As real estate investors, we all want the buying or selling process to be smooth sailing…
And that’s most likely to happen if you have a good understanding of what goes on through each step of a real estate deal. So, let’s take a high-level view of contracts and purchase agreements to get a clear picture of what’s really going on when we make that decision to buy or sell.
NOTE: This is general advice that is not meant to substitute for legal advice from a local real estate attorney. Make sure, as you assemble your team, that you find a great attorney with an investor mindset that you can trust. We are not attorneys. We are sharing info based on our experiences.
ELEMENTS OF A CONTRACT
Real estate contracts should always be written, not verbal.
A contract has to be written to be enforceable.
Have everyone sign and agree and have it reviewed by council.
The reason you have a contract is not only to set forth what both parties agree to now, but also to serve as a reminder in the future. People are forgetful, and if a dispute arises down the road, you want to be able to go back to a written contract and see the terms you both agreed to.
4 Elements of a Real Estate Contract
Let’s go through each of these elements in detail…
An offer is your written request to purchase a property.
Let’s say you want to buy the property at 104 Main Street. You write a request to purchase that property for $100,000 and submit that to the seller. You’ve just made the offer.
That offer is not accepted until it’s countersigned by the seller. Once the seller signs it, then it becomes a written, binding contract.
But, if the seller crosses out the $100,000 price you offered and writes in $110,000, then initials and signs the offer, that’s NOT a binding contract. That’s a counteroffer because there is a change to some of the terms.
So, now it’s up to you as the buyer to accept that contract. If you initial next to the updated amount, you have a fully executed contract, but it’s not fully enforceable YET.
To be enforceable, the intention has to be clearly stated in that contract. The contract has to clearly state that you intend to buy the property according to certain terms and conditions.
This can be very basic language. You can just list the price of the property and the closing date. Usually, though, you will incorporate many more terms.
There has to be some value offered, also known as a consideration, in the written offer. Usually that’s in the form of a dollar amount, typically in the amount of the purchase price.
In some cases, for example, if someone wants to give you a property, it might be a little different. You might assume liability for or agree to pay off certain liens.
When you have all 4 elements of a contract, then the contract becomes enforceable.
PURCHASE AND SALE AGREEMENTS
Some investors use one contract they found online for everything. You should NOT do that.
Use different contracts for buying and selling and for different scenarios. They should be written differently to protect your interests.
If you’re buying a piece of property, your inspection contingency (which tells you when an inspection is done and what happens if the inspection uncovers defects) should be drafted a little bit different than if you’re selling the property.
If you’re buying a property, you want the inspection contingency to state that if you find anything wrong with the property, you want to be able to cancel the contract.
But—if I’m a seller—I want that inspection contingency to be a bit different. Meaning, I don’t want the buyer to cancel the contract because they don’t like the electrical units or some other aspect of the property that would be easy to fix (or make an excuse like that because they got cold feet)…
So from the seller’s perspective, the inspection contingency should say that the contract is contingent on an inspection, but only in the event that a material or substantial defect arises that affects the value or the use of the property.
A real life example… of what NOT to do…
I recently had a buyer call me. She had made an offer to purchase a house for $110,000. She was working with a real motivated seller. Her Realtor wrote a standard Realtor contract. The inspection contingency read that if the buyer found any defects, they had to put the seller on notice of the defects, and then the seller had 5 days to respond as to whether or not they were going to correct the defects. And if the seller did not provide a response within 5 days, the contract was terminated…
So, the buyer had the inspection, found some minor things wrong and got a little greedy. The buyer counteroffered based on the inspection and said there were certain defects. She gave the seller the option to fix the issues or to reduce the purchase price to $105,000.
In the meantime, the seller got another offer on the same house for $125,000. So the seller just didn’t respond to the notice of the defects and waited 5 days until the contract was terminated. The seller went with the new buyer who was offering more, and the originally interested buyer lost the house.
All of that could have been avoided with the right language in the contract.
It would have been in the buyer’s interest to say that if a defect arises, the seller is put on notice. The seller then has 5 days to respond. Are they going to repair the defects or do a reduction in purchase price? After the seller responds, the choice flips back to the buyer to accept the new terms or terminate.
Many local Realtor associations have approved contracts. These have really standard language, and the goal is to protect the Realtor—NOT the buyer or seller.
So, make sure you understand the terms and conditions of all your contracts.
