How to avoid a real estate purchase contract

It's a dirty secret in the world of real estate brokers. The buyer is king in the world of real estate, and the realtor's standard form reflects this reality--so much so, that it's hardly a contract.

Maybe the buyer has found a better deal down the street and wants to get out of a contract for what is now a lemon. What are the buyer's options? It boils down to two major exit strategies: the inspection contingency and the financing contingency.

Inspection contingency
Typically a standard form contract contains some kind of allowance for a buyer to conduct inspections, and an opportunity for the seller to cure any defects revealed by the inspection. The paragraph might look something like this:

INSPECTIONS. Purchaser, at Purchaser's expense, shall have the right until the later of days after Acceptance or until _____________, __20 ("Inspection Period") to obtain inspections of the Property. Purchaser is encouraged to obtain such inspections and is advised that inspections required by FHA, VA or lenders do not necessarily eliminate the need for other inspections. Items specifically disclosed in this Agreement and in the Residential Property Disclosure Form remain subject to Purchaser's inspection rights. The results of Purchaser’s inspections pursuant to this Paragraph 8 are subject to the satisfaction of the Purchaser. In the event Purchaser is not satisfied with the results of the inspections, Purchaser shall have the right to terminate this Agreement by notifying Seller in writing before the expiration of the Inspection Period of said dissatisfaction. In the event Purchaser is not satisfied with the results of the inspections but desires to attempt to negotiate a satisfactory resolution with the Seller to remedy the inspection issues, Purchaser and Seller shall have a period of five (5) days after receipt of written notice of dissatisfaction ("Remediation Period") to agree upon a remedy satisfactory to Purchaser and if no such remedy is agreed upon in writing, Purchaser shall have the right to terminate this Agreement by providing written notice to Seller no later than five (5) days after the end of the Remediation Period (the "Cancellation Period"). If Purchaser and Seller agree to remedy an unsatisfactory condition of the Property, it is agreed that the remedy shall be performed in a good and workmanlike manner prior to Closing and is subject to the reasonable satisfaction of Purchaser.

I'll save you the time of mucking through that whole paragraph and pull out only the important points:

 The results of Purchaser’s inspections pursuant to this Paragraph 8 are subject to the satisfaction of the Purchaser. In the event Purchaser is not satisfied with the results of the inspections, Purchaser shall have the right to terminate this Agreement by notifying Seller in writing before the expiration of the Inspection Period of said dissatisfaction. 

That's right. The inspection, and therefore the entire deal is contingent on the Purchaser's satisfaction. It doesn't hold the Purchaser to any standard of reasonableness at all--the Purchaser can simply state that he/she is not satisfied with the location of the property and that will be that. The seller can't remedy a badly located property by moving it. The deal is dead.

Financing contingency

This one is a little trickier. Generally if you want to finance a property through the bank or another lender, you get a certain allowable timeframe for obtaining a commitment to lend from the bank prior to closing. There's some wiggle room here to get out of the contract if you can't come up with the financing (of course if the bank refuses to lend then the deal is dead -- they're not going to make you pay with cash).

5. FINANCING. This Agreement ( ) is not ( ) is conditioned upon Purchaser securing a Conventional FHA VA Other (if Other is selected, write in type of loan) loan commitment within days (this provision is not applicable if the number of days is left blank) after Acceptance (the “Financing Contingency Period”). Purchaser shall pursue such loan in good faith and with reasonable diligence. If a loan commitment specific to the Property cannot be obtained by Purchaser, either party may terminate this Agreement by delivering written notice of termination to the other within three (3) days from the expiration of the Financing Contingency Period and the termination procedures of Paragraph 21 shall apply. If this Agreement is not terminated as provided in this Paragraph 5, Purchaser shall be deemed to have the ability to obtain the loan, this Agreement shall no longer be subject to this financing contingency, and the method of payment shall be deemed to be “all cash”.

