‘Subject to Finance’ Clauses

This is a term I hear more frequently used these days. With lender scrutiny at the highest levels I’ve seen since the GFC period, many buyers, bankers and brokers are feeling anxious about potential finance issues.

The inclusion of the clause however is often detrimental to the success of the purchase. So when should it be used?

Melbourne is well known as the auction capital, and for good reason. More than 30% of Melbourne’s house sales are conducted via auction, and of this figure most are in the inner and middle rings. In popular and sought-after areas, more than half of the sales are auction campaigns.

When brokers or banks advise buyers who are targeting these areas to include a ‘subject to finance’ clause in the contract, they are eliminating the buyer’s opportunity to bid at auction.

That counts for a lot of missed opportunities.

Aside from auction campaign properties, a finance clause can disadvantage some private sale campaign buyers too. When a private sale campaign attracts multiple interested parties, agents will determine how they wish to conduct the negotiating or tender process.  

Some agencies (often in the inner-ring and middle-ring suburbs) will host a ‘boardroom auction’ where all interested parties attend the agency boardroom and compete in a simulated and transparent auction format for the property. The agent will declare the property on the market and specify the offer received earlier that day or week, and each competing buyer will have a chance to openly fight for the property. This method is often used when an auction campaign is toppled by an attractive offer prior to the auction date, but some agencies have made the boardroom auction a standard practice for private sale campaigns too. In these situations, in almost all cases the buyer is not permitted to bid with clauses in their contract.

Another popular method that competing buyers face is the ‘best and highest’ method where buyers are given a deadline to submit their single, best and highest offer. Agents then take all offers to the vendor and let the vendor decide which one to accept.

Some agencies have adopted the process of calling each and every buyer, back and forth and disclosing the current highest offer until the buyers drop out and the strongest buyer stands. In these cases, agents and vendors prefer all buyers to be on a level playing field with their terms and conditions. Sometimes all buyers have a finance clause (typical in the more affordable outer-ring ares, or first home buyer hot spots), but things can get tricky when one or more buyers have unconditional offers. An agent will always be hard placed to recommend a subject to finance offer to a vendor over a slightly lower priced unconditional offer. A finance clause is often acceptable in circumstances like this, however it can be costly if the buyer wants to beat an unconditional offer.

For a conditional contract to win the bid, an agent will need to determine with the vendor the value of the unconditional contract in dollar terms, versus the subject to finance offer. 

Some vendors may not be all that sensitive to the idea of the finance clause, but others may have been burnt in the past with sales that didn’t proceed, or they could be time-pressed and unwilling to take a chance on re-selling the property if the buyer’s finance isn’t granted.

Finance clauses present risk to any vendor.

I’ve seen the differential cost buyers anything from a few thousand dollars to over fifty thousand dollars when vendors have determined how much higher an offer needs to be to have them accept the contract with the clauses over the unconditional one. I’ve often had cases where I’ve represented the buyer who’s lower offer secured the property.

Regional towns are generally more accepting of a finance clause than our metro cities and for those buyers who are fortunate enough to encounter an agent who will ‘sell’ the property to the first offer received at the full asking price, their subject to finance clause won’t necessarily cost them a premium or disadvantage them, provided another unconditional buyer doesn’t make the same offer at the same time.

We would never suggest a buyer ignores the advice of their broker or bank, and in some cases buyers indeed need to seek the protection of such a clause, but for a large portion of buyers there are other ways to seek protection and address risk.

The first and most obvious step for a buyer is to obtain a lender pre-approval that has been physically assessed by a loans assessor.  Pre-approval processes vary between lenders, but indicative pre-approval is not a pre-approval to be relied upon. Indicative pre-approval is not physically assessed by an assessor and is most often merely a phone chat or worse still, a lender’s online portal supported by an algorithm.