If you’re making an offer on an MLS property, you might be stuck with a Realtor contract. In that case, use an addendum to modify the language in that initial contract to protect your interests.
Purchase Agreement = Escrow Instructions
The purchase agreement serves as escrow instructions to the title company or closing attorney…
It’s going to tell them how the closing costs are going to be divided, the closing date, what happens in the event of a dispute, who gets the earnest money… all of that.
If you’re working with your Realtor contract, you’re good. Those have been vetted and approved by attorneys, so they’re going to be compliant with local laws.
But be very careful if you’re in the habit of downloading forms off of the internet and filling in the blanks.
Templates are good things; there’s no need to reinvent the wheel, but you have to be careful that you understand what your contracts and purchase agreements say and that they protect your interests.
OTHER TYPES OF CONTRACTS
So far we’ve covered common contracts, but there are a few variations:
- Option Agreements
- Lease Agreements
- Land Installment Contracts
- Lease with Option to Purchase
You can use an option agreement if you think you want to buy a property but you’re not quite sure. The seller can give you an option to buy that says for a certain period of time—let’s say the next 3 months—you have first rights, or the option to buy that property.
If you’re going to be a landlord or employ a buy-and-hold strategy, lease agreements are incredibly important. And this is where a local attorney is worth his or her weight in gold…
There are certain ordinances specific even to individual cities. You have to take that into account. The lease agreement is also going to say the terms, such as whether you’re leasing it to the tenant for 1 or 2 years, or maybe it’s just a written month-to-month rental agreement. This all becomes very important if a landlord-tenant relationship goes south.
Land installment contracts and lease with option to purchase are important when the buyer or seller doesn’t have financing. A land installment contract is great for buyers. A lease with option to purchase is great for sellers…
The reason is that a buyer has more rights and protections under a land installment contract and the seller has more protection with a lease with option to purchase because if the buyer stops paying their monthly rent, the seller is the victim.
Think of these last 2 strategies as exit strategies. If the market’s a little dry, you might find someone who wants to buy, but maybe they had a point-in-time crisis. They lost their job, they got sick or they fell behind on some credit card payments and now they can’t get financing to buy your house. So you act as the bank and you put them into a lease with the option to purchase.
They’ll give you a big down payment or option consideration. It’s nonrefundable and they’re going to make monthly payments to you until they can exercise that option to purchase.
Now you’ve got cashflow.
An addendum is part of the contract, but it’s a change of the contract…
A classic addendum is a change in price: Let’s say an inspection uncovers a substantial material defect to the basement wall. It’s a $10,000 repair, but you want to close in 30 days, so it’s not really practical for the seller to do that repair before closing. So you write an addendum to the contract to change the purchase price from $100,000 to $90,000 to make up for the cost of the repair.
Another common addendum is a change of closing date if the seller or buyer needs more time.
If it’s a short sale, you’re going to want a good short sale addendum. It should clearly identify what a short sale is, what it means and how the parties are affected.
Both the seller’s attorney or Realtor and the buyer’s attorney or Realtor can write addendums.
Remember, if you offer an addendum, it could be deemed as a counteroffer to the original agreement. So you have to be careful because if you do something because you’re greedy, it could give the other party a reason to cancel the contract.
But addendums are sometimes important to clarify exactly what you need or to address unexpected situations.
Disclosures are things the seller knows about the property…
- So if it’s a rental, the seller discloses the rent roles (how much tenants are paying) and any lease agreements.
- Other common disclosers are property defects such as water in the basement.
- Pending assessments or scheduled development in condos should also be disclosed.
- The seller has to disclose anything adversely affects the value of the property and would affect the buyer’s decision to purchase it or not.
- Most states have a lead-based paint disclosure.
Why make disclosures?
Because that’s your get-out-of-jail-free card…
If you disclosed to a buyer that the property had water in the basement, then they can’t come back to you and complain when there’s water in the basement.
The buyer, unless stated otherwise, is buying the property in its as is condition subject to the seller’s duty to disclose material and substantial defects in the property.
Don’t avoid any disclosures, and if in doubt, disclose. If you know something, disclose it. You don’t want it to come back and bite you in the form of a lawsuit.
STEPS IN A REAL ESTATE TRANSACTION
What are the steps in a real estate transaction?
