The Definitive Guide to Understanding Section 8

Created to help low-income, elderly, and disabled households afford decent, safe and sanitary private housing, the Housing Choice Voucher Program (HCVP), commonly known as Section 8, provides a federally-funded subsidy to eligible families, paying for all or a portion of their rent and utilities costs. The Program provides not only significant benefits to these families, but also an opportunity for those landlords who chose to participate to potentially make their property more profitable.

Unfortunately, the process of application, approval and compliance under the Program (for both landlord and tenant) is confusing and complicated, often causing people to look elsewhere for seemingly easier opportunities. This article will clarify the confusing, and simplify the complicated, discussing:

• What Section 8 does
• Its advantages and disadvantages for landlords
• What a property owner must do to participate
• What households are eligible for the Program
• The tenant application, screening and housing process, and
• Ongoing obligations for landlords, tenants and the housing agencies administering the Program

One quick note: Section 8 is most commonly thought of as helping low-income families pay their rent, but it also provides rent subsidies for elderly and disabled families, and can even assist eligible households with the purchase of a home. We’ll touch on the rules for elderly and disabled households, and also take brief look at HUD’s Homeownership Voucher Program (HVP), but will focus primarily on HCVP’s rental assistance for low-income families.

Now, let’s start with a little background.

The Creation and Rationale for HCVP

The Housing Choice Voucher Program, created as a part of the Housing Act of 1937, and administered by the U.S. Department of Housing and Urban Development (HUD) and local housing agencies, seeks to address the difficulty of low-income families finding and being able to afford decent housing.

As noted in our Complete Guide to the Low-Income Housing Tax Credits Program (LIHTC), according to the National Low Income Housing Coalition, “in 2013, for every 100 extremely low income renter households, there were just 31 affordable and available units.” The Coalition then noted, “in no state can an individual working a typical 40-hour workweek at the federal minimum wage afford a one- or two-bedroom apartment for his or her family” without paying more than 30% of their income in rent.

While the specific percentage is up for discussion, historically personal finance experts have suggested that a family should pay no more than 30% of their income toward their housing, and the failure to do this can cause dire, long-term financial consequences.

As explained in a 2016 NY Times article, Jessica Yager, executive director of the NYU Furman Center, explained, “Housing is one of many basic needs. The more you pay for housing, the less income you have left over for food, child care, health care and clothing.”

Additionally, as explained in The Motley Fool finance website, “it’s important to start saving money for things like retirement, emergencies….” If a family is forced to spend too much on housing, and ends up spending all, if not more of its income on basic necessities, then nothing can be set aside for savings, retirement or emergencies.

Again, 30% of gross income isn’t universally accepted. The Motley Fool article suggests that 30% of after tax net income is appropriate, and a 2015 FORTUNE magazine article argues that the standard is irrelevant because (1) it’s an arbitrary holdover from the New Deal era, (2) housing affordability should take other costs into account, and (3) looking at certain economic trends, one should expect housing to take up an increasingly large part of people’s incomes.

Nonetheless, the federal government decided it’s in the public interest, through the adoption and use of Section 8, to help families live in safe, decent and sanitary housing, without having to spend more than 30% of their income on their rent and utilities.

How does the HCVP do this? Let’s take a look at the Program’s mechanics.

How Does Section 8 Work?

The Program is administered by HUD and local public housing agencies (PHAs) under contract with HUD. According to the Affordable Housing Online website, there are currently 2,427 PHAs offering the Section 8 Program. HUD maintains a searchable directory of these PHAs for applicants and property owners wishing to participate in HCVP.

The Program issues vouchers, or subsidies, to qualified households to be used to pay all or a portion of the household’s housing costs, consisting of rent and utilities. The PHA pays the voucher amount directly to the rental property owner. If the total housing costs are more than the voucher amount, then the household must pay the difference.

While the concept is fairly straightforward, the complexities arise in determining if a household is eligible for the Program, how it applies for the vouchers, what is a reasonable rent in the PHA’s area, how much of that rent should be paid by the subsidy and how much by the household, and on and on. Let’s start at the beginning: Who makes the rules, and where can you find them.

HUD Regulations and Policies and PHA Plans

The Section 8 HUD regulations are codified in 24 CFR Parts 982, 5 and 35. They fall into two categories: rules and policies.

Section 8 rules are specific requirements that every PHA must follow, including for example, vouchers are available only to US citizens or non-citizens who have eligible immigration status. The PHA can’t modify this requirement.

Polices on the other hand give direction to PHAs, but allow the local agency flexibility in crafting the specific rules it will implement. This is done so PHAs can address the unique qualities and needs of its area. One example is how a PHA chooses to prioritize the award of vouchers among applicants. HUD doesn’t require any prioritization, but allows PHAs to create their own. Some might want to give preference to residents of the PHA’s area over non-residents, while others might want to give priority to households with a certain composition. The effect of giving PHAs this flexibility is that the “rules” are different for virtually every PHA.

So where can an applicant or a property owner figure out these differences? In the PHA’s Administrative Plan.

Each PHA is required to create two written, HUD-approved plans: (1) a PHA Plan, and (2) an Administrative Plan. The PHA Plan describes the PHA’s mission, and its strategy for pursuing this mission. The Administrative Plan is where the nuts and bolts of the PHA’s policies and procedures are found. To see an example, you can look at the Massachusetts Department of Housing and Community Development’s Administrative Plan.

From a household’s perspective, the first item they’ll need to understand in the Administrative Plan is the PHA’s application process.

The Household’s Application

If a household wants to receive HCVs, it must submit an application to its local PHA. Because the amount of households seeking vouchers far outnumber the funds available for vouchers, PHAs use a waiting list. These lists are often so large that the PHA will “close” the list, meaning the PHA simply won’t accept any new applications. Due to this, households often look to multiple PHAs for an “open” waiting list, and apply to each. The Program allows this, so long as households submit separate applications for each PHA.

