Investment Real Estate Transactions 101 For Buyers (Part II)

Jeffrey S. Tarr, M.S. (Tax)

503.243.1677

                    Published in the Sussman Shank LLP Spring 2017 Newsletter

In our last Newsletter, Part I of this article started out by asking the following question:

Why own real estate as an investment? I responded to this question as follows:

"My answer lies in the fact that a signi­ficant amount of American wealth has been created over the past 100 years through investment in and long-term ownership of real estate. Simply put, over time, American real estate generally proves to be a very good long-term investment (with its returns at times outpacing stock market returns), thus making investment in real estate well worth the difficulties of ownership. A well-diversified investment portfolio often includes, in addition to stocks, bonds, and other ­ financial instruments, investments in real estate.

Okay, so you want to invest in real estate. What is next?"

In Part I of this article, I addressed the upfront consideration of who will be on your acquisition "team" and the important consideration of using a "limited liability" entity to purchase the real estate investment. You can find Part I of this article HERE.
In this Part II, I will address the purchase and sale agreement.


1. Purchase and Sale Agreement

Depending on the size and nature of a real estate transaction, the purchase documentation typically takes one of two forms: (1) an off­er, followed by one or more counter-o­ffers between the parties, until the parties mutually agree upon all of the terms and conditions of the purchase transaction, with the offer and counter-o­ffers collectively making up the single, binding purchase and sale agreement; or (2) a non-binding term sheet, or letter of intent, setting forth the major deal points in the purchase transaction, followed by a single, binding purchase and sale agreement entered into by the parties after they mutually agree on all of the terms and conditions of the purchase transaction.

Regardless of the form of the purchase documentation, many of the matters typically addressed in a purchase and sale agreement are the same no matter what type of real estate is involved. The following are some of the more major matters typically addressed in most real estate purchase and sale agreements, and how buyers often should address them:

(a) Identi­fication of Property Being Purchased.

Often, there are more components to a real estate purchase than just the land itself. For example, there may be improvements on the real estate (e.g., buildings); water or mineral rights; personal property (e.g., equipment and fixtures); and intangible property (e.g., the name of the property; leases to occupy some or all of the property). Care should be taken to make sure that the purchase and sale agreement adequately describes all of the property intended to be purchased to avoid future disputes over what was included in the purchase transaction.

(b) Earnest Money Deposit.

Most sellers of real estate will require the buyer to put down an earnest money deposit at the time the parties enter into a purchase and sale agreement. A seller will want the earnest money deposit to be made for a number of reasons, including ensuring that the buyer is serious about purchasing the real property and has the financial means to do so, and to provide the seller with compensation (for lost opportunity while keeping the real estate off of the market) in the event the buyer defaults on the purchase and sale agreement and fails to close on the purchase transaction (in such event, typically the purchase and sale agreement provides that the seller gets to keep the earnest money deposit as liquidated damages for the buyer's default). A typical earnest money deposit ranges between 2% to 4% of the purchase price, but can vary depending on the circumstances. Often, the buyer will want to initially provide a promissory note in lieu of cash for the earnest money deposit. An earnest money promissory note typically provides that the buyer has to convert the promissory note to cash at such time as the inspection contingency (discussed below) is satisfied or waived by the buyer. The buyer will want to make sure that the purchase and sale agreement provides that the earnest money deposit will be deposited into the escrow established for the purchase transaction (and not with the seller or the seller's broker). That way, in the event there is a dispute over a breach and forfeiture of the earnest money deposit, the earnest money will remain in the hands of an independent and neutral third party (i.e., the escrow) who will not release the earnest money until the parties mutually resolve the dispute and direct the escrow how to release the earnest money, or as otherwise determined and directed by a court.

(c) Contingencies (i.e., Conditions to Closing).

Typically, a buyer will want to include a few contingencies in the purchase and sale agreement, which permit the buyer to terminate the purchase transaction (without being deemed in default under the purchase and sale agreement) should certain matters fail to occur or turn out different than expected. In the event a buyer cancels a purchase transaction pursuant to a contingency, typically the purchase and sale agreement provides that the buyer's earnest money deposit (together with any accrued interest thereon, if any) will be returned to the buyer. Examples of typical contingencies included in most purchase and sale agreements and some considerations with each are as follows:

(i) Financing Contingency.