Assuming the inspection contingency has expired, your failure to get a loan commitment from the bank will not be held against you if you pursued the loan in good faith and with reasonable diligence. It's not excusable that the bank rejected you because you didn't send in your tax returns. If you want to use this contingency to escape the contract, it will require a good relationship between you and the bank -- they're always looking for reasons to reject loans for riskiness and you have to give them one. Perhaps you have a major expense coming up that will impair your ability to repay the loan, or you disagree with the appraised value of the property. Proceed carefully here, because you need to make sure that the seller can't accuse you of failing to pursue the loan "in good faith and with reasonable diligence."

Quick, which is faster: quitclaim or warranty deed?

I get it. Who the heck has ever used the word "quitclaim" in conversation? It's an unfamiliar word. So it's not surprising that many people mishear the term and instead think that they're hearing "quick claim." There's a pervasive notion in the world of real estate that it's somehow cheaper and easier than doing the "other" kind of conveyance.

Let's back up a bit. There are two basic ways (unless you're in Texas) that a live person or corporate entity can give (or "convey") real property to another: a warranty deed and a quitclaim deed. We commonly abbreviate these as "WD" and "QCD" in the title industry. Unsurprisingly, a warranty deed contains certain warranties made by the seller (the "grantor") and the buyer (the "grantee"). The language looks something like this:

TO HAVE AND TO HOLD the said tract or parcel of land, with the appurtenances, estate, title and interest thereto belonging to the said GRANTEES, their heirs and assigns, forever, and we do covenant with the said GRANTEES that we are lawfully seized and possessed of said land in fee simple, have good right to convey it, and the same is unencumbered, unless otherwise herein set out, and we do further covenant and bind ourselves, our heirs and representatives, to warrant and forever defend the title to the said land to the said GRANTEES, their heirs and assigns, against the lawful claims of all persons whomsoever.

There are actually several warranties contained within this long-winded Middle English paragraph, but we really only need to worry about the one: "to warrant and forever defend the title." In other words, if the grantee ever runs into title issues, he/she can drag the grantor or his heirs into the lawsuit for having sold a property with bad title.

Here's an example: Joe Smith buys a property from Don Jones. Five years later, Joe's neighbor conducts a survey and finds out that the neighbor's property as titled in the public record is actually the lot that Joe lives on, and Joe legally owns the lot next door to him. The neighbor sues Joe. Joe can then bring Don Jones into the suit for having sold him a property with bad title.

A quitclaim deed is much simpler (though not any "quicker"!) The concept is simple: the grantor simply conveys whatever interest he or she might have in the property, even if none actually exists. If the grantor is wrong about what the grantor actually owns, no harm done. For instance, I could quitclaim the entire state of California to you, but since I own no property in California, you get nothing. By contrast, I do own a little property in Ohio, so if I were to quitclaim you the entire state of Ohio, you'd get whatever property I own in Ohio. If I'm wrong about owning the entire state, you can't rely on the deed and you can't drag me into any lawsuits. These documents are mostly used to clean up title if people own some uncertain or incalculable fractional interest in property, most often after someone dies.

Which one is better? Well, let me try a third time to disabuse you of the notion about quickness: both documents take exactly the same amount of time to sign, notarize and file at the recorder's office, unless you've ticked off the clerks at the office (be nice to them!) Many people assume that the quitclaim deed is "safer" to use because it doesn't implicate lawsuits or hold you to any promises that you might not have meant to make. These concerns are real, but we as a society have already solved this problem with title insurance.

The warranties we put in our deeds allows us to tap into the protections we've already paid for through title insurance. If it turns out that there are major title issues, we can call up the title company and they'll defend the case and if necessary buy the house back from us for what we paid for it. It's the safety net that's invoked by the warranties.

One of the most wasteful practices, often preached by the get-rich-quick gurus, is to quitclaim all your houses to an LLC or a trust. If we do this, and a title issue pops up, guess who's getting sued? The LLC. Guess what the title insurance company is liable for? Nada. They're totally off the hook, because they insured you personally as the property owner, not some other entity. It doesn't matter if that LLC is your perfect alter ego and you share everything with it, that LLC is not you and the title company will tell you to take a hike.

