Starting with the right approach

Although everyone approaches negotiating from his own perspective, we think it’s important to understand that the real estate community in most areas is actually a close-knit group of professionals who network. Thus, word-of-mouth referrals and a reputation for honesty and integrity are critical elements to your long-term success. Patience, vision, and perseverance are also great virtues when it comes to making the best real estate deals. Hard-driving, one-sided transactions may make you some extra money in the short run, but word travels fast.

A university study indicates that people who have a favorable experience share their positive feelings with an average of four others. However, those who’ve had a negative experience go out of their way to tell more than 20 people how they feel about you. Human nature also indicates that they likely embellish the story with each conversation.

Here’s what we don’t recommend:

• A take-it-or-leave-it approach: Even in a weak market with few buyers and many potential sellers, the my-way-or-the-highway style is a short-term, egocentric strategy. It may work if you plan to purchase only a single property in a geographic area, but we believe you need to be active in the same market for many years and build a positive reputation to create long-term success and accumulate wealth. And this bare-knuckles strategy doesn’t always work even just once, because even the weakest sellers sometimes have alternatives and choices. They may decide life is better if they don’t sell their property to an inflexible jerk.
• A lowballing approach: Making patently frivolous offers in an attempt to get lucky is another technique recommended by some self-anointed real estate gurus. Our experience is that sellers aren’t stupid, and they quickly eliminate further offers, even reasonable ones, from such greedy bottom-fishers. Real estate agents will also see you as a lost cause, or worse, someone who will damage their reputation by association. Be prepared to make reasonable offers or don’t waste everyone’s time.

The problem with many aggressive negotiating techniques is that you can get so wrapped up in just making the deal that you forget what you’re doing. You can make some serious mistakes and buy properties that you should’ve eliminated during your pre-offer due diligence. Don’t get emotionally involved in any potential property. You’re buying investment real estate, not your dream home.

Building a solid foundation of knowledge

The most important negotiating tool in an investment property purchase is superior knowledge — if you’re unwilling to do the homework necessary to determine and justify the right price, you’re almost guaranteed to overpay for real estate. Your goal as an investor is to set the maximum price that you can pay and still receive a solid return on your investment in light of the associated risks.

In order to achieve this goal, you need to know more about your proposed property acquisition than anyone else, especially the seller. You need to know about the property, neighboring properties, local and state laws, and all the economic data we discuss in Chapter 10 that can help foretell which properties are in the path of progress versus those that have already seen their best days. Although an occasional seller dramatically underestimates the true market value of the real estate, the vast majority of properties you see offered for sale are overpriced. That is true regardless of where the real estate market pricing cycle is, including after a downturn in prices. You may encounter some sellers who enjoyed significant price appreciation over the preceding years but stubbornly refuse to accept that demand for their property has fallen and that prices must adjust to the current market reality. Of course, some of these sellers aren’t really motivated and are just hoping to find an uninformed buyer. Don’t let that be you!

Assembling attractive and realistic offers

In this chapter, we cover and hopefully dispel many of the negotiating theories or fallacies of the get-rich-quick gurus. We don’t want to just tell you what not to do, so here are some examples of realistic and creative ways to negotiate and structure a real estate offer that accurately reflects the value of the property and also provides you with a reasonable return on your investment.

Bilateral versus unilateral contracts

Real estate contracts can be either bilateral or unilateral:

• Bilateral: Most real estate contracts are bilateral, meaning that each party to the contract promises to provide some consideration (something of value) and adhere to the terms of the contract. For example, the seller agrees to give the buyer title to the property in exchange for cash and/or a promissory note (a written document promising to pay the holder of the note a certain sum of money at some given time in the future).
• Unilateral: A unilateral contract is a one-sided agreement in which only one party promises to do something. An example is an option agreement in which the seller (optionor) gives a potential buyer (optionee) an unconditional purchase option for a certain period of time. The option is enforceable only by the optionee. If the option isn’t properly exercised, the optionor’s obligation and the optionee’s rights expire.