However, even if a household is able to get on a waiting list, depending on the demand for HCVs in their area, they may still have wait months or even years before being approved for and issued vouchers.

Once a household finds an open waiting list it submits its application. Some PHAs require only an abbreviated pre-application at this stage, leaving the full application until the household is at the top of the list. Other PHAs require the full application before it will place an applicant on the waiting list.

While there is no HUD-approved application form, applications typically ask for:

1. Household income and sources
2. Household composition and size
3. Citizenship status, and
4. Any other items requires under the PHA’s Administrative Plan.

To see a sample application, you can check out this one at HomeForward.org.

If the application is denied, they can appeal the denial by following the process outlined in the Administrative Plan. As with so many of the Section 8 “rules,” the appeal process can vary from PHA to PHA.

If the application is approved, the household waits until the PHA tells them they have reached the top of the list, so they can take the next step. Notably, because there may have been a long time between being placed on the waiting list and reaching the top of the list, often that next step is re-certifying all of the information in the original application to the PHA.

Eligibility Requirements

Included in all applications is the information necessary to determine if a household is eligible for HCPV assistance. To be eligible, households are required to:

1. Have a household income of 50% or less of the area median income. HUD calculates these medians annually, and publishes them on their website.
2. Be U.S. citizens or non-citizens who have eligible immigration status.
3. Be in good standing with federal housing Programs (e.g., no evictions from public housing or fraud in connection with a federal housing Program), and
4. Satisfy all other criteria a PHA has included in its Administrative Plan.

While a PHA doesn’t have to perform special screenings of applicants (e.g., rental history, credit history, criminal background), some PHAs require that all applicants pass such screenings. Others leave the screening process to landlords.

Elderly and Disabled Households

In addition to providing assistance to low-income families, Section 8 also serves elderly disabled households. Elderly households are those with one or more persons who are at least 62 years old as of the date their tenancy begins.

A disabled household is one where the head, co-head, spouse or sole member is an adult with a disability. A person with a disability is someone who (i) is disabled under Section 223 of the Social Security Act; (ii) has a physical, mental, or emotional impairment that is expected to be of long-continued and indefinite duration, and, substantially impedes their ability to live independently, and, is of such a nature that such ability could be improved by more suitable housing conditions, or (iii) has a developmental disability as defined in Section 102 of the Developmental Disabilities Assistance and Bill of Rights Act.

Notably, these definitions mean that a household whose only disabled person is a minor child doesn’t qualify as a disabled family for Section 8 purposes.

Calculating the Voucher Amount

The information requested in the application isn’t only so the PHA can determine if the applicant is eligible for assistance, but also so it can determine the voucher amount needed for that household. Calculation of the amount requires a determination of (i) what’s a reasonable rent and utility cost for the type of housing sought by the applicant, and (ii) how much can the household contribute to the payment of those costs.

Section 8 requires that housing costs (rent plus utilities) must be within the fair market value (FMV) and Fair Market Rents (FMR). FMRs are determined by HUD (see their site for a current list of FMRs), and represent the costs for medium-quality apartments in a PHA’s area. FMRs are determined for different sizes of units.

Using the FMRs calculated by HUD, each PHA establishes its own “payment standards” for the total housing costs it will approve. Payment standards must be between 110% and 90% of the FMRs.

To determine how much a household can contribute to these costs (called the “total tenant payment”) the PHA looks at the applicant’s income. The PHA first calculates an applicant’s “annual income” and then its “adjusted income.” These calculations are very complicated, taking into account such things as the income of “Temporarily Absent Family Members,” educational scholarships, income from a business, and childcare and medical expenses.

For exactly what is considered “income,” and what items can be excluded or deducted from this amount to determine the “adjusted income,” take a look at Chapter 5 of the Program.

Once the PHA determines adjusted income, the general rule is that the total tenant payment is 30% of the adjusted income. Households can chose to contribute a higher percentage, but no higher than 40%.

The actual percentage for a specific household isn’t actually made until they find the unit they wish to rent. If that unit is more expensive than others of similar size, but they are willing and able to pay up to the 40% maximum, they can elect the higher percentage (as opposed to making the smaller 30% contribution) so that they can rent the unit they prefer.

For the purpose of determining the maximum subsidy, the PHA will start by using 30% of adjusted income, and then modify it if necessary. They subtract that amount (the minimum possible tenant payment) from the PHA’s payment standard to find the maximum voucher amount.

As an example, if the payment standard for a 3-bedroom unit was $1,000, and the PHA determined that an applicant’s minimum tenant payment was $400, then the maximum subsidy amount would be $600.

Of course, the actual subsidy amount can’t be determined until the applicant tells the PHA where it wants to live. If the rent and utilities of that unit is lower than the payment standard, then the voucher calculation requires that the subsidy be lower too. If the applicant wants to live in a unit with housing costs greater than the payment standard, it has to increase its contribution to make up the difference.

In all cases, as noted above, the PHA won’t subsidize housing costs where the applicant will have to contribute more than 40% of their adjusted income.

As a side note, Section 8 will not subsidize any security deposits required by landlords. This cost must be paid entirely by the household.

Briefing Sessions

Once the applicant is issued, it has a “briefing session” with the PHA. Agencies can vary how these are done, and what information is given, but at a minimum they must explain:

• The Section 8 Program
• Discrimination and fair housing issues
• Household responsibilities
• The PHA’s payment standard and utility allowance policies, and
• How to find housing where they can use their vouchers.

Following the session, the tenant begins their search for a suitable property. They must find one within the time frame established by the PHA, though HUD requires that they have at least 60 days to find a unit. If they don’t get this done within the time period, they can ask for an extension, but, if an extension isn’t granted they’ll lose their vouchers.

