Day 49: How Much Earnest Money Should You Put Down on a Self Storage Deal?

Oh, welcome back to day 49, folks, of the Storage 100 series. I am Joe Downs with the Storage Moguls Mastermind. Hope you enjoyed last night. That was a lot of fun, wasn't it? Today we are tackling a crucial topic: earnest money. Your earnest money deposit. How much should you risk when putting a deal under contract? This is actually one of the most common questions I get from investors, and it's a delicate balance showing you It's a delicate balance showing the seller that you're serious versus overcommitting your capital. So I have seen investors lose actually significant money by getting this wrong. And, you know, you do everything you can to make sure you protect your earnest money deposit at all costs. But there's some things that can happen at the end of deals, folks, that are wacky. And so it's like playing craps, if you know what that means. You manage how much money you have it on the table because eventually you will lose it. So same thing here, and there's no eventually you will lose it, but you do want to manage how you risk your earnest money deposits, how you structure them, how and when you risk them. So let's dive into what that actually is because this is very important. So think of it as your skin in the game, right? It's the skin in the game deposit, right? It's not a down payment, but it signals your serious intent to the seller. So it tells them you're committed to closing the deal and you're not just browsing, right? The money doesn't go directly to the seller either. It's held in escrow by a neutral third party, sometimes a title company. And this, this is held while you conduct your due diligence. So Like inspections, while you line up financing, not just inspections, third-party reports, you're doing your search, all the due diligence stuff that we've covered and we'll continue to cover. While that's going on, your deposit, your earnest money deposit is being held and it's released based on certain things. So if the deal proceeds, if everything goes forward, the earnest money deposit then is Then becomes the deposit towards your purchase price, right? At closing. So you're not going to get it back. It just becomes, you know, less money you bring to the table at closing. But then what happens? The deal falls apart and deals fall apart. I just had 2 fall apart on me in the last month, but we didn't lose any deposits because you structure them the right way and you have the right contingencies. So that's, it's a balancing act, but that's what we're going to go over. So For instance, if you offer too little, the seller actually might not take you very seriously. They might think you either lack confidence in closing or you don't have money. That's even worse. And they might go with another buyer. So you can't, you know, you can't, you can't be $10. You can't be $1,000 on a million-dollar deal. And then the flip side, if you offer too much, now you might be risking your capital depending on how it's structured. So if the deal goes south somewhere at the last minute, you could lose that entire deposit. So it's a balancing act. So the sweet spot is just enough to demonstrate commitment, but structured to minimize your actual risk. So how do we achieve this? Well, you you use a strategy that breaks the deposit into smaller, more manageable pieces. Instead of one large deposit, we you can use what I call the tranche strategy. And there's different ways to use this, and I'll just give you one right now: the tranche strategy, which can protect your earnest money deposit. So. Here's how it works. You're going to break it down into multiple deposits or tranches tied to specific milestones. So let's say the first tranche is a smaller deposit when the contract is signed, right? Maybe it's $5,000, maybe it's $10,000. This initial deposit secures the deal so you can begin your due diligence. The seller realizes, all right, they're serious and they've got money. They've got $5,000, $10,000. They're going to hold it here. They're moving forward. No guarantees, but this is the way the game's played. And then at some later stage, there's a second, maybe it's larger, could be the same amount, could be larger tranche that's released, but only after you've completed all your physical inspections and everything's satisfied. And then you might have a third tranche and that might be released when your financing is fully approved and locked in. And what this approach does, it means you're releasing only money as you clear certain hurdles and each hurdle you clear is reducing your risk that the deal's actually going to go through. And so this is kind of structure that works because it's tied to contingencies, which determine if your money's refundable or not. So then this brings us to the critical point of what is refundable versus non-refundable deposit and how do you make that work? So and the difference between the two is everything. So your earnest money is refundable as long as it's protected by contingencies in your contract, and these contingencies are your escape clauses. So covering things like. Unsatisfactory inspection or financing issues. And if you withdraw for any reason or for a reason covered by a contingency, then you get your money back. However, once the contingency is removed in this scenario, the way I laid it out, that portion of your deposit often becomes hard or nonrefundable. You'll see this, these multiple tranches structured more in like land development deals. Because