April 19th, 2012

Earlier in the week one of our consulting clients asked me several questions about an investment property she was buying.

As we got to talking I thought that you might find it very valuable if I shared the “contract lessons” I’ve learned about 8 clauses you must have in your agreement when buying an investment property.

In real estate you need a set of “standard” contracts to use when you are buying and a second set to use when you are selling. Your contracts should be carefully prepared by your attorney to cover you as the buyer when you are buying and to cover you as the seller when you are selling.

Here are 8 key clauses you need in your purchase agreement when you are buying a property. Make sure you go over this list before you sit down and meet with a seller so that you understand what you are asking for. You can also use this list as a checklist as you are having your attorney draft your contracts so that you save lots of money and protect yourself when you are buying.

Clause One: Liquidated damages clause:

A liquidated damages clause is critical to your minimizing risk because it lets you contain the cost of walking away from a deal. When you enter into a contract with another party you both have the right to expect the other party to perform everything that was mutually agreed to in the contract. If one party doesn’t do what they agreed to do, the other party may sue for “specific performance.” This means that they ask a court to make the defaulting party live up the terms in the contract.

When you are buying real estate and you sign up an agreement to buy a property, you want to be able to walk away from the deal if after doing your due diligence you discover something wrong with the deal. Now the way many investors give themselves this freedom is by using all sorts of “subject to” clauses in their agreements with the seller. For example, “This agreement is subject to Buyer’s inspection and approval of the property.” Or, “This agreement is subject to Buyer obtaining satisfactory financing.” You get the picture.

If you were a seller and your buyer showed you paperwork with all kinds of these overt escape clauses, would you feel confident that you had a real buyer? That’s where a liquidated damages clause comes in to play. It accomplishes the same thing as an escape clause, provided it’s used correctly, without arousing seller concerns about your commitment as a buyer.

A liquidated damages clause merely spells out the exact payment one party must make to the other party in a contract should a default occur. When you’re buying a property, you use a liquidated damages clause that spells out that if you as the buyer default (i.e. don’t buy the property) then the seller gets to keep all the money you’ve paid to the seller so far as “full and complete liquidated damages.” This sounds pretty strong and sellers like that, but remember, you are only giving the seller a token up front payment. Normally I use a single dollar. Some investors use up to $500. The key is to delay the payment of any serious up front money until the point that you have done your due diligence and are sure you want the deal. (Preferably you will have already found your end user for the property before you ever give the seller any serious money, whether you put a tenant buyer in the property or are selling to a retail buyer for all cash.)

Here’s what the legalese version of a liquidated damages clause sounds like: “In the event of default of Buyer, all money paid to Seller by Buyer shall be retained by the Seller as consideration for the execution of this contract and as agreed liquidated damages and in full settlement of any and all claims for damages.”

Clause Two: “… or assigns, Buyer”

Anytime you sign up a deal to buy a property you want to maintain maximum flexibility. You may one to buy and hold the property or you may decide to quickly resell the property for a fast-cash profit. One important component to this flexibility to sell fast is the ability to assign your interests in the deal over to another party for a quick cash payment. While any contract is always assignable unless there is a clause in the contract limiting or forbidding the assignment of the contract, it still makes sense to clearly put in your agreement the fact that you can may assign the contract.

The best way to do this is to pre print into the contract the words “or assigns” right after the blank where you fill in who is the buyer. The reason you pre print it into the contract is because if you write it in by hand into the line of who the buyer is (e.g. John Smith or assigns, buyer) it calls it to the attention of the seller. Anything that is printed directly into the agreement flows smoothly past the seller and is usually accepted without comment.

If the contract that your seller wants you to use has a “non-assignment” clause, make sure you cross out this clause and have both you and the seller initial the change.

Clause Three: The Closing Date and Closing Agent

Controlling the closing is critical for your success when buying (or selling for that matter). You always want to be the one who gets to control who will be doing the closing so that you can make sure they do it in a way you are comfortable with. That’s why I recommend you always reserve the right to be able to choose who the closing agent will be. Also, when you are buying you want to be able to have a degree of flexibility in case you need a little extra time to finish getting your financing together, find your renter for the property, or just to do other preparation for the closing. You can accomplish both these things by using the following clause:

“Closing shall be held on or about ___________ unless extended by no more than 60 days by either party in writing. Closing shall be at a time and place designated by Buyer, who shall choose the escrow, title, and/or closing agent.”

Clause Four: Get Access to the Property and Permission to Start Your Marketing BEFORE You Close

Why wait to get started on marketing the property to your end user? Maybe you’ll want to rent out the place, or even sell it on a rent to own basis. Either way, one of the best ways to reduce your risk in any deal is to have a non-refundable earnest money or rental deposit from your end user before you ever close on the property. But to do this you need access to show the property and ideally permission to put your marketing sign in the front yard while you are waiting to close. Now I can hear some of you saying that the seller will get upset that you are selling it for more than they sold it to you for. Of course you are selling it for more! I sit down and make sure every seller understands that the reason I am willing to buy their property is because I want to make a profit. I also tell them that if they don’t feel the deal we’ve agreed to is a real win-win for them then we shouldn’t do it. By being up front with the seller they will be happy when you win too. Remember, you aren’t buying from just any seller. You are buying from a motivated seller who has a specific need or problem you are helping them to solve.

