Are Earnest Money Deposits Refundable? Everything CRE Developers Need to Know

As commercial real estate developers drift into a restless sleep, they can almost hear sellers whispering in their ears, "Are you truly serious about buying?"

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Picture this: you've found the perfect commercial property, planned every detail, and are ready to seal the deal. But wait. Providing earnest money can strain your resources and limit liquidity. So, you have wondered, are earnest money deposits refundable? And are there any alternatives for CRE financing?

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To begin with, let’s identify the top points commercial real estate (CRE) developers often face, which vary depending on the specific circumstances and market conditions:

1. Paying earnest money requires upfront capital, which can strain the liquidity of CRE developers.
2. If a deal falls through, there is a risk of losing the earnest money deposit.
3. Financing contingencies are often included in purchase agreements to protect sellers, requiring developers to put up additional earnest money.
4. Negotiating the amount of earnest money can be a sensitive issue between buyers and sellers.
5. Different jurisdictions may have specific regulations and requirements concerning earnest money deposits.

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CRE developers should work closely with their legal and financial advisors to develop strategies that minimize risks and optimize their financing approach; however, to provide a better understanding of the possible solutions, this article will cover the following:

1. Common forms of commercial real estate financing
2. Are earnest money deposits refundable? (And other challenges)
3. Strategies to overcome earnest money challenges
4. Soft deposit financing to overcome liquidity shortages for earnest money

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[Starting a new CRE investment and need to find reliable funding quickly? Duckfund provides CRE developers loans in less than 24 hours, and with lower interest rates and higher approval rates than traditional loans.]

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1. Common forms of commercial real estate financing

Funds are the cornerstone for developing a successful investment in commercial real estate. Here are several commonly utilized options for financing commercial real estate:

Bank loans

Traditional or bank loans are the most commonly used tool for financing commercial real estate properties. They usually offer lower rates than other types of loans and are highly customizable.

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Bank loans are long-term loans, usually extended to 20 years, allowing developers to pay off the loan while keeping some liquid assets for future developments. However, qualifying for such loans can be difficult as they require a down payment, income verification, and a high credit score. Additionally, the approval process can take a long time.

Crowdfunding

Crowdfunding has emerged as a relatively new and increasingly popular option for financing commercial real estate. Through online crowdfunding platforms, CRE developers have flexibility in connecting with potential investors. It allows small capital investors to invest in projects historically reserved for the ultra-wealthy.

CMBS loans

CMBS loans, "Commercial Mortgage-Backed Securities," are also a common way to finance commercial real estate deals. These loans are structured through a financial firm, usually a bank that pools multiple commercial mortgage loans and sells them as bonds to investors.

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The CMBS loans grant the developers access to significant capital, longer loan terms, fixed interest rates, and non-recourse liability for borrowers. And it is a favorable choice for investors due to the diversified investment opportunity and the ability to choose different return plans.

SBA loans

The United States Small Business Administration(SBA) loans are government-backed loans designed to finance small businesses in the United States. The two common types of SBA loans are SBA 504 Loans and SBA 7(a) loans with funding up to $5 million. However, the main difference is in the repayment as 7(a) is a short-term loan ranging from 7 to 25 years, while the 504 loans range from 10 to 25 years.

Hard money loans

Hard money loans are a fast financing solution that might be processed and secured in one day. They are short-term loans with fewer eligibility requirements and high-interest rates. Like traditional loans, the loans are evaluated based on the commercial property value, not the developers' credit history.

Online lending platforms

Online fintech platforms are a rising trend in the commercial property market for quick and easy financing. Such platforms streamline the eligibility process for loans by ignoring some financial requirements, such as credit scores and years of business experience. Additionally, these loans are available around the clock, and the lending process sometimes takes less than 24 hours.

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2. Are earnest money deposits refundable? (And other challenges)

After identifying the right commercial real estate property and finalizing all the necessary arrangements, the next step is to proceed with closing the deal. This is when earnest money, referred to as a "good faith deposit" or "soft deposit," comes into play.

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Unlike down payments, the earnest money is typically refundable.

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According to Paul Kim, an associate editor at Personal Finance Insider, “Earnest money can be refunded to you under certain circumstances and if it's built into your contract.”

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A third party normally holds the earnest money in an escrow account until the deal is completed. If the sale is successful, the earnest money is applied to the purchase price or used to cover closing costs. However, suppose the transaction fails due to certain circumstances in the agreement, such as a failed inspection, inability to acquire finance, or seller breach of contract.

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In that case, the earnest deposit may be refunded to the buyer. The specifics of refundability should be clearly stated in the agreement or contract. So it is critical to thoroughly review those terms before signing into any arrangement and to seek legal counsel if necessary.

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Additionally, earnest money deposits may raise additional challenges, such as:

• Appropriate amount: It can be difficult to determine the proper amount of earnest money.
• Disputes and cancellations: Buyers and sellers may disagree on releasing or forfeiting earnest money if a transaction is canceled.
• Legal and contractual obligations: Both parties' legal and contractual obligations must be carefully considered when resolving disputes involving earnest money.
• Reviewing terms and conditions: Understanding the terms for refundability and any obstacles requires carefully reading the agreement.