Finding a Home and the Landlord’s Application

Section 8 vouchers can be used to rent single family homes, apartments, duplex/townhouses and mobile homes, provided they meet the “decent, safe and sanitary” standard defined by HUD in its Housing Quality Standards (HQS).

The vouchers can’t be used for public housing, nursing homes, or properties in which the owner also resides.

PHAs often keep a list of properties accepting HCVs, but an applicant is not restricted to these units. If they find a property they like, they can ask the landlord if it accepts Section 8 vouchers, and if not, if they’ll apply to participate in the Program. To participate is simple: (1) the property owner notifies the PHA that it will accept Section 8 vouchers.

While that’s all that is necessary to attract possible Section 8 tenants (landlords may of course also use traditional marketing to attract these tenants, but adding that it “Accepts Section 8 Vouchers”), before it can actually receive the vouchers, a landlord will need to take a few more steps:

1. Submit the landlord documents required under the Administrative Plan
2. Pass an initial inspection
3. Sign a lease with the tenant that includes all PHA-required addenda, and
4. Sign a Housing Authority Payment (HAP) contract with the PHA

We’ll look at each of these steps below.

Additionally, there are some cases where a household is living without assistance in private rental housing, but then applies for, and is issued, vouchers. In these cases, they may be able to stay in the same housing (this situation is sometimes referred to as “lease in place”) if:

1. The unit passes the PHA’s initial inspection
2. The unit meets Section 8 payment standard requirements
3. The owner is willing to accept Section 8 vouchers and participate in the Program, and
4. The landlord and tenant sign a new lease with all required PHA addenda.

This situation may be attractive where the parties have an established rental relationship, and the landlord would prefer to keep the tenants in the unit.

Landlord Documents

Once a tenant finds a property that accepts vouchers, the landlord typically sends the PHA a Request for Tenancy Approval (RTA) form, a W-9, proof of property ownership, and a direct deposit form so the PHA can make voucher payments to the owner’s bank account. The PHA reviews this information and determines if the rent requested is reasonable. If the rent amount is approved, the PHA will schedule an initial inspection.

Property Inspections: Initial, Annual and Special

HUD requires that all properties accepting HCVs pass three different types of inspections: initial, annual, and special inspections (e.g., complaint inspections, quality control inspections). The inspections determine (1) whether the housing meets HUD’s Housing Quality Standards (HQS) requirements, and (2) the reasonableness of the rent.

The HQS requirements consider (13) performance areas:

1. Sanitary facilities
2. Good preparation and refuse disposal
3. Space and security
4. Thermal environment
5. Illumination and electricity
6. Structure and materials
7. Interior air quality
8. Water supply
9. Lead-based paint
10. Access
11. Site and neighborhood
12. Sanitary condition, and
13. Smoke Detectors.

Initial Inspection

The initial inspection has to be done before the lease is signed. If the property fails the initial inspection, it’s given a certain number of days to correct the deficiencies, and then the PHA re-inspects the unit. If the property still doesn’t meet HQS requirements, the PHA can cancel the tenancy approval, and tell the tenants to look for other housing.

While the other types of Section 8 inspections occur later in the process, let’s take a quick look at them.

Annual Inspections

HUD requires that all properties accepting Section 8 vouchers pass an HQS inspection no less than annually. Like the initial inspection, if a unit fails the annual inspection, the property owner is given a reasonable period of time to correct the deficiencies before reinspection.

However, under two deficiency circumstances the PHA must stop voucher payments: (1) if a life-threatening violation isn’t fixed within 24 hours of inspection and the PHA didn’t give an extension; and (2) a routine violation isn’t corrected within 30 days of the inspection and the PHA didn’t grant an extension. If the repairs are made, the PHA can restart the voucher payments, but if they aren’t, the PHA can terminate the Housing Assistance Payment (HAP) contract.

Special Inspection No. 1: Complaint Inspections

If a landlord, tenant or the general public files a compliant about the state of an HCV property, the PHA will conduct a complaint inspection according to its Administrative Plan (a sample complaint procedure can be seen here). Just like initial inspections, complaint inspections examine if HQS requirements are met, and give landlords a specific period of time to correct any deficiencies before re-inspection.

Special Inspection No. 2: Quality Control Inspections

These are done to determine to determine if a PHA’s initial, annual and complaint inspections are being done in compliance with HUD’s rules and the PHA’s Administrative Plan. To ensure impartiality, independent parties perform quality control inspections.

Housing Assistance Payment (HAP) Contract and Tenant Lease

If the housing passes the initial inspection, the PHA sends the owner: (1) a notice of approval, (2) any PHA addenda the owner has to attach to the lease, and (3) a Housing Assistance Payment (HAP) contract. The HAP contract details the amount and terms of voucher payments.

Before signing a lease, the landlord may, but is not required to perform any screening it wishes, such as rental history and credit check. It should be noted that whether a landlord accepts a tenant is entirely up to the landlord.

Following signing of the lease, the owner sends a copy to the PHA, and rent payments begin soon after. While the PHA’s payments are automatically sent to the owner, the owner has to collect the portion of the rent covered by the tenant just as they would with any other tenant.

Landlord-Tenant Issues, Termination of Leases, and Rent Increases

Generally PHAs are not involved with landlord-tenant issues, but some will act as a mediator. In any case, most PHAs require that they be copied on any lease notices given to the tenant.

If a landlord wants to terminate a lease because its tenant isn’t meeting its lease obligations, typically they have to contact to the PHA for specific guidance. If they end up having to evict the tenant, Section 8 requires landlord to use a court-ordered eviction procedure. This is required even if state law provides for non-judicial evictions.

If a landlord decides it doesn’t want to renew the tenant’s lease, it just has to follow the notice provisions in the lease and notify the PHA.

If a tenant loses their HCV eligibility, the HAP contract’s terms determine what happens next. Typically the PHA sends a 30-day notice to the owner detailing when the HAP contract will terminate and when the HAP payments will end. When the HAP contract terminates, so does the lease. Accordingly, if the landlord wants the tenant to stay, it has to enter into a new lease, and then collect the full rent from the tenant.