It is often the little details that can preclude borrowers from lending eligibility and for this reason it is imperative that every detail has been considered by the lender. Elements such as the type of employment the borrower is working under, the length of time in a particular job, the number of other loans applied for in the past year, any unpaid debts (even old telco bills) that remain, the cost of the borrower’s current lifestyle, directorships, credit card limits, and many more… can all make the difference between an approval and a decline.

Once the buyer has a finance pre-approval, the next step is to understand the conditions of the pre-approval. They are generally listed in bullet point format on the approval letter. Most are easy to navigate around, but many pre-approvals list these two conditions;

• Satisfactory security property
• Satisfactory bank valuation

Recognising the types of properties that banks don’t consider satisfactory is not easy, but asking the bank or broker for a specific list is certainly helpful. Most lenders will have a concern with a particularly small apartment or a property with fire or flood damage. It is the invisible aspects that can trip buyers up and some of the invisible aspects include restricted postcodes, the bank’s exposure to an already-large number of purchases in a new apartment block, unusual title types or alternative zoning to residential (just to name a few). The established residential properties with residential zoning, strata or freehold title are far less likely to be problematic for lenders. If in doubt, buyers can ask their broker or bank about the general acceptability of a property.

Bank valuations frighten many buyers. What do they do if the valuation is reported at a lower level than the purchase price?

While this can be a real risk, it isn’t a high risk if the buyer is familiar with other recent comparable property sales and can confidently point to at least three that have sold and settled at a similar price. 

Having a plan B for issues like this is critical though, and being conscious of the degree of risk is important. A buyer who is borrowing 95% of the value of the property is at a higher risk of being scrutinised than a buyer who is borrowing 80% or less. Many banks have a different valuation process or policy for those buyers who are borrowing at (or under) 80%. Some lenders have a policy that states a contract price will be automatically accepted for that buyer, and others may accept the contract price provided it falls within a computer-modeled range. 

If the risk of a valuation shortfall is concerning, buyers should initially talk to their broker or bank about whether any opportunities exist to mitigate this.

If the loan type requires a bank valuation and the buyer is still uncomfortable, they can consider a valuation clause within the contract. While it still weakens the offer, it is not as risky for the vendor as a finance clause would be. A valuation clause says to the agent and the vendor that the buyer is confident about obtaining finance, but is worried that they are paying what the bank could determine is an over-payment. If the condition is a short-range condition (ie. a week or less), it could be easily accepted by a vendor. Buyers must remember though that this approach won’t be an option for an auction campaign.

Some of the occasions that we’d consider require a protective finance clause are;

• Buyer is borrowing above 90% LVR and has no other lending option to turn to as a Plan B, and has no buffer cash reserves to bridge a valuation shortfall
• Buyer is unclear on whether they will obtain finance (ie. has no/lapsed pre-approval or the lender has a condition which is unable to be confirmed until loan assessment)
• Property is not residentially zoned and lender hasn’t given confirmation of security acceptance
• Property is a high rise or off the plan purchase*
• Buyer’s circumstances have changed since pre-approval was granted (ie. new job, pregnancy, job termination/redundancy)
• Buyer is holding a Visa and bank isn’t aware of it
• Property has limited comparable sales identified

Borrowing money for all asset classes represents risk.

Considering the magnitude of the risk and the likelihood of issues occurring should be part of every buyer’s thought process before they clutch onto a blanket finance clause and reduce the number of properties they can target. 

Being completely protected and missing out on good properties time and time again is upsetting for buyers. In many cases, those  who they are missing out to are carrying the same risks. 

Taking a risk with finance when no pre-approval has been sought is a dangerous move in this market however.

All buyers should discuss their approach with their finance provider or broker.

*Off the Plan purchases are difficult to facilitate with a finance clause because most developers, agents and vendors won’t entertain the risk of permitting a finance clause. It’s vital for buyers to recognise that valuations are conducted once the property is completed, not at the time of signing the contract, and buyers must also factor in the risks of buying OTP. These risks include (but aren’t limited to) valuation shortfall, market decline between signing contracts and settlement, build completion delays and developer/project liquidation.