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For many developers looking to expand their investments, having additional liquid funds readily available in the form of earnest money can be burdensome for the following reasons:

Initial capital requirements

Similar to other payments involved in purchasing commercial real estate, such as due diligence fees, earnest money deposits are a percentage of the property's total price. Developers may find it challenging to allocate these funds to demonstrate their seriousness to sellers, especially when they may require the money for other essential processes like construction.

Opportunity costs

The earnest money deposits are usually held by a third party in an escrow account, and they will become temporarily unavailable to use by the developer. Such capital will tie the developers from investing in other opportunities to generate revenue or be used as working capital.

Limited cash flow

Earnest money limits the cash flow usually generated from existing properties or projects, restricting the developers' ability to fund ongoing operations, pay bills, or cover project expenses.

Risk of forfeiture

Despite being a refundable deposit, earnest money could be lost as a forfeiture if the developer failed to fulfill certain conditions in the purchase and sale agreement. Such loss can impact the cash flow and negatively impact the developer's ability to secure financing for future projects, as lenders might consider it a red flag.

“When earnest money is non-refundable from the beginning of a purchase contract, that effectively makes the offer non-contingent.” Said Gregg Davis, a Director at High Ground CRE, a KW Commercial affiliate.

Impact on the debt-to-equity ratio

One of the most important factors for a commercial real estate loan is the debt-to-equity ratio, which is the ratio of Total Debt to Total Equity, and a higher ratio indicates a higher risk investment for lenders. In this context, earnest money doesn't directly impact the debt-to-equity ratio but might have an indirect impact.

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When the developers use all their funds to set earnest money deposits, they will need to rely on debt financing to complete the purchase, increasing the debt and the debt-to-equity ratio.

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For example, if the developer plans to purchase a $5 million property, The developer may pay 10% as earnest money, which is $500,000. If the available cash is $600,000, then only $100,000 is left available to contribute to the equity, raising the debt-to-equity ratio.

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3. Strategies to overcome earnest money challenges

Some strategies can help developers mitigate the earnest money impact and overcome financing challenges:

Plan and budget

Developers need to manage and forecast their timeline and cash flow to ensure they have enough funds to cover earnest money deposits. This involves setting aside some of their available capital specifically for earnest money.

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Negotiate lower deposit amounts

Negotiation is the oldest trick in the book that can help reduce the earnest money deposit. Developers can support their negotiation by doing the following:

• Showing a track record of successful investments
• Having a good reputation
• Expanding personal networks
• Conducting market research to gather information about comparable properties and recent transactions in the area
• Providing alternative security proof, such as standby letters of credit

Earnest money financing

Securing a large loan for commercial real estate can be challenging due to strict qualifications. However, some financial firms offer smaller financing options to address the upfront cash requirement for earnest money deposits.

For instance, Duckfund provides soft deposit financing online, which enables developers to access the funds needed to secure a property while keeping their available capital intact for other project expenses.

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4. Soft deposit financing to overcome liquidity shortages for earnest money

Soft deposit financing platforms are a new method that allows commercial real estate developers to access quick financing solutions simply and easily, regardless of their credit reports or scores.

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In this process, they apply for financing from a specialized company. Upon approval, the financing company establishes a limited liability company (LLC) and creates a call option agreement with the borrower.

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The LLC, acting on behalf of the borrower, signs the commercial real estate purchase and sale agreement and transfers the soft deposit to an escrow account. If the borrower proceeds with the deal, they will wire the soft deposit back to the financing company, resulting in the financing company obtaining a 100% stake in the LLC and taking control of the purchase and sale agreement.

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However, if the buyer decides not to proceed with the real estate transaction, the financing company will cancel the purchase and sale agreement and retrieve the deposit amount from the escrow account. This financing mechanism provides flexibility to investors, enabling them to secure a property without tying up their own funds while allowing them to proceed or withdraw from the deal based on their assessment.

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Duckfund specializes in providing soft deposit financing for real estate investors. The platform offers a smooth and fast application process that takes just two minutes. And applicants will be approved within 24 hours (no credit reports required), and then funds will be released within 48 hours.

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Also, Duckfund charges a 2% monthly interest rate, one of the lowest in the industry compared to many lenders, which typically charge a percentage of the purchase price. With Duckfund, CRE developers can work on multiple commercial real estate deals simultaneously, even when you don’t have the liquidity on hand.

[Need financing for your next CRE investment? Duckfund offers affordable and fast financing with higher approval, lower interest rates, and easy applications.]

Takeaways

• CRE developers need liquid cash to keep up with the evolving CRE market
• Banks, crowdfunding, hard money loans, SBA loans, and online lenders are the most common financing options
• Purchase deposits, especially earnest money, pose financial challenges such as a lack of cash and lost investing opportunities
• One technique to overcome financial obstacles is effective budgeting, negotiation, and soft deposits
• Duckfund provides easy-to-obtain soft deposits for 2% interest and a processing time of less than 24 hours