Once a year a property owner can ask the PHA to approve a rent increase. Generally these requests are accepted if the higher rent is found to be reasonable. In those cases where the rent increase would require the tenant to spend more than the 40% of income maximum toward their housing costs, the rent increase can still be approved if the tenant agrees to increase its contribution above the 40% maximum. This situation is an exception to the 40% maximum rule.

Transferring Vouchers: “Porting”

Situations arise where a tenant needs to move to another unit outside the PHA’s area, but wants to keep and use its vouchers for the new property. Transferring the vouchers from one property to another is referred to as “porting,” and generally is allowed only if (i) the tenant has lived in the initial unit for at least one year, (ii) the PHA approves of the transfer, and (iii) the tenant complies with any lease requirements relating to the move. Of course, the tenant can only use the vouchers at another property if it still meets all the Section 8 eligibility requirements.

Exception to Porting: Project-Based Voucher Programs

In addition to the tenant-based voucher program we’ve been discussing, Section 8 also utilizes a “project-based” rental assistance program. Under these programs the voucher can only be used for a specific property. Accordingly, porting isn’t typically permitted for such vouchers. However, a family can move from a project-based property after one year, and switch to a tenant-based voucher when the PHA has new vouchers available.

Section 8 doesn’t allow a multi-family project to use these project-based vouchers for more than 25% of its units, thought this limitation doesn’t apply to units for elderly or disabled households. When a PHA and owner agree to a project-based program, they enter into an HAP contract, generally with a 15-year term and extensions.

Ongoing Landlord and Tenant Responsibilities

Section 8 households must meet certain obligations while using their vouchers. In addition to any obligations required under a PHA’s Administrative Plan, they must:

1. Recertify every year their income and household makeup (changes in either can result in changes to the subsidy amount)
2. Notify the PHA if there have been any changes to income or household
3. Cooperate with annual inspections of the property, and
4. Meet all their lease obligations (e.g., pay their rent on time, maintain the property, etc.).

If they fail to meet these obligations, they may be terminated from the Program.

Similarly, landlords must (i) cooperative with, and pass initial, annual and complaint inspections, and (ii) comply with any landlord obligations under a PHA’s Administrative Plan.

Advantages of Section 8 to Landlords

Because the PHA is paying for all or a portion of the rent, rent payments are more consistent and timely. This reduces costs associated with collecting late rents, and reducing the likelihood that an eviction for non-payment will be necessary.

Additionally, HCVP tenants have a lower turnover rate than non-Section 8 renters. Low turnover saves landlords the costs associated with bringing in new tenants, including marketing, prepping a unit for new tenants, screening for new tenants, etc. Further, Section 8 units generally have shorter vacancy periods, meaning the time a unit isn’t producing rental income is shorter than if it were only rented to non-HCVP tenants. This is so because there is almost always a high demand for properties accepting HCVs. Accordingly, if a landlord loses a Section 8 tenant, it can quickly find a new tenant.

Disadvantages of Section 8 to Landlords

Because the rent has to be within the FMV and FMR, and any rent increases have to be approved by the PHA, a landlord gives up the ability to charge whatever rent it wishes.

Further, property owners will have to pass, at a minimum, one inspection every year. While HQS standards are intended to be no stricter than local building code standards, any repairs that have to be made because of a Section 8 annual inspection may be considered a disadvantage to the owner. This is because many jurisdictions rarely enforce local building codes (absent a complaint), and these repairs might not have been necessary if the annual inspection hadn’t happened.

That being said, some landlords view these inspections as an advantage because (i) they are paid for by the PHA, and (ii) alert the property owners of potential problems.

Another disadvantage is one mentioned earlier: Section 8 tenants can only be evicted through a court approved process. In those states that allow for non-judicial evictions, this means that a landlord will incur greater costs (legal fees, court costs, notices, etc.) to evict a Section 8 tenant than it would have evicting a non-Section 8 tenant.

One more disadvantage is that the cost of repairing damage to a property by HCV participants isn’t recoverable from HUD. While landlords face the risk that a tenant’s security deposit, whether the tenant uses HCVs or not, will be less than the cost of repairs, because Section 8 tenants are by definition low-income, the chance of recovering funds by suit against Section 8 tenants is generally less than against non-Section 8 tenants.

Homeownership Voucher Program

As mentioned earlier, Section 8 can also assist families with the purchase of a home. Where a PHA participates in HUD’s Homeownership Voucher Program (and not all do), a participant can use a Section 8 voucher to help with its mortgage payments and home-ownership costs.

Where a party has been approved for, and is using HCV vouchers to rent housing, subject to meeting income and eligibility requirements, it can use these vouchers toward buying a home. As with rental units, any home must first pass an HQS initial inspection.

There are many requirements an applicant must meet to qualify for a Homeownership Voucher, including that:

1. They be a first-time homeowner
2. They meet certain minimum income requirement (except for elderly and disabled households)
3. One or more adults in the household has full-time employment and has been continuously employed full-time for at least one year before it receives HV assistance (except for elderly and disabled households), and others.

Under the HV program the PHA subsidy is either (i) the PHA’s payment standard minus the total tenant payment, or (ii) the monthly homeownership costs minus the total tenant payment, whichever is less. Homeownership costs can include such things as mortgage and property insurance, real estate taxes, maintenance, repairs and utilities.

How long a PHA will make homeownership payments depends on the family type and the mortgage term. If the term is more 20 years or more, PHA assistance can’t exceed 15 years. If the term is shorter than 20 years, PHA payments can’t exceed 10 years. However, if the participant is an elderly household or a disabled family, there are no term limitations.