Elements of a contract

A legally binding contract is valid because it contains all the necessary elements that make it legally enforceable. In the following list, we outline the basic elements of a legally binding and enforceable real estate contract. The terms may sound a bit technical, but you need to be familiar with them.

• Legally competent parties: Every party to the transaction must have legal capacity, which is defined as being of legal age (18 in most states) and having the mental capacity to understand the consequences of their actions. Convicted criminals and certain mentally ill persons may not have legal capacity. Be careful when dealing with older persons if they seem to have any difficulty understanding or communicating. Equally of concern are any language barriers. Most states have passed strict elder abuse laws, and you don’t want to find yourself in court defending allegations that you defrauded an elderly widow out of her home.

• An offer: An offer to purchase real estate is a written communication to the current owner of the buyer’s willingness to purchase a specific property at the terms indicated. The seller can continue to market the property while considering the offer. Unless an expiration clause is included, an offer may be accepted by the seller at any time before it’s rescinded by the buyer.

  Virtually all offers have a specific expiration time. (“This offer is valid until Friday, January 19 at 5 p.m. EST only.”) You want to allow the seller a reasonable time to receive, consider, and evaluate your offer, but enforce the expiration clause to minimize the seller from using the offer as a negotiating tool with other interested parties, shopping your offer around, or trying to entice another buyer to raise her offer. Also, if the offer is open-ended, the buyer has to affirmatively rescind the offer, which is more work and trouble than simply having the offer expire after some passage of time.

• Acceptance: Acceptance is a positive written response in a timely manner to the exact terms of an offer. Acceptance legally requires that the buyer must be given legal notice of the acceptance. Commonly, the seller doesn’t accept the offer as presented but proposes changes in the terms or conditions — which is a counteroffer.
• Counteroffer: This is legally a new offer; the original offer is rejected and is void. Counteroffers can go back and forth until both buyer and seller have agreed and the final accepted offer becomes the binding agreement between the parties. Just like offers, counteroffers must be in writing and can also be rescinded at any time prior to acceptance.
• Consideration: Consideration is basically the exchange aspect of the deal: The buyer offers payment of money or something of value to the seller, who agrees to give over ownership of the property in return. A real estate contract isn’t binding if each party doesn’t offer at least some consideration to the other party.
• Clearly and uniquely identified property: This identification is required so there’s no uncertainty about precisely which property is being sold and transferred to the buyer. Typically, a legal description of the property is used. Other identifiers, such as Assessor’s Parcel Number (APN) or a similar governmental reference term, can also be used depending on the custom and practice in each municipality or jurisdiction.
• Legal purpose: The real estate contract must be for a legal purpose and can’t be for an illegal act or an act so immoral that it’s against public policy. For example, a buyer purchasing a single-family home with the intent to run his property management company there would want to cancel the purchase if, during the due diligence process, he were to discover that such use violates local prohibitions against operating a business in a residentially zoned area.
• Written contract: A written contract is required for all enforceable transfers of real estate. All terms and conditions of the purchase agreement or sales contract must be set forth in writing, even for minor items that may not seem consequential. Generally, the written contract helps ensure that there is no confusion about what is included in the sale. For example, if you want to make sure that the supplies in the maintenance shop for a commercial or apartment building are included and not taken before the sale, you must specify that in the contract. Remember that if something isn’t in writing, it’s not part of the contract.

Agreements for the sale of real estate must be in writing or they’re unenforceable. Never make an oral agreement of any type regarding real estate no matter how convenient, expedient, or reasonable it may seem at the time. The Statute of Frauds is a legal concept that requires all transfers of real estate to be in writing to be enforceable in a court of law. Real estate–related contracts that must be in writing include sales contracts or purchase agreements, leases for more than one year, real estate loans secured by a mortgage or note, real estate agency disclosures, listing contracts and commission agreements with agents, and an employment agreement with an agent to locate property.