- Negotiate the Terms
- Draft and Execute the Contract
- Due Diligence/Inspection Period
- Contractor Quotes
- Municipal POS Inspections
- Escrow Period
- Closing the Deal
First of all, you negotiate the terms…
A lot of times those are verbal conversations, but they should be followed by a written purchase contract. Then, as soon as you have the contract done, you want to set forth in your due diligence right away:
- Do your inspections.
- Evaluate all the relevant information.
- Get your contractor out and get an estimate for your rehab.
Do your municipal point of sale inspections. A lot of cities, some but not all, require that you have an additional local inspection to make sure that there aren’t any housing violations…
Then you wait through your escrow period. That’s the time between when you sign the contract and the closing date. A LOT happens in that time:
- You do your due diligence.
- The buyer procures his or her financing.
- The bank and Realtors work with the title company.
- The title company (or closing attorney) puts everything together and conducts the closing.
Then you close the deal.
PARTIES IN A TRANSACTION
There are a TON of people involved in real estate transactions. It’s important to have a high-level understanding of what all these players do:
- Self-Directed IRA Company
- Title Company (Title and Escrow Functions)
- Members of your team (attorney, mentor, contractor, CPA, insurance agent)
KEY TERMS… AND WHY THEY’RE IMPORTANT
The goal of paying earnest money is to show that you’ve got some skin in the game—you don’t get it back if you breach the contract without cause (and you may be liable for other damages, depending on your contract).
Earnest money is usually deposited in escrow with the title company at the time of the offer. It’s different from a down payment. A lot of times it’s 1% of the purchase price, although $500 is also common.
This is the amount you pay up front depending on your loan amount. For example, the bank might give you 80% loan to value, so you need to make a down payment of 20%.
You need a closing date on all your contracts. The closing date is the date you plan to transfer the title and pay the balance of the purchase price. It’s best to use a calendar date, such as August 31st, rather than a number of days, such as 52 days from the date the contract is signed. That way, the date is fixed and not dependent on when the contract is actually signed.
Also, banks look for dates. If they have a 30-day close period or a 60-day close period, they want to know an exact date—and you want that too, because you want your loan ready to go for closing. Use terms such as “on or before August 31st” to give a little bit of flexibility.
These are a contingency in most contracts. If you’re a cash buyer, you need to state that your contract is a cash purchase and isn’t contingent on financing. but, you might not have that cash sitting in your bank account.
While a cash offer looks great to a seller, if you have any potential concerns at all about your hard money lender coming through, for example, include in the contract that it is contingent on you obtaining the requisite financing.
These can vary from state to state. Some states pay taxes a year behind. So make sure that you understand your text prorations.
I mentioned these earlier… make sure you understand the terms of the inspection. If the contract says you have 7 days (and is that business days or calendar days?) to have an inspection, get it done within 7 days.
Know how long the seller has to respond to any defects found in the inspection. Most contracts are going to have this term called time is of the essence. That means that if you don’t get an inspection done in the indicated timeline, you lose your right to have an inspection and you buy the property as is.
Allocation of Closing Costs:
This is a BIG deal. Some states have a standard or customary allocation. For example, the escrow fee might be split between the buyer and the seller. The seller might pay the conveyance fee AND the tax stamps. The title exam and title insurance might be split.
But, these closing costs are always negotiable. As an investor in a competitive market, your offer is going to be a lot more appealing if you offer to pay the buyer’s closing costs or the seller’s closing costs. These closing costs are relatively fixed, so you can punch that number into your formula when you make the offer to make sure it’s a good deal for you.
Sometimes people want to buy a house and they like the drapes or they like that really unique patio furniture that was built for that patio. Make sure the contract lists fixtures included/excluded. Any fixtures you want to come with the house need to be listed there.
One you don’t see very often is mineral rights, but you’ll see it in rural or country areas where there’s a lot of mining for natural gas. If you want the mineral rights to a piece of land you’re buying, make sure that your contract states that you’re acquiring the mineral rights. Otherwise, an owner can lease those out to an energy company.
DON’T BE AFRAID TO ASK
Okay, I hope that this high-level view of contracts and purchase agreements didn’t make you dizzy…
The great thing is, you can learn all this information, then instead of getting them and completing them the painful, old-fashioned manual way… you can AUTOMATE it.
Over the last 13 years as a real estate investor, coach and national speaker, I’ve discovered that THE key ingredient to being successful in real estate (or any business for that matter) is SPEED.