Conclusion

Hopefully its clear that while the HCV Program has the potential to benefit both residents and property owners, those benefits only are possible if the maze of HUD regulations and PHA policies and procedures are understood and followed. Further complicating the use of the Program, HCVP rules are amended from time to time. Accordingly, if you have any specific Section 8 issues, you should talk with your local PHA or a lawyer who regularly works with the Program.

Source: https://propertymetrics.com/blog/the-definitive-guide-to-understanding-section-8/

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The Essentials of Commercial Real Estate Sale and Purchase Agreements

A commercial real estate sales contract can be one page or one hundred pages. There are no rules, and every term, every word, is up for negotiation. Nonetheless, there are provisions that are typically included in most CRE purchase agreements, and understanding these provisions is essential for both buyer and seller to protect their interests.

Let’s begin with a quick story.

Quick Contract Story No. 1

An attorney friend was suffering through the longest of purchase contract negotiations. There had been dozens of revisions by each side, and the agreement had grown to almost 200 pages. In a meeting with the other side’s lawyer, when it appeared they were close to a deal, but the other side started to waver again on the language, my friend said:

“I’ll agree to the contract as it is right now, and we can be done, if I can insert just one word.”

Opposing counsel, said “Sure. What’s the word?”

And my friend answered, “Not.”

Ahhhhh, the joyous free-for-all of commercial real estate negotiations.

That being said, this article discusses contract common provisions, their purposes, modifications that sellers and buyers may request to them, and their reasons for those requests. Let’s start with the purpose of contracts.

Purpose of CRE Purchase and Sale Agreement

A contract has several purposes: it specifies each party’s rights, obligations, and liabilities; it details the steps that must happen in order to close the transaction; and, naturally, it defines exactly what property, real and otherwise, is being conveyed.

While there is sometimes the inclination to keep a contract “short and simple,” a well-drafted contract will clearly address and define the purposes above, regardless of the document’s length or complexity. The time and money spent to create a thorough and complete contract will be returned ten-fold if conflicts arise.

Contract Form, Negotiation and Drafting

The first draft of agreements is typically done by the seller’s attorney, and then sent to the buyer for their input. The two parties exchange revisions until both accept a final document. The agreement will likely contain the common provisions discussed below, but it will be tailored to address the specific deal, including the specific type of property. For example, the sale of an unoccupied industrial property will have different issues than undeveloped land or a retail complex with multiple tenants.

Depending on the complexity of the transaction and value of the property, contract negotiations can be extensive. Who gets to choose what provisions are included? A quick story…

Quick Contract Story No. 2

A real estate attorney with 40+ in practice was asked why he refused to negotiate, or even discuss, a contract term that the opposing side colored as a “deal-breaker.” Noting first that they eventually accepted the term just as he wanted it, he then answered, “Because my client had the bigger stick.”

While not all parties and their attorneys negotiate with that attitude, the tale does highlight one truth: no party is entitled to a specific term. Everything is up for negotiation (including the decision, when one side is in a position of power, to not negotiate at all!).

Okay. Let’s dive into some common commercial real estate contract provisions…

Common CRE Sale and Purchase Contract Provisions

After identifying the parties and the effective date of the contract, the next words you’re likely to see in a commercial real estate sale agreement are “Whereas…”

1. “Whereas” Clauses

Often sale contracts start with a series of “whereas” clauses, also referred to as “recitals.” “Whereas” means literally “given the fact that,” and are a sort of introduction to the transaction, explaining the facts that led up to the contract. It’s generally accepted that recitals aren’t a part of a contract’s operative provisions. Accordingly, if a party views the language in a “whereas” clause to be a binding right or duty, it has to be taken out of the contract’s recitals, and included in the body.

2. Description of Property & “As-Is” Term

Depending on what is being conveyed, a contract will describe three types of property: real, personal and other. Real property descriptions detail the land and improvements to be transferred with as much specificity as possible. If a legal description exists, it should be used, and if not, the contract should provide that the description will be amended following a survey.

If personal property will be conveyed, the contract spells out those particular items. Because seller may intend to keep some of the personal property, an exhaustive list of the items to remain is ideal to avoid confusion.

Other property interests can include such things as lease and contract rights, licenses, intellectual property and warranties. Another quick tale…

Quick Contract Story No. 3

A party was purchasing a group of ski resorts. The sales contract correctly identified legal descriptions for all of the resorts’ land, a thorough list of all personal property to be transferred, and multiple leases, contracts and licenses relating to the operation of the resorts.

But, it didn’t address one important item: water rights. In performing its title review the buyer discovered that the rights to the water necessary to feed the ski resorts’ snow-making machines were granted to the seller personally, and not attached to the land.

While the parties argued about whether water rights were covered under the contract’s language, and eventually resolved the matter, the issue could have been avoided at the outset with better understanding of the needs of the property and a more complete description of property rights to be conveyed.

Lastly, where an agreement states that the property will be transferred “as-is,” this means the seller is making no representations as to the condition of the property. This limitation should be consistent with seller representations or warranties under the agreement, but in all cases an “as-is” disclaimer won’t shield a seller from fraud claims if it misrepresents conceals material aspects of the property.

3. Transfer Documents (Deeds, Assignments, and Bills of Sale)

Real, personal and other property are transferred by different instruments, so let’s take a look at possible issues with each.

a. Deeds

Because there is more than one type of deed, and they differ in the amount of protection given to the buyer, the contract must describe the type of deed to be used. The types, in order of the most protective of buyers to the least, are:

A general warranty deed, which “not only conveys to the grantee all of the grantor’s interest in and title to the property but also guarantees that if the title is defective or has a ‘cloud’ on it, such as a mortgage claim, tax lien, title claim, judgment, or mechanic’s lien, the grantee may hold the grantor liable.”

A special warranty deed (also called a limited warranty deed), which “conveys the grantor’s title to the grantee and promises to protect the grantee against title defects or claims asserted by the grantor and any persons whose right to assert a claim against the title arose during the period in which the grantor held title to the property. In a special warranty deed, the grantor guarantees to the grantee that the grantor has done nothing during the time he held title to the property that might in the future impair the grantee’s title.”

