How Does Earnest Money Work in Commercial Real Estate?

As earnest money becomes more common in commercial real estate, investors must understand what it is all about and how to secure these funds quickly when they need them.

Though the use of earnest money in commercial real estate (CRE) has not become a legal requirement, it has grown so much in popularity that investors seeking to complete commercial real estate deals must be knowledgeable about them.

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CRE sellers have embraced earnest money as a way to differentiate serious buyers from those who are just doing market research. Consequently, they will not arrange an inspection or negotiate prices without an agreement to pay earnest money.

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Buyers have also adopted it as a way to show they are serious and thus gain an advantage over other buyers, especially given how competitive the US CRE market is.  

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In this article, we provide you with a deep dive into the world of earnest money so you can be better placed to complete your CRE deals without hitches. We’ll cover:  

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1. The use of earnest money in commercial real estate
2. How earnest money deposits in commercial real estate works
3. How to get earnest money for your commercial real estate deals

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[Do you want to gain a competitive advantage in the commercial real estate market by getting quick access to earnest money? Sign up for Duckfund to get the earnest money you need within 48 hours at a very low cost.]

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1. The use of earnest money in commercial real estate

For the sake of clarity, we need to clearly define what earnest money is and differentiate it from other similar concepts in the CRE market.

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Earnest money, also known as a good faith deposit, is a deposit made by the potential buyer of a property to show seriousness or good faith to purchase the property in view. In most cases, the seller will not continue with inspection and negotiation until this money has been paid.

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The use of earnest money has become popular for all types of commercial real estate: multifamily, office, retail, industrial, etc.

Earnest money vs down payment

Knowing how earnest money and down payment differ can help to better understand what earnest money is all about.

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A down payment is the portion of a property’s purchase price that a potential buyer must pay in cash to the mortgage lender as a show of capacity to repay the mortgage loan.

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We can identify a few differences between the two concepts. First, earnest money is paid at the beginning of the transaction while a down payment is paid once the deal has been finalised and the buyer needs a mortgage loan to pay the purchase price.

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Second, earnest money is between the seller and the buyer (though it is held in an escrow account) while a down payment is between the buyer (now borrower) and the financing company.

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Third, while earnest money is required for all types of commercial real estate transactions, a down payment is only needed when the buyer is taking up a mortgage to finance the purchase.

Earnest money vs due diligence fees

A due diligence fee, also known as an option fee, is the fee paid by the potential buyer to the seller in exchange for them taking the property off the market while the potential buyer conducts due diligence on the property (this is called the due diligence period). (Some potential buyers can also pay a title company to confirm legal ownership during this time period.)

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There are important differences between earnest money and due diligence fees.

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First, earnest money is a show of commitment that the seller demands before negotiation continues, while a due diligence fee is compensation for the buyer’s request to conduct due diligence on the condition of the property before committing to a purchase.

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Second, while earnest money is refundable, due diligence fees are typically non-refundable. Third, earnest money is widespread in its usage while due diligence fees are only common in states like Texas and North Carolina.

What is a normal earnest money deposit in CRE?

Since earnest money is not yet a legal requirement, there is no fixed figure demanded by real estate sellers. So, how much is earnest money for commercial property in the US?

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Research by Duckfund into typical earnest money deposit for commercial real estate has revealed the following trends:

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• The national average is 1%-5% of the property’s purchase price. This is the range you should expect in Montana, Colorado, New Jersey, New Mexico, Oregon, Vermont, and West Virginia.

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• There are certain states where the maximum limit does not even reach 5%. These include Iowa, South Carolina, South Dakota, Tennessee, Arizona, and Maryland where earnest money does not typically exceed 1% of the purchase price.

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• In Nebraska, Missouri, Wisconsin, Wyoming, Texas, and Ohio, earnest money is often between 1% and 2%.

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• The maximum is 3% in California, Connecticut, Georgia, Kansas, Utah, Virginia, Washington, and Mississippi.

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• In Pennsylvania, Louisiana, and Florida, earnest money is often between 5% and 10% of the purchase price.

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• In Alaska, New York, South Florida, and Michigan, the average is 10%.  

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Duckfund has also produced research going deeper into the dynamics of the earnest fund requirements in Texas, Georgia, and Florida.

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In some markets, earnest money is stated as a fixed figure rather than as a percentage. For example, in Nebraska, the average earnest money requirement is a fixed payment between $500 and $2,000.

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Similarly, in some markets, you can pay earnest money in two instalments. In Rhode Island, for example, you can pay 1%-2% of the purchase price after contract signing and between 3%-20% after the due diligence period.  

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Note that the above figures are only typical. How much earnest money you will pay for a particular property will depend on your ability to negotiate and how hot the property is.

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We said in the introduction that buyers are now exploring earnest money as a way to gain advantages. So, you should expect the earnest money required for some competitive properties to go well above the average.

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2. How earnest money deposits in commercial real estate works

So far we have focused on clarifying what earnest money actually is and what you can expect to pay in various states in the US. Now we turn our focus to the actual operation of earnest money.

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We do this by answering the following questions:

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Who pays earnest money?

The potential buyer of the property pays the earnest money, either directly or through a realtor or brokerage company.

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How can earnest money be paid?