there are some things that happen along the way that might take months. And we just, we just did this one of our deals and you, you do start risking more and more capital. There are simpler ways to structure this as well. Probably go over that in another, another episode or if you end up in our community. So anyway, this means if you back out at that point, you lose that money, right? If you've hit it, if you clear a contingency period, And you're still moving forward, that money then goes hard. So you should, you should never go fully nonrefundable from day one. That's completely gambling with your capital before you've even seen the cards, especially if we're talking development. So then you might ask, well, what actually protects your earnest money once you've put it down? Well, again, it's about the contingencies and the safety nets in the contract. So an inspection contingency lets you back out if the property isn't up to par or after your due diligence is up. Or before your due diligence is up. The financing contingency might mean you're protected if your loan falls through. And then you could have environmental and title contingencies cover you for unexpected issues with the land ownership or the survey, anything that comes up in the survey or environmental, everything like that. And these contingencies are crucial because they're your escape hatches, your contractual escape hatches out of the contract. So Without them, you're essentially signing away your earnest money deposit. So, all right, now that you know what protects your earnest money, next question should be, well, how much is actually normal to put down? So the amount can vary, but there's some guidelines. So a lower earnest money deposit, like 1%, might signal a weak commitment to the seller, but you might get a deal done that way. You know, million-dollar deal, $10,000 down, not Not crazy. A lot of commercial deals you see in that 2% range. I mean, I'm trying for the 1%, but, you know, a lot of times you'll see in the 2%. But let's take that same million-dollar deal and now I'm talking $20,000. Well, I might structure that 10 and 10 if it's just a straight, you know, self-storage acquisition where I'm not— I don't have 3 or 4 different tranches. I'm there. I'm just having a down payment and then One at the end of, um, not down payment, a deposit, and then one at the end of due diligence, and then they both go hard. So I'm going to be in or out before due diligence. Um, but you know, depends on the market. If it's competitive market or the seller requested, you might— they might want more. They might have someone willing to put down more. Um, it's not just a random number. It reflects your seriousness as a buyer. So, but remember, the higher the percentage, the more you stand to lose if things go wrong. Right. So let's talk about those situations and where you might actually lose your Your deposit. So you lose if you if you walk away from the deal outside of your agreed upon contingency periods, and that could happen for any number of reasons. Maybe your investors backed out, or maybe something else happened in your life. Another way is if you fail to close the deal without a valid reason that's covered by your contract, right? So maybe that's actually the examples of what I just gave. And of course, if you breach the contract in any way, your earnest money is at risk. The big lesson here is to always protect your timelines and your contingencies. Don't let those dates slip by without making a decision or getting an extension. It's all about being diligent and understanding your contractual obligations. So never, ever, ever miss the deadlines. And don't— and pro tip, don't wait till the last minute. If you need an extension, start talking about why with the seller. All right, let's wrap this up with a final thought on structuring your earnest money to minimize risk. So bring it all together. Here's a closing thought on earnest money. Always try to structure your earnest money in 3— in tranches, sorry, or stages if possible. Strike 3, just in stages if possible. Could be 2, could be 3, could be 4. I think we had a deal with 6 because it was a development deal. This— what the net effect is, you're not putting all your risk up front, right? Smart move. Always protect your earnest money with robust contingencies in your contract. Never risk more earnest money than is absolutely necessary. Necessary for the deal. It's about being strategic and minimizing your financial exposure. Your goal is to show commitment without putting yourself in an overly vulnerable position. All right, I hope you are enjoying this series so far, and if you're watching them one at a time to keep learning and growing, make sure you like, subscribe, and share our content. Your engagement helps us reach more people. Who are serious about self-storage investing and joining our community. Up next, we'll be diving into day 50, which is—I know it's the storage 100. It sounds like that's halfway. It's not because it's actually 106 days. It's the way that sway the belly buttons, folks. So day 50, we are going to tackle reading a self-storage PNL in under 10 minutes. You're going to love it. It's critical skill for any investor. You do not want to miss it. Make sure you subscribe so you get notified when that episode drops. Plus the lives like last night. You don't want to miss them. And thanks again for joining us today. Don't forget to share this episode with the last person you talked about self-storage with. They will thank you later.