On the other hand, if you gave warranties to the LLC in your deed (and why wouldn't you? It's essentially you) then you'd be able to invoke the protections that you've already paid for.

So there it is. Use a warranty deed when you can, and only use a quitclaim deed when you don't know what you have but want to give it away.

Commercial v. residential mortgages: the difference revealed

LLC or not?  There's a parade of gurus and booksellers urging us constantly to form trusts, LLCs, offshore partnerships and pay them for their kits to do it. All of these have their place, but the easiest way to achieve our protection goals is to hold all rental property in one or more LLCs.

It sounds cheap and easy, but as with many other critical factors in real estate, the question is TIMING!

When is the right time to quitclaim our property into an LLC?

The answer to this critical question has to do with how banks lend to investors. There are generally two types of purchase money mortgage loans written in today's markets:

1. Residential conforming loans

• Lowest interest rates available (currently about 4.5-5%)
• 30 year terms
• Fixed interest rate for entire term of loan
• 3.5%-20% down
• Lender will generally only write these loans for an investor purchasing property in their personal name
• Limit 10 per person

2. Commercial loans

• Higher interest rates (the lowest I've seen lately is 5.5%)
• Usually 20-25 year terms
• Sometimes a bank will offer a fixed rate, but most are 5/1 ARM (adjustable rate)
• Lender has the flexibility to write a loan in the name of any entity, including an LLC
• Usually 25% down or more

Usually the lender has plans to sell off residential loans into the residential secondary mortgage market (hence why they are "conforming" to the standards of the market). In contrast, the lender usually plans to hold a commercial loan in its own investment portfolio for the term of the loan. So usually you'll only see smaller banks writing commercial loans - my first one came from a bank who primarily lent to the Amish!

Purchase agreement. 

Whose name is going on the purchase and sale agreement - your own, or your LLC's? The answer is whether you want to end up with a residential conforming loan or a commercial loan. Since the residential conforming loan offers favorable terms, we definitely want to use all of these loans for our ten most expensive properties.

The due on sale clause. 

Many investors will buy in their own name with a residential conforming mortgage and then quitclaim the property into their LLC's name. It is a widespread practice. A note about this: it's not without risk. Every residential conforming mortgage has a due on sale clause which gives the lender the right to foreclose if title has transferred. Quitclaiming a property from one's personal name to an LLC triggers this clause, but the lender doesn't have to do anything. In this market, most banks are happy to have a performing loan at all, so they likely aren't going to foreclose simply because an investor quitclaimed the property into a wholly-owned LLC. In the event that interest rates double, however, it's possible that banks might go hunting for defaults on low-interest fixed loans -- and you might be forced to refinance. At this time, it's a non-issue, but it's always something to keep in mind.

Cash out refinancing. 

One strategy is to buy with cash or a commercial loan and then later refinance into a residential conforming loan, pulling cash out of that property. This strategy works best when buying a house that needs substantial rehab. The problem you'll run into here is seasoning. A lender is going to require you to hold a property in your personal name for 6 to 12 months before refinancing. This means that you can't simply deed the property from your LLC's name to your personal name the day before closing the refi. (Sometimes banks will write a HELOC without a seasoning period - more on this in a future post). So in order to execute this strategy properly, you'll have to have some idea as to what your plans are in 12 months.

Portfolio loans.

Once you hold more than 5-10 properties, you'll want to find a commercial lender who is able to combine multiple properties onto a single mortgage. The seasoning period will likely still apply, and commercial loan terms will apply, but potentially you can seek financing for an unlimited number of properties based solely on their valuation and cashflow.Wrapping up. 

Try your best to find a bank that will write commercial loans for your properties, even if you don't plan to get one right now. It's useful for planning purposes to have a contact at that bank to pick his or her brain about the requirements. And as always, have a 12-month plan in mind!