If the buyer is going to obtain acquisition financing to cover a portion of the purchase price, then the buyer will want to include a financing contingency in the purchase and sale agreement. A financing contingency is important to protect a buyer from the inability to obtain the necessary financing on terms and conditions acceptable to the buyer. A lender may refuse to lend money for many reasons, including due to the condition of the real estate (e.g., poor condition of the structures on the real estate; environmental contamination of the land); the valuation of the real estate (e.g., the appraised value of the real estate comes in lower than expected); or the financial condition of the buyer (e.g., the buyer had a recent loan default or recently filed for bankruptcy protection). In the event the buyer is unable to obtain the necessary acquisition financing to close the purchase transaction, the buyer can exercise its right under the financing contingency to terminate the purchase transaction.

(ii) Inspection Contingency.

In almost every real estate purchase transaction, a buyer will want to include an inspection contingency in the purchase and sale agreement. An inspection contingency will permit the buyer to undertake significant and important due diligence with respect to the real estate before being committed to close on the purchase of the real estate. A well drafted inspection contingency will permit the buyer to examine and inspect such things as the physical condition of the real estate and the improvements on the real estate; the environmental condition of the real estate; the rent roll, leases and other contracts, insurance policies and all other financial aspects of the real estate; the governmental permits and approvals for the real estate; the plans and specifications for the improvements on the real estate; and the feasibility of the buyer using the real estate for the buyer's intended purpose. In the event the buyer finds a problem with the real estate and the seller is unable or unwilling to address the problem to the buyer's satisfaction, then the buyer can exercise its right under the inspection contingency to terminate purchase transaction.

(iii) Title Contingency.

In every real estate purchase transaction (with virtually no exceptions), a buyer will want to include a title contingency in the purchase and sale agreement. The title contingency is intended to permit the buyer to inspect and approve or disapprove all encumbrances and other matters of title record with respect to the real estate. Typically, a buyer will disapprove and require the seller to remove on or prior to the closing all financial encumbrances (e.g., trust deeds, mortgages and tax and other financial liens) recorded against the property as a condition to closing on the purchase transaction. In the event the buyer finds a problem with title to the real estate and the seller is unable or unwilling to address the problem to the buyer's satisfaction, the buyer can exercise its right under the title contingency to terminate the purchase transaction.

(d) Seller's Representations and Warranties.

A representation is a statement of fact upon which another party is expected to rely. A warranty is a party's assurance as to a statement of fact, as it is coupled with an implied indemnification obligation if the statement of fact turns out to be false. Representations and warranties are intended to allocate risk between parties and, in the case of a breach or inaccuracy, serve as a foundation for an indemnification claim to address the breach or inaccuracy. Typically, a buyer will want to include in the purchase and sale agreement some representations and warranties made by the seller regarding the real estate and matters relating to the seller, including the following: (i) that the real estate is not in violation of any building code, building or use restrictions, zoning ordinances, or other applicable law; (ii) that there is no threatened or pending litigation involving the real estate; (iii) that there is no threatened or pending eminent domain proceedings involving a governmental "taking" of all or any part of the real estate; (iv) that the seller has not caused any hazardous substance, waste or material to be used, generated, stored or disposed of on, or transported to or from, the real estate in violation of applicable environmental laws; (v) that the seller will not be in violation of any other agreement to which the seller is a party by entering into the purchase and sale agreement and consummating the purchase transaction; and (vi) if the seller is a legal entity, that the seller has been authorized by its owners and operators to enter into the purchase and sale agreement and consummate the purchase transaction.

(e) Default and Remedy Provisions.

A well drafted purchase and sale agreement will include provisions addressing when a party is in default under the purchase and sale agreement, and setting forth each party's remedies in the event of a default. Often, the default provision will also include a "cure" provision, giving a defaulting party an opportunity to cure a default before the other party is entitled to exercise any remedies. With respect to a seller's remedies (for when a buyer is in default), a buyer will want to limit the seller's remedies to retention of the earnest money deposit (often referred to as a "liquidated damages" clause). With respect to a buyer's remedies (for when a seller is in default), a buyer will want to make sure that one of the specific remedies available to the buyer is the equitable remedy of specific performance (i.e., permitting the buyer to commence a legal action to obtain a court order requiring the seller to remedy the default and close the purchase transaction).

In Part III of this article (coming out in Sussman Shank's next edition of its Newsletter), I will address the due diligence process, closing the purchase transaction, and some post-closing matters in real estate investment transactions.

Please contact Jeffrey Tarr at jtarr@sussmanshank.com or (503) 227-1111 with any questions about, or to assist you in connection with, your real estate investment transaction.

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