A fiduciary deed, “used to transfer property when the grantor is acting in his official capacity as a trustee, guardian, conservator, or executor, etc. A fiduciary deed typically only warrants that the fiduciary is acting in his appointed capacity and in the scope of his/her authority and doesn’t guarantee the title of the property.”

And lastly, a quitclaim deed, which is a “release by the grantor, or conveyor of the deed, of any interest the grantor may have in the property described in the deed. Generally a quitclaim deed relieves the grantor of liability regarding the ownership of the property. … The holder of a quitclaim deed receives only the interest owned by the person conveying the deed. If the grantee of a quitclaim deed learns after accepting the deed that the grantor did not own the property, the grantee may lose the property to the true owner. If it turns out that the grantor had only a partial interest in the property, the quitclaim deedholder holds only that partial interest.”

b. Assignments

As discussed below, a seller may be conveying its interests in leases, property-related contracts, licenses, permits, intellectual property and other items. Generally, buyer must determine whether the specific items to be conveyed are assignable, and if it wants to assume them. If they can, and it does, seller will transfer its interest in each my assignments delivered at closing.

c. Bills of Sale

A bill of sale is the usual method to convey personal property, and, like the contract itself, should identify the items transferred with as much specificity as possible.

4. Purchase Price, Adjustments, and Earnest Deposit

The purchase price is typically a set amount, subject to adjustments at closing. However, sometimes the amount will be based on square footage where the property’s actual size won’t be determined until a survey has been done. If personal or other property is included in the sale, the parties may, generally for tax purposes, allocate what portions of the purchase price are attributable to the land, the personal property, and the other property interests conveyed.

Additionally, the contract should detail what adjustments to the purchase price will be made at closing. Generally these relate to apportioning property expenses to each party for items such as closing expenses, real and personal property taxes, assessments, rents and security deposits.

Further, the contract will dictate who holds the deposit (typically a title insurance company or other neutral third party) and what happens to the deposit if the deal closes or not. Typically, if (i) the transaction closes, the deposit is credited towards purchase price, (ii) the deal didn’t close because buyer exercised one of its rights to terminated (e.g., one or more of buyer’s contingencies weren’t satisfied or waived), the deposit is returned to buyer, (iii) the sale didn’t close because the buyer defaulted, the deposit is kept by seller, and (iv) if the sale didn’t close because seller defaulted, the deposit returned to buyer.

Additionally, the contract should state whether the return or retention of the deposit resulting from a default will prevent the non-defaulting party from seeking damages under a breach of contract action.

5. Buyer’s Contingencies

Because a buyer won’t know everything it needs to know about the property at the time the contract is signed, it will be given a certain amount of time to review those aspects of the property it believes important. If following buyer’s review it determines that any one of these items is not satisfactory (as defined for each contingency), it may (i) give seller the opportunity to act to make the item satisfactory, (ii) accept the item as it is and waive its right to terminate the contract, or (iii) terminate the contract.

In order to determine if contingency items are satisfactory, it needs access to certain information in seller’s possession, including, for example, leases, property related contracts, permits, licenses, notices of land use or environmental violations or issues, and financial information such as income and expense statements and tax returns. Accordingly, the contract will require seller to provide all such property-related documents, as well as the obligation to provide any updates or new documents through closing.

The contingencies in a contract will differ depending on the purchase, but the following common ones are discussed below:

• the buyer’s ability to secure satisfactory financing
• satisfactory title
• satisfactory survey of property
• accepted building and property condition following inspections
• review of leases
• property income and expenses
• property-related contracts
• land use approvals, and
• satisfactory environmental condition

For a comprehensive checklist for commercial property due diligence items, check out our due diligence checklist

a. Buyer Financing

Central to the success of a sale is whether a buyer has the funds to purchase. If they don’t have cash (meaning readily available funds), and the seller isn’t providing financing, then buyers will look to third party lenders. If they can’t find satisfactory loan terms, this contingency will allow the buyer to terminate the contract. The seller will generally define the satisfactory loan terms (e.g., minimum loan amount, maximum interest rate and minimum term) so that buyer can’t opt-out under this contingency for a nebulous “we didn’t like the financing” reason.

b. Title Review

The agreed-upon title insurance company will review the chain of title and all other documents in the public record relating to the property to prepare a title commitment for buyer’s review. The commitment should establish that the seller owns the property, set forth any interests attached to the property (e.g., liens, easements, recorded leases, reversions, options to purchase, and covenants, conditions and restrictions (CCRs)), and then detail the conditions that have to be satisfied at or before closing so the company can insure the title required under the contract.

The buyer’s title contingency will generally provide that if the buyer objects to any title conditions, it can give seller the opportunity to cure or insure over buyer’s title objections. Where the seller can’t or won’t cure or insure, the buyer has the option of terminating the contract or waiving its objection.

Contracts may also provide that the seller must give the title company any items needed to remove the standard title exceptions. The American Land Title Association (ALTA) standard exceptions are:

• undisclosed parties in possession
• accurate survey or inspection
• adverse possession or prescriptive easements
• easements not shown by public record
• construction liens, and
• taxes not yet due and payable

Once the parties have agreed to the commitment, including what exceptions have been removed or insured over, the title company provides a title insurance policy to the buyer (and its lender, if any) at closing.

The importance of title review cannot be overstated. It can mean the difference between being able to use the land or not.

Quick Contract Story No. 4

In an article by PropertyMetrics about CRE deals gone bad, a seasoned real estate attorney described the following title review tale, “The Italian Villas:”

A client was buying property around [a high-end retail corridor] to build some Italian looking villas. He engaged us to get the property’s land use approved.

He had a big model made up of the villas to show city council. Must have weighed 60 lbs. We got the zoning approved, and I asked him “What are you going to do about the restrictive covenants?” He said, “What are those? How do I get rid of them?”

