By: Robert C. Hackney
Successful syndicators understand the nuances in acquiring property for syndication.
Obviously, a real estate syndicator must have control of the property that is going to be syndicated to his or her investors. There are basically two ways to gain control of a property:
1. Obtain an option to acquire the property, or
2. Execute a firm contract to purchase the property.
Specific real estate laws vary state by state, so you need to check with your local attorneys if some of the matters that we discuss herein apply in your state.
Why I don’t like options
I personally do not like the method of obtaining an option to purchase the property. Usually when you acquire an option it is very clear to the seller that you do not have the money to buy the property and since he knows that you do not have the money to buy the property, you are dealing from a position of weakness. The result of that weakness is usually translated into you having to pay a higher price for the property than you would if you simply went to a firm contract with contingencies, or “outs.” Whether you use the option method or the firm contract method you typically will need ninety to one hundred and twenty days to put together your syndication documents and bring your investors into the fold.
Why I don’t like letters of intent
Some syndicators try to use a letter of intent as opposed to an option agreement or a firm contract. A letter of intent is simply an “agreement to agree” and is not usually legally binding. If you use this method you could find yourself in the position where you have spent the money to create all the appropriate documentation, have raised the money from your investors, think that you are ready to proceed and then find out that the seller backs out of the letter of intent and begins to negotiate the purchase contract, with terms that vary substantially from the ones contained in the letter of intent. Don’t get caught in that box.
Purchase Price Issues
The primary consideration that you should concern yourself with in the purchase and sale agreement is the obvious one, the purchase price of the property. Unfortunately, many purchasers of real estate get bogged down in the minutia of the contract dealing with various and sundry terms and do not focus as closely as they need to on the most important term, that being the purchase price.
The best advice I can give you is to do your homework and check not only with local real estate brokers and appraisers, but do some checking yourself in the public records of the county where the property is located to try to determine if there are similar properties that have been recently sold. Do not rely solely upon an appraisal, particularly one that is over a year old. Unfortunately, many appraisals are not accurate when delivered and certainly within twelve months thereafter would probably not reflect an accurate value of the property.
Consider the Closing Costs
Keep in mind that there are typically substantial closing costs, adjustments and prorations that take place during the purchase of a piece of property. Therefore, you cannot rely solely on your negotiated price, without taking into consideration the costs of the transaction and who will bear those costs. For example, the issue of which party pays for title insurance is variable. Even within the State of Florida, it varies among counties as to what is the typical way to allocate that cost. In one county, it may be customary for the seller to pay for title insurance, in another it may be customary for the buyer to pay for title insurance. It is critical that you know what is the custom in the location where you are dealing and attempt to negotiate at least a split of that expense. I mention this because typically your largest single closing cost in a real estate transaction is the title insurance premium.
Documentary Stamp Taxes
Another cost that is of concern to purchasers of property involves the documentary stamp tax. Most states have some form of a documentary stamp tax, again check in the local area where the property is situated to determine if there is a documentary stamp tax and what rate of that tax is there. In Florida, for example, documentary stamp tax is due on deeds or other instruments relating to the transfer of real property. At the moment, that tax is 70 cents per $100 of consideration (unless you are in Miami, where the rate for anything other than a single family residence is $.60 plus a $.45 surtax for $100 of consideration). For example, if you bought a building in Florida for ten million dollars, (not in Miami) your documentary stamp tax would be $70,000 (or $105,000 in Miami). While that may sound like a lot, the stamp tax in the Bahamas is 10% of the consideration paid for the property.
Sale of the Entity vs. Sale of the Property
A practice that was prevalent in the State of Florida, for example, is the practice of selling not the real estate but the entity that owns the real estate. For example, if you own a ten million dollar office building and the title is held in the name of a limited partnership, and the only property owned by that limited partnership is your office building, you could sell your interest in the limited partnership, and theoretically, avoid paying a documentary stamp tax. If the entity has no other assets, this process can be valuable. In 2005 the Florida Supreme Court held in Crescent Miami Center, LLC v. Florida Department of Revenue, 903 So. 2d 913 (Fla. 2005), that transfers of the interest in the entity are not subject to documentary stamp tax. In response to this court decision, the Florida legislature two different statutes to change the outcome of these situations. One law, passed in 2007, required notice to the property appraiser in the county of any change of control, and the other, passed in 2009 made a transfer of an entity within three years of acquiring the property subject to the documentary tax. Additional changes to Florida law made mergers of trusts owning real estate with entities such as LLCs subject to the documentary stamp tax. This is an important issue, and needs to be reviewed on a state by state basis. On a large purchase, the cost is substantial, and a syndicator and the investors need to review this with their legal counsel.
There is also more due diligence required in this type of transaction and if you buy the entity, you get not only all of its assets, but all of its liabilities. These liabilities could include items that you were not expecting, such as latent issues that can result in litigation (which is never inexpensive). In addition, virtually all mortgages are now written such that a change of control of the entity triggers the due on sale clause, so a new owner of the entity must qualify with the lender just as though it were a new loan.