A failure to meet all of these essential elements can lead to the contract being declared void. A void contract has no legal force or effect and is unenforceable in a court of law. A voidable real estate contract is one that may be treated as legally unenforceable at the option of a party (usually the injured party) but remains enforceable until that party exercises her option. An example is a real estate contract with a minor that is voidable only by the minor.

Besides all the legal elements, real estate sales contracts specify the sale price and the terms and conditions as well as any contingencies (see the “Using contingencies effectively” section later in the chapter). The contract must be signed and include a standard statement that “time is of the essence,” which ensures that all dates and times of day noted in the contract are important and can’t be ignored by any of the parties without the written consent of the other party; otherwise, there is a breach of the contract. If the contract is breached, the other party may be entitled to monetary damages or can sue to force the seller to complete the sale.

Showing intention with an earnest money deposit

Right after the purchase price, one of the most important terms that can set the emotional tone for further negotiations is the amount of the earnest money deposit you’re willing to submit with your purchase offer. The earnest money deposit is usually fully refundable for a defined time period. Your deposit is held in trust by either the seller’s agent or a title or escrow company. Never make an earnest money deposit payable directly to the seller.

The purpose of the deposit is to show good faith by the buyer and the intention to follow through with the terms of the purchase agreement. The amount of the deposit varies in different areas depending upon local custom or the specific needs of a particular transaction. Also, depending on state law, the earnest money deposit may or may not go into an interest-bearing account. If you can, always insist that your earnest money be placed in an insured trust account that bears interest and that the purchase agreement clearly spells out that you (the buyer) are credited with all interest earned.

Some psychology is involved because the size of the deposit has an effect on the desirability of the offer. An offer with no earnest money or a nominal amount may be interpreted by the seller as coming from a buyer who isn’t serious about the transaction or lacks the cash to make a meaningful deposit. From the perspective of the seller, with occupied rental income properties, the tenants are often disrupted or inconvenienced with any potential sale of the rental property. The seller rightfully won’t want to bother his tenants with a buyer and his due diligence unless he is confident that the buyer has every intention of going through with the transaction if the property checks out. The size of the earnest money deposit can often separate the sincere buyers from those buyers just looking.

A lousy recommendation suggested by some real estate investment gurus is for the buyer to offer a promissory note with her offer. That’s a sure way for a seller to identify that you’re not a serious buyer. Such no-money-down seminar graduates may be classified as bottom-feeders or opportunists who are really only interested in properties with desperate and uneducated sellers.

When determining the earnest money deposit, remember that if you don’t live up to the agreement or don’t cancel it within the allowed time frames, you forfeit the deposit to the seller. The forfeiture of the earnest money deposit for nonperformance is called liquidated damages, which is essentially the payment for any and all damages incurred by the seller as a result of you not completing the purchase as proposed. Under the terms of most purchase agreements, a seller who keeps the earnest money deposit can’t sue for any further damages.

To avoid any expensive lessons about earnest money, follow this advice:

• As a buyer, make sure you know the exact date upon which your earnest money goes hard, which is the real estate industry term meaning it’s nonrefundable and passes to the seller regardless of whether you complete the purchase of the property.
• Don’t wait until the last few days to cancel your purchase agreement. If you’re still unsure of your interest or ability to complete the transaction as proposed, send a written cancellation of the purchase agreement and then try to renegotiate additional time, while spelling out in detail exactly what your concerns are and why you need more time.
• Both buyer and seller must agree to any changes in writing. Never rely on any verbal representations as to any extensions or changes of terms or conditions.

Assigning your rights

Many purchase agreements specifically include a clause giving the buyer the ability to assign his interests to another party. Assignment is the transfer of the right or duties under a real estate contract by the buyer to a third party. This is an extremely important clause for buyers, and we strongly encourage you to include the right to assign the contract as a term of your purchase offer. In the contract, simply include the language “or assignee” after the name of the legal entity indicated as the purchaser. Of course, if the preprinted purchase offer has a clause that prohibits assignment, you need to cross out that language and have both parties initial the change.

