse, as prices head for the mean price trendline
Consider a buyer who submits an offer to purchase a home. A purchase agreement is entered into with the seller, and escrow instructions are prepared and signed.
As the weeks go by, the buyer notices other nearby, similar homes offered and available at lower and declining asking prices than they have agreed to pay. They now realize they are in a falling price environment and have agreed to overpay for the home they have under contract.
In this situation, buyers occasionally might decide to cancel the purchase agreement and buy a lesser-priced comparable home — or, simply wait for prices in the local market to bottom.
Conditions covered by contingency provisions may permit buyers to cancel their purchase contract with legal justification, as they lose their qualifications to buy, including:
- unexpected job loss without a reemployment opportunity due to economic conditions; and
- higher interest rates pushing their debt-to-income (DTI) ratio beyond the maximum threshold.
As the above scenarios continue to play out in a recession, more buyers are canceling purchase agreements.
The question then arises as to whether they are also breaching their contract with the seller when they cancel without cover of an enforceable contingency provision. When the contract is breached, the seller is entitled to recover money losses for failure of the transaction to close and deliver the net proceeds.
Buyers and the buyer’s agent ought to do their full due diligence review before entering into a purchase agreement — including sufficient contingency provisions allowing for cancellation due to mortgage qualification, property condition disclosures, or time-essence issues; maybe even third-party valuation appraisal approval.
Thus, agents need to be prepared for the common occurrence of cancellation — either on a questionable exercise of a contingency provision or one without justification to excuse the buyer from proceeding to close the transaction.
When the buyer’s cancellation of a purchase agreement constitutes a breach for lack of proper justification, the implications for the seller can range from an inconvenience to a minor or huge money loss on the resale of the property. Either way, it will be the buyer’s and seller’s agents sprinting into the fray to assist their clients to meet now conflicting objectives.
Read on to supplement your knowledge about managing buyer cancellation decisions.
Value fluctuations in the market
During periods of reduced regional economic activity, the boom-bust cyclical nature of real estate sales typically causes California property values to drop dramatically below the price the buyer agreed to pay just a few months earlier before the bust phase – the buyer’s market – takes hold.
Further, the intangible impacts on a property’s market value, due to its “shopworn” listing status and the “fall-out syndrome” of a lost sale, give the property an aura in the local real estate market which negatively affects some buyers and their brokers. This aura is often reflected in a further dampening of the property’s value on the date of breach. [Bouchard v. Orange (1960) 177 CA2d 521]
Related article:
A seller’s options when the buyer cancels
A seller of real estate faced with the failure of the sales transaction when their buyer cancels needs to promptly decide whether to:
- enforce the purchase agreement and have a court order the buyer to close escrow, called specific performance, which we do not discuss in this material;
- remarket the property for sale and diligently seek a buyer; or
- retain the property and postpone or entirely forego any resale effort.
On a resale effort, only money losses are recoverable
A buyer, due to their breach – unjustified cancellation – of the purchase agreement, owes the seller their actual money losses caused by the breach, called damages, which are classified as:
- general damages, the dollar amount of any decline in the property’s fair market value (FMV) below the price agreed to in the purchase agreement as of the date of the buyer’s breach;
- special damages, also called consequential losses, being:
- transactional costs incurred by the seller while preparing to close under the breached purchase agreement;
- marketing expenses, increased closing costs and ownership and operating costs incurred to remarket and sell the property;
- collateral losses the buyer reasonable expected the seller will incur on the buyer’s breach; and
- any further drop in property value after the buyer’s breach for as long as and only when the buyer interferes and stalls the seller’s resale effort; and
- interest from the date of the buyer’s breach to the closing date of a resale of the property on all money and any carryback note the seller was to receive; [Calif. Civil Code §3307] less
- offsets or credits due the buyer for:
- any rent received from tenants or the implicit rent for the owner’s use of the property;
- the amount of any price increase on the resale; and
- the amount of any reduction in the seller’s expenses on the resale, so the seller is not placed in a better financial position than had the breaching buyer fully performed. [Smith Mady (1983) 146 CA3d 129]
Price-to-value money losses in a falling price environment
A seller decides to resell the property when their buyer breaches their purchase agreement. The property’s value on the date of the breach is less than the price set in the purchase agreement. Thus, the seller has incurred a loss in value which is recoverable from the buyer, called general damages.
However, the amount of value difference — typically due to a decline in market value or when the buyer simply agreed to pay to too much — that is recoverable when the seller resells the property is limited to two time periods:
- the initial decline in value below the purchase price during the period before the breach, recoverable as general damages; and
- any further decline in value after the breach, recoverable but only when and for so long as the buyer interferes with the seller’s resale effort, as special damages. [CC §3307]
The price-to-value difference on the date of breach is recoverable by the seller whether the property is retained, remarketed or resold by the seller.
Related article:
Equal or greater net proceeds on a resale
In contrast, a property is resold and the net proceeds from the resale are the same or the cash equivalent, or more, than expected had the breached purchase agreement had closed escrow. Here, the price-to-value difference on the date of breach is no longer recoverable. With equal or greater net proceeds on a resale, the seller incurs no money losses since there is no lost property value to recover.
To set the dollar amount of the price-to-value difference on the date of breach, any “noncash” terms for payment of the purchase price by the breaching buyer and “noncash” terms for payment of the resale price are converted to their cash equivalency.
For example, the terms for payment of a sale price might include a seller carryback note for principal and interest. When the interest rate bargained for reflects a discount from mortgage money market rates, the principal amount of the carryback note is adjusted downward to convert the carryback paper to its cash equivalent, i.e., its present value (PV) in cash. In turn, the price is adjusted downward an equal amount, the result of adding together the amount of a first mortgage principal balance, the PV of the carryback second mortgage and the down payment amount.
Related article:
To read examples of when a buyer’s breach entitles a seller to collect on a monetary loss, see Part 2 of this series.
