Demystifying Real Estate Purchase Agreements
What's in a Letter of Intent and Purchase & Sale Agreement - and why you shouldn't be intimidated by them
Last week we discussed the process of finding your first real estate investment.
Building market knowledge.
Establishing broker relationships.
Finding and analyzing the right property for you.
The process is simple, but by no means easy. It requires focus and persistence.
Stick with the process. You will find a deal that works for you.
But what do you do once you have found a deal you want to buy?
Do you tell the broker or seller you are interested in buying the property?
Yes!
Do you have to send them something in writing?
Yes! A letter of intent.
Will you have to sign a legally binding document?
Yes! A purchase and sale agreement.
(It’s OK. We sign legally binding documents all the time. It you lease an apartment or a car, you have signed one.)
Will you have time to back out of the deal if you discover a problem?
Yes…up to a certain deadline. The due diligence period.
Never fear! I will walk you through the documents and the steps.
Let’s dig in.
The Letter of Intent: A Non-Binding Agreement
As with many real estate (and non-real estate) transactions, the process of buying a property from a seller usually includes two documents:
Letter of intent: a non-binding agreement.
Purchase & Sale Agreement: a binding agreement.
There are also a series of closing documents signed by each party just before closing, but these tend to be standard forms that are not as actively negotiated. Let’s not worry about the closing documents in this discussion.
So what is a letter of intent?
Think of the letter of intent (LOI) as a “handshake” agreement in 1-5+ pages. It will address the following:
Property Description
Names of Buyer and Seller
Purchase Price
Key Dates: due diligence start and end (aka the contingency period); closing date; extension options (if any)
Deposit - typically around 3% of the purchase price (ex. 3% x $500,000 = $15,000)
Name(s) of Broker(s) Involved
Escrow and Title Company
Confidentiality Requirement by Buyer and Seller
That the LOI is Non-Binding: make sure you check that it is!
Contingencies (if any): examples - loan assumption, tenant signing a lease, physical repairs
That’s about it.
It can be done in as little as one page.
Bigger firms may have more extensive LOI forms that include the list of due diligence items they require or other specifics, but the list above is the core of an LOI.
Most of the time lawyers are not involved as the buyer and seller, with the assistance of their brokers, prepare the LOIs.
The LOI goes back and forth between the buyer and the seller as the way to track the offer and counteroffers. This could happen one or many times.
Once the LOI is agreed to, the parties sign the LOI and move to the purchase and sale agreement.
Purchase and Sale Agreement: The Official Binding Agreement
The purchase and sale agreement (“PSA”) is both (a) much more extensive document than the LOI and (b) legally binding.
When you sign a LOI, you are putting your reputation on the line.
When you sign a PSA, you are putting your reputation AND your money on the line.
Even though most PSA’s give you a 15-30+ day due diligence period before your deposit goes non-refundable (i.e. you can’t get it back), you need to be very serious about buying the property if you sign a PSA.
You don’t want to build up a reputation as someone who signs a PSA but “can’t perform” - never actually buys (i.e closes on) a property. Brokers and sellers won’t take you seriously. The real estate community in most markets is surprisingly small.
So what’s in a PSA?
A PSA has all the components of an LOI plus (i) a more detailed description of the LOI terms, (ii) many additional terms and descriptions, and (iii) the PSA is binding.
Important Note: Refundable vs Non-Refundable
As we discuss the PSA agreement and the purchase process, let’s anchor in on the difference between the refundable (aka contingency) and non-refundable period.
Refundable: From the date the PSA is signed (the “effective date”) through the expiration of the due diligence period, the buyer can typically back out of the deal for any or no reason and get their deposit back. No penalty. No foul. They still have to pay the consultants and advisors they may have hired and their reputation may suffer, but they don’t have to buy the property nor forfeit their deposit.
Non-Refundable: Once the due diligence period expires, everything changes. The buyer can still back out of the deal, but doing so will mean they lose their deposit. Additionally, at this stage they are normally 15-30+ days into the process and emotionally invested in the deal. In my 20+ years of investing in real estate, I have seen less than a handful of cases where someone backs out of the deal after the due diligence period expires.
With that important foundation, let’s run through the additional terms and descriptions contained in a PSA that builds off the LOI.
Operating Conditions During the Purchase Process (aka Escrow)
The seller will continue to operate the property during escrow. Leases and contracts may be signed. Invoices will need to be paid. This section addresses how the buyer and seller will work together during escrow.
Contracts & Leases: the buyer will often have rights to approve contracts and leases during the due diligence process. Once the buyer is non-refundable, they may have controlling rights.
Leasing Costs: the buyer typically pays for commissions and tenant improvements from leases executed after the effective date.
Due Diligence
The buyer will want to review everything they can about the property before they put their deposit at risk by going non-refundable.
Materials: list of materials the seller will supply to buyer. Typical materials include: (i) leases and contracts, (ii) historical income statements, (iii) list of vendors and utilities, (iv) warranties, (v) list of ongoing capital improvements, (vi) details on any outstanding insurance claims, property tax issues, municipal correspondence, and/or legal claims, (vii) seller disclosures of issues affecting the property, and (viii) any other items both parties agree upon.
Inspections: the buyer will have the right to inspect the property, including with their consultants, in a non-invasive way. They will need to get explicit approval from the seller to be able to perform invasive testing.