Setting the closing date

An important term of your purchase offer is the proposed closing date for the transaction, which determines the anticipated escrow period (see Chapter 14 for escrow information). The length of the escrow period is a matter of negotiation between the buyer and seller, with consideration given to the length of time needed to obtain financing and the amount and complexity of due diligence necessary to complete the sale. A complicated financing transaction, a property in need of a zoning change, or possible environmental issues require a much longer escrow period than a simple transaction.

Of course, the seller is usually interested in selling the property as soon as possible and wants a short escrow period and a fixed closing date; the buyer generally wants as much time as the seller will allow, some flexibility on the closing date, and the unilateral right to close the transaction earlier if he’s completed his work. But the lack of a specific time line can create problems for the seller, particularly if she’s trying to buy another investment in a tax-deferred exchange (see Chapter 18) or has tenants in place who need to be vacated.

The more time for the buyer, the better opportunity he has to make sure he’s not making a mistake — and the seller knows that. But, the seller also knows that many buyers aren’t serious about purchasing the property or use an extended due diligence period to find problems with the property and try to wear down the seller into granting concessions or lowering the purchase price.

Some buyers also use a long escrow period to tie up the property, hoping to find another investor who will pay more for it. If they find one, they can then close escrow and immediately flip the property in a double escrow, which is actually two separate transactions done at the same time. The investor purchases the property from the original owner and simultaneously sells the property to a new buyer, usually at a profit, without really even taking possession of the property other than for possibly a matter of minutes between the recording of the two transactions.

Ultimately, what you agree on in the purchase agreement is legally binding, but it’s really just an estimated closing date because so many different moving parts can affect when you close the sale. The closing date should be met unless both parties agree to an extension with a written addendum or escrow instruction (see “Ironing out straggling issues” later in the chapter).

Using contingencies effectively

A contingency in a real estate purchase agreement is simply a condition that must be fulfilled or an event that may or may not happen in the future before a contract becomes firm and binding. Contingencies can be for the benefit of either the seller or the buyer; if the contingencies aren’t met, the deal doesn’t go through. The seller of an estate property, for example, may require a contingency that the probate court approves the sale. Buyers often have contingencies for financing, physical inspections, the review of the current tenant leases and service contracts that will run with the property, and other items. Naturally, sellers attempt to eliminate unreasonable contingencies. For instance, most purchase agreements include contingencies that ask for 10 to 30 days to conduct the physical inspection and/or approve the books and records. If you request 60 days to conduct these items, the seller may reject your offer as unreasonable.

Contingencies are escape clauses that can protect the buyer from purchasing a property that doesn’t meet his needs. Without contingencies, purchasing a property would be extremely risky because you’d have to be sure that you had all the financing in place and that the property was in good condition, met your needs, and the terms and conditions were acceptable before you even made the offer. Few buyers would be willing to do this, or they’d do it but discount their offer to account for the additional risk.

Although legally different from an option, contingencies can have a similar effect by allowing a prospective buyer the exclusive opportunity to buy the property in a limited time frame but not obligating the buyer to complete the transaction.

The terms of most purchase agreements provide that by certain defined dates, all the contingencies must be resolved one way or another by the beneficiary, or party that stands to gain from the contingency. After it’s in place, a contingency has one of three outcomes:

• Contingencies can be satisfied. This means that the pending sale is no longer subject to cancellation or modification for that particular item. For example, the buyer can comply with the financing contingency upon receiving a written loan commitment at acceptable terms.
• The beneficiary of the contingency can unilaterally agree to waive or remove the contingency. For example, the seller may have asked for a contingency to identify a replacement property as part of an IRS section 1031 tax deferred exchange. If the seller decides not to do an exchange, then she may simply notify the buyer in writing that she’s waiving that condition or contingency.
• A contingency can be rejected or fail. The beneficiary of the contingency is then no longer obligated to perform under the contract. For example, the buyer may receive a termite inspection report indicating that there’s extensive damage and infestation and then decide that he’s no longer interested in completing the purchase. Under this scenario, the buyer typically receives the return of his earnest money deposit (and is glad that he diligently conducted a physical inspection).