We weren’t hired to do any of his acquisition or title work, but figured out he had to get 51% of the property owners to waive the covenant. So he took this big model around to all of them, but couldn’t get more than 49%. Long story short, he had to sell. Didn’t lose his shirt, but had to sell.

Moral of the story, review title early on…

c. Survey

Obtaining a survey is important to verify the property’s size and location, that it has access to public roadways, access to sufficient utilities, locate easements and their potential impact on any proposed land use, and identify any boundary issues (e.g., unlawful encroachments). Additionally, a survey can reveal a potential prescriptive easement: a property use right given without the landowner’s knowledge or consent to a third party. Prescriptive easements, if enforced, can severely impact the property’s use and value.

The contract establishes which party pays for the survey, how long the buyer has to make objections to the completed survey, and how long seller has to cure them. Of course, seller can refuse any cures, and the buyer then decides whether to waive its objection or terminate the contract.

The agreement should specify the required standard of survey. Most lenders require the survey to meet the standards of the American Land Title Association (ALTA) and National Society of Professional Surveyors (NSPS): the “ALTA/NSPS Land Title Survey.” As explained by a due diligence consulting firm, the origin of the ALTA/NSPS survey was designed to give the title insurer all the information it needed “to delete the standard survey exceptions from their title policy[, answering] relevant questions, such as: 1) the surveyor’s findings about property boundaries, 2) any observed easements and exceptions to coverage in the title commitment and 3) the improvements, utilities, public access and significant observations on the property.”

The contract will generally specify that seller gives the buyer and its surveyor access to the property (though they may limit the times when surveying can happen), and that buyer indemnify seller against any injury or damage claims resulting from the surveying.

d. Inspections

Inspections generally will look at the state of improvements, personal property, and building code and other land use violations. As with surveying, seller will grant a right of access during a specified time, and require buyer to indemnify seller from injury or property damage claims arising from the inspections.

e. Commercial Tenant Leases

If the subject property includes existing tenants, verifying these tenants, their rental rights obligations (including options to purchase), the lease terms (e.g., can they be assigned to buyer), leased premises, and whether the leases are in default, are necessary to understand the obligations a buyer will be taking on, and the income and expenses generated from the leases.

Accordingly, buyers typically will ask the seller to provide:

• copies of all leases
• rent rolls, including past due rent payments
• notices given tenants
• estoppel certificates from tenants (here is a sample certificate form), and
• seller’s tax returns to verify rental income

Additionally, buyers will want sellers to indemnify them against tenant claims arising before closing, and may ask seller to notify all tenants of the pending sale.

For a detailed look at tenant estoppel certificates, take a look at our  article on tenant estoppels

f. Property-Related Contracts and Expenses

Similar to lease review contract provisions, a buyer will want to know its rights and obligations under property-related contracts currently in force with the seller, including the costs associated with each contract and whether they can be assigned to buyer. Such agreements can be for services like property maintenance, management, repairs, and others.

As with leases, the sale agreement may require seller to (i) assign at closing the contracts buyer wishes to assume, (ii) terminate those contracts buyer doesn’t want (to the extent it can under each contract’s terms), (iii) indemnify buyer against claims under the contracts for actions occurring before closing, and (iv) obtain estoppel certificates from the contract parties.

g. Land Use Approvals

If the buyer won’t be changing the current use of the property, it will want to confirm that the existing uses are lawful. This means reviewing compliance with zoning approvals, variances, conditional use permits, building permits, occupancy permits, signage permits and other similar approvals.

If the buyer will be changing the use, the contract will include a contingency that the buyer has a certain period of time to get approval from the appropriate governing body for its proposed uses. If the buyer diligently pursues the approvals, but isn’t successful, it may terminate the contract.

h. Environmental Review

A buyer will want to ensure that either the property has no environmental issues, or if it does, that it has an accurate understanding of the issues, and who must cure them.

To determine a property’s environmental health, a buyer often asks the seller to provide existing environmental assessments and agreements, as well as permits relating to environmental obligations. Buyers will also ask for the right to perform their own assessments, and terminate the contract if the assessment results are unsatisfactory. Typically these assessments are Phase I and II environmental site assessments.

A Phase I assessment involves a review of records, a site inspection, and interviews with owners, occupants, neighbors and local government officials. Even if the buyer doesn’t think such a review is necessary, its lender may require one. If the Phase I reveals potential contamination, a Phase II may be done to determine if hazardous materials are present. Phase IIs include site sampling and analysis with tests such as surface and subsurface soil samples, geophysical testing for buried tanks and drums, and sampling for Polychlorinated Biphenyls (PCBs).

The agreement should: (i) state who performs the assessments, and within what time frame; (ii) if items are revealed, who must remediate them, and how long they have to do so; (iii) provide that buyer can terminate the contract if it’s not satisfied with the reports’ conclusions; and (iv) require buyer to provide all reports to the seller.

Lastly, where potential environmental issues arise, a seller may want to require that all communications with any governing bodies relating to the potential issues be done either by the seller, or by the buyer only with seller’s consent. Sellers want this provision because while the buyer may walk away from the deal if the assessments reveal problems, any discussions with governmental agencies, and the results of such discussions, could create significant and long-lasting obligations for the seller.

6. Default Provisions

The agreement should clearly define what constitutes a default, how parties must be notified of the default, whether they are permitted to attempt to cure, how long they have to cure, and what happens upon an uncured default and termination of the contract. For example, the contract may require the buyer to return to seller all materials provided as a part of the buyer’s due diligence.

Additionally, the contract should describe a conflict resolution process to deal with any claims of breach.