Representations & Warranties
This is a fancy way of saying (a) what is each party saying is true <a “rep”> and (b) what will each party agree to do <a “warranty”>. They generally focus on the seller and include:
Reps: the seller has the authority to sell the property. The seller is not bankrupt nor has any pending litigation. There are no tenants, leases, and contracts other than the ones provided in due diligence. The due diligence materials provided are true and correct.
Warranties: the seller will maintain insurance. The seller will continue to operate the property in a professional manner leading up to closing.
Damage & Destruction, Condemnation
Damage or Destruction: what happens in the event the premise is damaged or destroyed? The buyer may have the right to back out and keep their deposit if more than 5% of the property is destroyed.
Condemnation: what happens in the event the premise is condemned? The buyer may have the right to back out and keep their deposit.
Closing Process
The PSA documents the details of the closing process including:
Closing Conditions - Buyer: waived due diligence contingency; received title policy from title company.
Closing Conditions - Seller: maintained reps and warranties; delivered required closing documents to escrow.
Closing Costs: list of what buyer and seller will each pay. Seller typically pays the broker commission.
Closing Steps: description of how the escrow company will handle the closing logistics.
Exhibits
Although PSA may be only 15+ pages, there could be 20+ pages of exhibits. These can include:
Legal Description of the Property.
List of Due Diligence Materials.
Form of Deed: this is the legally recorded document that confirms the property has been sold.
Form of Bill of Sale: this documents the sale of any personal property related to the physical property. Examples: parts and materials for repairing the property such as flooring or light bulbs.
Form of General Assignment: this documents the transfer of the various contracts such as leases, warranties, and service contracts.
Form of Estoppel: very briefly, an estoppel is a unilateral statement signed by the tenant for the benefit of a buyer and their lender confirming the key terms of a lease. Estoppels are common in larger commercial transactions.
Any other specifics details relevant to the property such as the status of ongoing capital improvements.
At a Glance: LOI vs. PSA
LOI
Legally Binding: no
Length: 1-5 pages
Purpose: handshake agreement before legal documentation
At Risk: reputation
Lawyer needed: no
PSA
Legally Binding: yes
Length: 15-35+ pages
Purpose: legal contract
At Risk: reputation and money
Lawyer needed: if not using standard forms
How to Digest All of This
That was a lot to cover.
Some of you may be overwhelmed with the amount of detail and feel that it can’t be this complicated. Some of you may feel I am only scratching the surface.
You are both correct.
The level of complexity mainly depends on whether you a buying a 1-4 unit residential property or a commercial property (industrial, retail, office, or multifamily).
1-4 Unit Residential
If you buy a 1-4 unit residential property, whether for your personal residence or as an investment, you will likely use a templated agreement that is literally “fill in the blanks”. You won’t even use a letter of intent.
Everything will be done using the PSA offer and counter offer templates.
No lawyers. No negotiating items you are struggling to understand.
Some of you can breathe a sigh of relief.
Commercial Properties: Industrial, Retail, Office, Multifamily
For the rest of you, you will likely need to take the time to develop a basic understanding of what I described in the LOI and PSA documents.
For deals under $10 million, you may still use standard form PSA agreements like those created by AIR CRE. This is referred to as “using an AIR form”.
The benefit of this approach is that the buyer and seller are each agreeing to most of the items that get negotiated. They can focus their efforts on adding exhibits for items that either (i) fall outside the AIR form or (ii) they want to more actively negotiate.
This can be a great approach and one I support for smaller deals.
For those of you buying larger commercial deals and using customized PSAs, here’s my advice:
Find a Good Lawyer: work with a lawyer who understand the issues that will come up AND is business minded - i.e. they want to figure out a reasonable solution to each item that is negotiated as opposed to proving how smart they are by over negotiating every item.
Get Smart: spend the time needed to understand the issues from a business perspective as opposed to just relying on what the lawyer says. Think through what the issue really means. Ask your lawyer to explain issues in simple language and give you examples of real situations where this language would apply. As the buyer, you make the call on the final language. Not the lawyer. It is your money and reputation.
Red Flags to Watch For
While most sellers are honest, watch out for red flags such as:
Seller resistant to reasonable contingencies > make sure you protect yourself.
Significant items missing from due diligence materials > dig in to make sure the seller is not hiding something important.
Seller rushing you through due diligence > take the time you need but understand that you can never make a “risk free” investment.
Trust your gut and don't proceed with the deal if it doesn’t feel right.
The Purchase Process in 5 Steps
The LOI and PSA are integral steps in the overall purchase process:
Find property (last week’s newsletter)
Submit and agree on a LOI (handshake agreement): 3-7 days
Negotiate and sign a PSA (binding contract): 7-14+ days
Complete the due diligence and go non-refundable (next week’s newsletter): 15-30 days
Close: 15-30+ days
Yes it gets more complicated with additional investors and obtaining a loan, but this is the basic process. A fast process takes 30 days. A more typical process takes 45-90 days.
My Two Cents on How to Think About a PSA
I tend to find the heavy negotiation of PSAs to be overkill.
Why?
If there are issues that come up in the purchase process, reasonable buyers and sellers are normally motivated to work it out regardless of what the PSA says.
View the PSA as your purchase process handbook. It should guide you in the process.
But, remember that your most important asset is your word and your reputation.
Over negotiating the PSA as a way to plant trip wires to out maneuver your counterparty (whether buyer or seller) may help you on an individual deal, but will set you up for being known as a bad actor in the long run.
Be as good as your handshake.
Be a good person.
Life is better that way.
Professor Bateman