Although the list varies depending on the property type, size, and location, here are contingency clauses that we recommend:

• Marketable title: Obtain a preliminary title report with full and complete copies of each and every exception and have your attorney review these documents.
• Financing: Outline the specific terms (type of loan and maximum acceptable interest rate) of a new loan required in order to complete the purchase. Require copies of the current loan documents and the most recent loan statement, plus receiving the approval of the lender in writing, if you’re attempting to take over existing financing.
• Appraisal: This condition demands that an independent professional appraisal of the property arrive at a value equal to or greater than the proposed purchase price. This requirement may be a necessary part of the financing or simply a safeguard to prevent you from overpaying for the property.
• Physical inspection: Most purchase agreements include an inspection clause mandating that you have unlimited access to the property for a certain amount of time to inspect the interior and exterior of the property. Hire qualified property inspectors, including specialists in key areas such as roofing, plumbing, and electrical systems, to conduct a thorough inspection of all rental units or suites. The results of the inspection can be used to negotiate with the seller by giving her the opportunity to make the necessary repairs, adjust the purchase price, or simply terminate the purchase agreement.
• Books and records inspection: If you’re purchasing a large residential or commercial property, another important contingency is the opportunity to review and inspect the income and expense statements and the leases. Ask for a copy of the seller’s Form 1040 Schedule E (filed with the IRS) to ensure that the income and expenses for the property are consistent with what the seller has been reporting. If the seller refuses to provide these tax documents, there is nothing you can do — but simply making the request sends a signal that he better not be misrepresenting the actual numbers. If litigation ever ensues, these documents can be subpoenaed and used as a basis to prove fraud and misrepresentation. A review of the leases should also include estoppel agreements (see Chapter 11).
• ALTA property survey: This survey shows the property boundaries or parcel map along with the site plan for all existing improvements, plus any easements and restrictions. It may be required by the lender, particularly if the loan is from an institution.
• Contracts: Make sure you receive copies of all service agreements and contracts currently in place at the property. Ideally, the seller should be required to cancel or terminate all nonessential contracts (unless they’re especially attractive in the current market conditions) at the close of escrow so you have the option of bringing in your own preferred vendors.

Ironing out straggling issues

In addition to the contingency clauses, many buyers negotiate a separate clause giving them the unilateral right to extend the closing date under certain conditions. For instance, the lender may require an environmental report, which when received indicates that further investigation is necessary before it can make a loan commitment. Or you may need legal action to get access to a stubborn occupant’s property. A well-written purchase agreement provides for an extension of the closing date under such circumstances. Be sure that all parties agree to any such extension in writing prior to the closing date indicated in the purchase agreement to avoid any potential disputes.

Be sure that your purchase agreement clearly indicates what personal property is included. The personal property can be a significant factor in large apartment buildings because it can include the appliances and window coverings, plus common area furnishings and fixtures, as well as parts, materials, and supplies for future maintenance and repairs.

Depending on your plans for the property, you may want the property transferred with or without tenants. If the tenants aren’t on valid and enforceable long-term leases, and you can increase the property value by renovation and gaining new tenants, requiring the seller to deliver the property vacant and what’s called broom clean (free of debris, dirt, personal property, furniture, and so on) at the close of escrow can be prudent. This is also true if you buy a seller-occupied property. Either include a clause requiring that they vacate prior to the close of escrow or negotiate a lease with them for continued tenancy at mutually agreeable terms.