Seller Financing
Frequently buyers will attempt to obtain at least some of their financing from the seller in the form of a second mortgage or a purchase money mortgage. The most important aspect that the buyer needs to be concerned about in a purchase money mortgage situation is whether or not there will be any personal liability on the note and mortgage to the individuals who comprise the buyer. For example, the buyer is a newly formed LLC and the seller realizes that the only asset of the LLC will be the property that he is selling to it, in most cases he will request that the owners of the LLC purchasing the property to personally guarantee the promissory note and mortgage. Some personal guarantees are more onerous than others, in other words, not all guarantees are created equal. Many times lenders will also require that the spouses of the principals also execute the personal guarantees. While many sellers and other lenders know that there may not be substantial assets to get from an individual, it keeps the individual focused on getting the lender repaid, as they are personally on the hook for the loan. Don’t be too surprised when the seller asks for these guarantees, but respond by trying to get the lender to limit the guarantee to a shorter time than the term of the loan, and limit it on a prorata basis so that it is not “joint and several” which simply means you are on the hook for the whole loan, even if there are three other partners who have also signed a personal guarantee.
The buyer also needs to be sure that the purchase money mortgage is second in line behind any first mortgage obtained by the buyer for the purchase of the property. Make sure the subordination language in the second mortgage insures that he is in second position, not first. In addition the buyer needs to make sure that there is no prepayment penalty involved in the purchase money mortgage so that if he is able to refinance the property and take out the first and second mortgages at the same time, he will not be hit with a prepayment penalty by either the first mortgage or second mortgage holder. The primary lender may not be comfortable with you taking out a purchase money mortgage, so be sure you read the terms and conditions of the first mortgage closely to be sure you will not be in default for having a second mortgage, or worse, that you get close to closing and find out that the first mortgage holder won’t allow a second mortgage (after you have spent a ton of money on all the other up front costs).
The Reasons I like Firm Contracts
The reason that I like to negotiate a firm contract as opposed to an option, is that you can accomplish the same result with the firm contract but you can usually obtain a better price and actually tie the seller in more securely. This is done by using various contingencies in your firm contract. The most typical conditions and contingencies used are as follows:
1. The Due Diligence period. A buyer should attempt to negotiate the longest due diligence period possible. During the real estate boom of a few years back, sellers were not interested in giving a very long due diligence period. During those times, it was common to see something as short as a five day or ten day due diligence period. That time period is unrealistic. A buyer needs a reasonable time period to verify that there are no title problems, zoning problems, environmental problems, issues relating to the soil, pest control issues, and a host of other matters that need to be looked into by the buyer. While most of the matters can be taken care of within a sixty day period, it is best to attempt to obtain a ninety to one hundred and twenty day due diligence period so that the syndicator has time, not only to complete a thorough due diligence on the property, but also time to prepare his documentation and raise his money from his investors.
2. Financing Contingency. When the syndicator needs to put new financing in place, which is the typical situation, the contract should require that the closing is contingent upon the acquisition of such financing. The clause needs to be specific, particularly with regard to the specific terms of the financing that are acceptable to the buyer. The seller may be providing a portion of the financing, and may request the ability to change the terms of his financing in the event that the outside lender does not offer the particular terms and conditions requested by the buyer. This way the seller has the opportunity to fill the gap by making an adjustment that results in the buyer getting the overall same payment amount, interest rate and time for repayment that was originally contemplated. Remember that in most cases the seller is not usually happy about having to put the property back on the market, as he has already determined what he is going to do with the proceeds of the sale. (In other words, he has already spent the money.)
3. An “As Is” Purchase. Watch out for the “As Is” purchase. A shrewd seller will want provisions saying that your purchase is on an “as is” basis. The best way to deal with this issue is to make sure that your due diligence period is sufficiently long enough so that you can properly review all of the pertinent information about the property. If a seller demands an “as is” sale, counter with a longer due diligence period.
4. Escrow Provisions. You can either use a separate Escrow Agreement or incorporate the terms of the escrow into your purchase and sale agreement. My preference is to incorporate the terms right into the original purchase and sale agreement, as it reduces the potential for conflict in the provisions of the agreement, and avoids the need to specify which agreement governs in the event of a conflict. In addition, there may be a tendency to sign the purchase and sale agreement first, and then get bogged down on the escrow agreement terms. Will your deposit gain interest during the escrow term? When may the escrow agent release the deposit? What happens to the deposit if you don’t close in a timely fashion? All of these questions, and more, are answered in the escrow provisions of the purchase and sale agreement.
5. Survey. I usually require that a current survey be delivered by the seller within a reasonable, but short, period of time after execution of the agreement. It is best to try to negotiate a provision that says that your due diligence period does not begin until you have received a current survey from the seller. Sellers don’t like this provision, because they are generally trying not to spend any money at this juncture.
6. Title. The receipt of a title commitment and a survey are usually the basic standards needed to make a quick determination if there are any substantial issues with regard to the property. Depending on the situation, there are obviously other inspections that will need to be done, and such inspections should be scheduled as soon as you have executed the agreement. Waiting until closer to the time that your due diligence period runs out puts you in the position where you may not be able to complete your inspections, and will have to decide whether or not to go forward with the deal when you don’t have all the facts needed to make a reasonable decision. Once your deposit “goes hard” it is lost unless you close on the transaction, so do not delay in scheduling your engineering, soil inspection, pest inspection, environmental inspection, and any other inspection that is unique to your project.
The syndication process can be a long and difficult process, and this portion of the process is just the beginning. Syndication can be lucrative, but involves perseverance of the highest level.