Here’s what the legalese version of this clause looks like:

Buyer shall be entitled to a key and to access the property prior to closing to show partners, lenders, inspectors, contractors, and other interested parties prior to closing. Buyer may place a sign on the property prior to closing to help Buyer find end user for the property. (Be aware, if the seller still lives in the house and it’s not empty then usually rather than him giving you a key, you simply arrange to bring any interested parties, whether they be prospective buyers or renters or contractors, over at a time when he can leave the house for a few hours and take the kids to a movie or to the park.)

Clause Five: Execution in Counterparts – How to Sign Together Even When Your Miles Apart

Let’s say you are working with an out of town owner who really wants to dump their property. Do they have to fly out to sign the purchase contract with you? Not if you are smart enough to use a clause like this one that lets you lock up the property with a signature signed on a separate copy of the agreement that you can fax, email, or overnight to the seller and that they fax or overnight (preferably both) back to you.

“Execution in Counterparts: This agreement may be executed in counterparts and by facsimile signatures. This agreement becomes effective as of the date of the last signature.”

Clause Six: The World’s Best Inspection Clause

Check this inspection clause out. It not only clarifies that everything should be working in the property and that the seller will pay for any needed repairs prior to closing, but it also says that unless otherwise noted you get all the personal property, read curtains and appliances and such things, too. It also comes with a guarantee from the seller that survives the closing that everything is in working order when you buy. Now I know I’m getting pretty excited over this clause, but after using it for close to a decade now I am very partial to it.) One thing to be clear on is that if you are buying a fixer for a low, low cash price then you are going to have to modify this clause in most cases since part of the reason you are getting a great cash price is the fact that you are going to be responsible to do the repairs to fix the place up.)

Here’s the clause: Buyer or his agent may inspect all appliances, air conditioning and heating systems, electrical systems, plumbing, machinery, sprinklers and pool system included in the sale. Seller shall pay for repairs necessary to place such items in working order at the time of closing. Within 48 hours before closing, Buyer shall be entitled, upon reasonable notice to Seller, to inspect the premises to determine that said items are in working order. Unless specifically excluded in this agreement, all other items of personal property located in or on the property shall be included in the sale shall be transferred by Bill of Sale with warranty of title. Seller expressly warrants that property, improvements, buildings or structures, the appliances, roof, plumbing, heating and/or ventilation/air conditioning systems are in good and working order. This clause shall survive closing of title.

Clause Seven: Automatic Renewal or Extension of Note

Many times when you are structuring owner carry deals the seller won’t want to have to wait for 30 years to get all of his money. In these cases using a balloon note works wonders. A balloon note is a loan that has a clause saying that the unpaid balance all becomes due at some future date. For example, we recently bought a 4 bedroom house where the seller carried back the financing with a five year balloon due for the balance of the note. This meant that we paid the seller monthly interest payments and at some point within 5 years of closing we must pay of the balance of the loan. This is called a balloon payment. Typically it’s paid by either reselling or refinancing the property.

Obviously as an investor the more time you have before that balloon note comes due the more flexibility you have. But there are times that the seller won’t give you as much time as you would like. The best way to handle these types of sellers is indirectly. Don’t argue with them and butt heads, instead agree to go along with them. Then later in the negotiations simply ask for either a one or two time renewal of the term of the loan, or for an extension if you need it.

Here’s the way to ask the seller for this, “Mr. Seller, I’m OK with a balloon note of 4 years. That should be enough time for me to still conservatively make a profit here. But I would like to have as a worst case scenario the ability to renew the loan one time. Obviously I’d have to have paid you on time every month and all that. Does this seem fair with you?”

If the seller won’t give you a renewal, ask for the right to extend for 24 to 36 months. (Use months here not years, it seems much shorter to most sellers.) Even if you only get the seller to agree to a one time extension of 12 months, that is still one year more on the note than you had before! If worst comes to worst offer to pay the seller a payment of a few thousand dollars to extend the note.

If you do use this idea make sure you spell out that this payment is of principal (i.e. it counts towards the money you would have had to pay the seller anyways!) The time to ask and to get it in writing is up front, NOT at the end of the loan.

Here’s an example of what the legalese version could look like: “Borrower may renew this note for __ additional terms by paying to Note Holder $X of principal on or before 30 days prior to the expiration of this promissory note.”

Clause Eight: Substitution of Collateral

The final clause you should always ask for in your seller carry deals is called “substitution of collateral.” This means the seller gives you the right to free up the property you are buying of any lien and move that lien over to another property you have.

Imagine you are buying a $200,000 house and the seller carries a second mortgage of $50,000 at 7.5% interest. You want to sell that house but don’t want to want to lose out on the low interest use of the $50,000. If you have a substitution of collateral clause in your loan agreement with the seller you can move that low interest second mortgage of $50,000 over and secure it against another property you have that has enough equity in it to be fair to the seller. Again, you don’t have to use this clause, but it does give you maximum flexibility.

Here’s the legalese version: “Note Holder agrees to allow Borrower to substitute any property(ies) in which the Borrower has a total amount of equity equal to or greater than the amount of equity as existed to secure this note at the time this note was created, as collateral for this promissory note and accompanying Deed of Trust. Furthermore, Note Holder agrees to execute in a timely manner any documents necessary for the implementation of this substitution of collateral.”

I hope these ideas give you a better base to more profitably and safely do your investing. Having done hundreds of single family house deals over the past 20 years, I sure wished someone had given me a list like this!

My best to you,

David Finkel
Maui Mastermind®

P.S. Make sure you take advantage of the entrepreneurial FREE tools up on taxloopholes.com to help you succeed!