Pitfalls and Consequences You Should Know
When presenting an offer to purchase real property, the offer is written as a letter of intent (LOI) or a purchase agreement. A purchase agreement becomes a binding contract once both parties have signed it and often a letter of intent is also binding once it has been signed. It is important to understand all of the terms in the agreement so that both parties know what they are committing to in advance.
Commercial purchase agreements can be complicated and I often receive offers from other agents that are not familiar with all of the clauses and do not fully understand how they affect their customers. Below are six points that often confuse buyers and sellers and are important to understand when using a standardized commercial purchase agreement, such as the Michigan Commercial Alliance of Realtors (MICAR) form that is most often used in our market.
One of the most confusing issues is how we prorate taxes at closing. Because every township has different tax millages that cover various periods of time, and some are paid at the beginning of the taxing period and others at the end of the period, taxes are almost never prorated based on the actual millage of the township. Instead, the purchase agreement states that taxes will be prorated as if they cover a certain period of time.
Most often we see taxes prorated as if they cover the current calendar year. Buyers and sellers need to understand that the winter tax bill, which comes out in December but is often not paid until January or February, covers the previous year and not the following year. This is because state law says the bill is “due” the day it comes out (December 1), even though taxpayers have a grace period to pay until January or February before there is a late charge.
Another method often written into purchase agreements is where taxes are prorated as if they are paid in advance. This is the state statute and is used if there is a dispute or unclear language in the offer. It is also typically a standard use in southern Michigan, so offers from agents in that area often include this language. When prorating taxes as if they are paid in advance, the seller gets credited for taxes previously paid, so it is beneficial for a seller to use this method.
A third method is to prorate taxes as if they are paid in arrears. This is not as common, but it is important to understand that this single word change from advance to arrears will shift the payment of an entire year of taxes onto the seller. This benefits the buyer and could save the buyer tens of thousands of dollars depending on the annual taxes.
There are many contingencies that specify how long a buyer will have to perform due diligence. It is important to understand that many of these do not begin the day the agreement is signed (which is referred to as the “effective date”), but begin after another event has occurred.
For example, if the MICAR purchase agreement says that a buyer has 30 days to do a survey, it further specifies that the 30 days begins once the seller has provided the title work to the buyer. The title work is needed for the surveyor, so it makes sense, but that could easily add another 30 days if that is how long it takes to get the title work.
Another time frame to be aware of in the MICAR agreement is the time to receive a loan commitment. Many agents think the loan must be secured within the number of days stated, however the agreement reads that if the buyer has not received a loan commitment within the specified time frame, the seller may terminate the offer. If the seller does not terminate, the loan contingency is not removed, it just continues until the buyer has received their loan or waives the contingency.
Default Provisions and Penalties
It is important to understand what happens if there is a default. The buyer often escrows a good faith deposit with the offer. Some offers limit the buyer’s penalty to the amount of the deposit if there is a default. Other agreements give the seller the right of specific performance, which allows the seller to force the buyer to purchase the property. This can be difficult to enforce if the property is being financed or there are unfulfilled contingencies, however a cash offer with no contingencies would certainly be enforceable. Conversely, if the seller defaults, the Buyer often has the right to specific performance, however, if the seller wrote their default clause to only allow for termination of the contract, the buyer may lose the money they have spent on due diligence.
Due Diligence Costs
Since the offer is a contract, all of the terms are negotiable until the contract is signed. We often see buyers and sellers negotiating who will pay for environmental assessments, new surveys that are needed, and closing costs. How the expenses are allocated often follows our economic cycle. We are currently in a strong seller’s market, and buyers are paying most of these expenses, however, a decade ago when it was a buyer’s market, we saw the sellers picking up many more of these costs.
There are many standard contingencies such as inspections, financing, survey, title, environmental, and financials. The buyer must do due diligence to make sure the property meets their expectations. It is equally important that it works for the buyer’s use.
If a special use permit is needed or zoning does not allow for the buyer to use the property the way they intend to, the buyer shouldn’t buy the property. There may be special considerations for additional contingencies such as getting a buyer’s use approved or needing township approval for a site plan. For example, in new construction where there is a new driveway needed, the department of transportation may require a traffic study to be done and may require a road widening or turn lane if the new development will put too much traffic on the road. This could be cost-prohibitive for the buyer and it is important to make sure that contingencies address any requirements a buyer may have.
It is important to make sure that the sale price is allocated between the real estate, personal property, inventory, and goodwill, if these exist. The buyer and seller must agree on how the price is allocated and there could be considerable tax advantages to one party for doing it a certain way. For the seller, they will need to know their basis in each of these items to understand their tax consequences. Discussing this allocation with your CPA before closing is important for both buyers and sellers.
There are numerous other issues to watch out for in real estate contracts such as the type of deed, title insurance, who pays which closing costs, and many others. It is difficult to anticipate all of the different issues that could arise, but it is easy to remember that the terms are negotiable and you will benefit from working with an experienced team that includes your commercial real estate agent, accountant, and attorneys when creating commercial real estate contracts.
Note: This is not meant to be a comprehensive list of all concerns, but ones that are seen most often in day-to-day business.
Dan Stiebel, CCIM