Payment methods vary; cash, wire transfers, cashier’s check, and personal check are some of the popular ones.

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However, cash is not universally accepted, especially in a place like Colorado.

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Who receives the earnest money?

Though the money is technically being paid to the seller, the seller does not take possession of the funds.

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Instead, the earnest money is held by an escrow agent until the deal is ready to be completed or cancelled.

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How is earnest money handled?

If the deal progresses and both parties are ready to close, the earnest money will be released by the escrow agent and used to fund the closing costs of the deal.

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Alternatively, the money can be applied to the down payment the potential buyer needs to pay to finance a mortgage for the real estate property.

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In essence, as long as the deal goes according to the plan, the seller never takes possession of the funds. It is only used to the benefit of the buyer.

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What happens to earnest money if the deal falls through?

The important question here: Is earnest money refundable?

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There are two situations where the buyer will be able to get a refund if the deal falls through.

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First is if the reason for the failure is part of previously-agreed contingencies built into the ongoing real estate transaction. Some of these contingencies include:

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• Appraisal contingency: If the property ends up being more expensive than what the potential buyer expected based on initial discussions, they can opt out of the deal.  

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• Inspection contingency: We said previously that earnest money is often paid before property inspection can even be done. If after inspection the potential buyer discovers that the condition of the property is below expectation, then they can opt out of the deal.

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• Financing contingency: A potential buyer can also opt out if the financing source they were counting on didn’t come through.

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• Home sale contingency: Similarly, if the purchase of the property depended on the sale of another property, the deal can be cancelled if the real estate agent has been unable to make the sale.

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The important point here is that these contingencies were agreed upon (in the purchase agreement, also known as purchase contract) between the seller and the potential buyer. If the contingency was not specified and agreed, then the potential buyer cannot appeal to it as a ground for opting out of the deal.

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Secondly, the potential buyer will get a refund if the deal falls through because of the seller.

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However, if the deal falls through because of defaults from the buyer and for contingencies not previously agreed, then the earnest money will be given to the seller.

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Potential buyers can expect to get their earnest money back within 10-14 days if everything goes smoothly. By everything going smoothly, we mean the seller is not playing hard ball. This is because the escrow will need the assent of the seller before returning the money.

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If the seller is stalling, the refund might take a longer time and there might even be a need to involve a real estate attorney. Nevertheless, as long as the deal falls through because of a previously-agreed contingency or the seller’s fault, buyers have nothing to worry about (except potentially delayed payments).

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3. How to get earnest money for your commercial real estate deals

CRE investors can find themselves in situations where they don’t have the cash to pay for earnest money to facilitate a real estate purchase. This can happen in hot markets where earnest money can be up to 10% of the property’s price.

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The problem is that investors need earnest money to be in contention for the property at the very beginning but they can’t start processing mortgage financing until they have sealed the contract and all that remains is payment of the purchase price.

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This difference in timing has been a challenge in real estate investing, preventing many investors from securing deals that would have been very important to them.

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Inefficient ways to get earnest money

Investors have resorted to different lending options to solve this problem.

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Many have resorted to traditional bank loans but have found the process rather lengthy and cumbersome. Some have tried online lending platforms but have been appalled by the high interest rates.

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Similarly, SBA 7(a) requires collateral and credit reports while SBA 504 (a) loans require you to prove that the loan won’t harm your business (in addition to taking a lengthy time to process).

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A more efficient way to get earnest money

In response, companies like Duckfund have created financing solutions that are specifically designed to help investors get earnest money for their deals. We call it ‘sign now, pay later.’

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There are many advantages that ‘sign now, pay later’ earnest money financing provided by Duckfund offers:

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• Quick processing: You can apply for earnest money financing in two minutes and get the required cash in just 48 hours.

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• Accessibility: Investors don’t need a collateral or a credit report to get earnest money for their deals.

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• Financing for multiple deals: Duckfund provides earnest money financing for multiple deals at the same time. You don’t need to focus on only one deal if you can process multiple ones, especially given the competitiveness of the CRE market.

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• Low-cost financing: Duckfund only charges 2% financing fee per month (calculated on the earnest money amount rather than the purchase or sale price), which is far lower than what other lenders charge.  

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• Smooth and low-risk process: Once your application has been completed, Duckfund registers an LLC on your behalf. It is this LLC that will sign the purchase agreement for the property.

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If the deal succeeds, all you need to do is repay the loan amount to get 100% stake in the LLC.

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And if the deal falls through due to previously-agreed contingencies and the seller’s fault, you won’t need to do anything. Duckfund will get the money paid back from the escrow and the purchase and sale agreement will be cancelled.

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[Are you a real estate investor looking to move fast on important deals, unhindered by earnest money requirements? Register on Duckfund for fast, smooth, and low-cost access to earnest money for as many deals as you want. ]

Takeaways

• Earnest money is the deposit potential buyers must pay to show they are serious and committed to purchasing a property.
• Earnest money is held by an escrow and it is used towards the closing costs of the deal or as part of the down payment needed for mortgage financing.
• The typical earnest money deposit for commercial real estate in the US differs from one market to another but what you will end up paying will depend on your negotiation skills and how hot the property is.
• CRE investors who want to close more deals (and do it fast) must have a reliable source for earnest money financing.