How Contract Abandonment is Helping Restore the Real Estate Market

real estate flipper Leave Morality Out Of It:
How Contract Abandonment Is Helping Restore Reality to The Real Estate Market By Jared H. Beck, Esq.
Beck & Lee Business Trial Lawyers
Miami, Florida

“Ditching Condo Deal May Have Been Smart.” That recent headline from the Palm Beach Post announced what many who bought condo units in the preconstruction phase during the last several years have known for some time. The calculus between walking away from hefty deposits – or closing on a rapidly depreciating property in the midst of a global credit crunch at 2005 or 2006 prices – has proven clear. Walking away typically makes the most financial sense.

But while doing the math is easy, making the decision to abandon a purchase agreement – and to forfeit substantial deposits – is not necessarily so simple. Take, for example, this observation from a banking analyst quoted in that same Palm Beach Post article who sees a “dangerous precedent” being set by those who walk away: “The whole concept of capitalism is based on the rule of law. . . . It’s bad for the economy, bad for capitalism and bad for business in general when people realize they can find legal room to get out of any deal.”

Is it true that failing to perform on a contract harms the economy? At first glance, the idea makes sense: if contracts are so easily scrapped when the economy goes south, then businesses and individuals will be less inclined to ink deals when times are good.

But consider this when trying to apply that same logic to the context of a piece of real estate purchased at 2005 or 2006 prices: According to Freddie Mac, each foreclosure costs the lender approximately $60,000 on average. So, if a buyer closes on a real estate contract – and then goes into foreclosure because he or she cannot afford to pay the mortgage, or determines that it no longer makes financial sense to do so – then the bank will end up spending about $60,000 to foreclose on the property. That’s $60,000 subtracted from the pool of funds available to new borrowers. Ultimately, the buyer’s decision not to walk away prolongs the credit crunch. Still convinced that walking away from a contract harms the economy?

The moral principle that one should always honor one’s word as expressed in a contract has long been enshrined in law. But the view that agreements should be broken when times call for it has also found strong legal expression. For example, under the theory of “efficient breach,” as famously endorsed by the federal appellate judge Richard Posner, the law ought to encourage parties to breach contracts – and not punish them – when breaching is socially efficient.

Applied to our real estate example, it is socially efficient for the buyer to breach the purchase contract rather than close, because breaching saves the bank (and society) from spending $60,000 on a foreclosure. As an added benefit, the property in question will likely more quickly find its way into the productive hands of someone who values it at a more realistic (and lower) price, rather than suffering the disuse and abuse that many REO properties experience. In an important sense, walking away hastens the market to correct itself.

No one can dispute that the functioning of the economy depends on the sanctity of contract – the freedom to make contracts, and the faith that their terms will be honored. At the same time, however, room to extricate one’s self from a bad deal when the terms become too onerous is just as indispensable. Without room to walk away, market correction would be a longer and more difficult process than it already is.

Jared H. Beck has a law degree from Harvard Law School. He writes the popular blog, “Jared Beck’s Real Estate Market Crisis Law Report,” at http://beckandlee.wordpress.com. His law firm, Beck & Lee Business Trial Lawyers in Miami, is dedicated to the practice of business and real estate litigation, as well as pursuing the rights and remedies of consumers and investors. A significant portion of Mr. Beck’s practice is devoted to issues arising under purchase contracts for real estate, including condominiums, condo-hotels, single-family homes, and commercial property. Mr. Beck is a member of the Florida and California Bars, and litigates in other U.S. jurisdictions in conjunction with qualified local counsel. He can be reached at 305-789-0072 or jared@beckandlee.com