For a discussion of conflict resolution processes, see our article on boilerplate lease clauses

7. Seller Representations and Warranties

A seller will make certain representations and warranties relating to the property. They should be spelled out explicitly, note whether some or all are limited to seller’s knowledge, and state whether each survives closing, and if so, for how long. Some of the more common representations and warranties include:

• the property is free and clear of all encumbrances
• there aren’t any land use violations (e.g., zoning, building codes)
• all permits necessary for the operation of the property are in place
• there are no environmental contaminations or violations
• seller has disclosed all claims against the property
• no parties have a right to occupy the property other than the identified tenants
• the leases, contracts, and financial documents provided to buyer are complete and accurate
• seller has the proper authority to sign the contract, and
• the improvements are free of any material defects and suitable for their intended uses

8. Other Seller Duties – Continuing Management, Insurance, Damage to Property

Buyers want to ensure that the property at closing is in virtually the same condition as when they entered into the contract. To ensure this happens, a buyer will obligate the seller to continue (i) to operate and maintain the property in a reasonable manner, (ii) lease the property in a reasonable manner (if there is an important tenant, buyer may want to limit seller’s ability to modify or terminate that lease without the buyer’s prior approval), (iii) keep the property insured, and (iv) not encumber the property without the buyer’s consent.

If notwithstanding seller’s efforts to maintain the property, it is damaged prior to closing, most purchase agreements describe the parties’ rights following damage. Generally contracts deal with the issue based on the extent of the damage. If the property can be fixed prior to closing, then seller will do so. If it can’t, then seller’s insurance proceeds will go to the buyer at closing so buyer can make post-closing repairs. However, if (i) the cost to repair the damage exceeds a certain amount, or (ii) the damage to improvements exceeds a certain percentage of the improvements’ total area, the contract will typically give buyer the option to terminate the contract.

9. Broker Involvement

Where one or more brokers are involved in the sale, the contract should identify those brokers and which party is responsible for their fees. It should also note that no other brokers were used, but if any unnamed brokers make a claim for fees, the party that dealt with them is responsible for their fees. Where there were no brokers, the contract should state this.

10. Assignment

Assignment provisions determine whether the buyer can assign its rights under the purchase agreement to another party. While the parties may disagree on whether assignment should be permitted, a compromise may allow for limited assignments to (i) specifically identified assignees, or (ii) any other party if the seller first consents.

11. Boilerplate Provisions

At the end of almost every CRE purchase contract are several pages of so-called “boilerplate clauses,” or clauses which supposedly are near-identical for all contracts, and thus less important. This is of course not true. Not only is every commercial real estate sale agreement different, but also these clauses can significantly impact the parties’ rights and obligations.

“Boilerplate clauses” include such items as:

• notice provisions
• attorneys’ fees
• merger/entire agreement clauses
• choice of law/governing law
• jurisdiction/forum selection
• force majeure
• the definition of the property
• dispute resolution
• parties, signature blocks, and others

For a discussion of each of these, examples, and pitfalls to look out for, see this PropertyMetrics article, “10 Boring Boilerplate Commercial Lease Clauses You Should Understand”

12. Closing

The contract should detail when and where closing will occur, and who will conduct it. Often parties will include the clause that “time is of the essence” as to the closing date, meaning there is no flexibility in the date. If closing doesn’t occur on that date the buyer can terminate the contract.

The documents to be provided at closing are described in the agreement, but generally consist of: (i) transfer deed, (ii) bills of sale, (iii) assignments and assumptions of leases and property-related seller contracts, (iv) title insurance policies, and (v) any other documents required by the title insurance company.

13. Pre-Contract Documents – Letter of Intent and Confidentially Agreements

Because the drafting of a purchase agreement can be time consuming and expensive, parties often chose to first draft a letter of intent (LOI) outlining the transaction’s principal “deal points,” e.g., property description, parties, price, significant contingencies such as the need to get proper zoning approval for a new use, etc. These will then be incorporated into the draft contract.

Depending on the circumstances, the parties may want the LOI to be binding or not. However, if they don’t want it to be binding, it’s critical that the letter include a clear statement that it’s not enforceable. If they fail to do this, and the LOI includes the material terms of the sale, a court may enforce it as a binding agreement. Nonetheless, binding or not, courts will typically impose on the parties the duty to use their best efforts to negotiate in good faith towards the terms of the LOI.

The second agreement sometimes used before the contract is signed, though often as a part of the contract, is a confidentiality agreement. To allow for the buyer’s due diligence the seller will be providing a substantial amount of information about the property, its environmental status, claims against the property, the seller’s management of the property and leases, etc. While the seller accepts that this information is necessary for buyer to determine if the purchase is worth pursuing, it doesn’t want this information shared with the world.

Hence, buyer will be required sign a confidentiality agreement (attached as an exhibit to the contract) providing that the buyer can’t disclose any of such information to parties other than those needed to interpret them, e.g., buyer’s lawyers, engineers, architects, accountants, environmental experts, surveyors, etc. (“consultants”) Additionally, in some cases the seller may require that buyer’s consultants also agree to be bound by the confidentiality agreement.

Sample Agreements

With the substantial caveat we’re not endorsing these agreements, and that any form or sample agreement must be modified for each specific deal, and should be drafted by a licensed real estate attorney, here are a few examples of CRE sale contracts:

• American Bar Association sample Purchase and Sale Agreement
• Northern Illinois Commercial Association of Realtors’ Commercial Real Estate Purchase and Sale Agreement
• New York City Bar Association’s Contract of Sale – Office, Commercial and Multi-Family Residential Premises
• DIRT’s Contract for Sale of Commercial Real Estate

Conclusion

Get ready to negotiate! Each property is unique. Each buyer and seller has different needs. And each CRE sale contract will be unique. But with an understanding of the above items, those common and essential items, you’ll have a little advantage at the negotiating table. That is unless the other side has a bigger stick…

In any case, because this article is given for informational purposes only, and not legal advice, if you have any specific issues regarding a real estate sale, please contact an experience real estate attorney.

If you have any comments or questions, or would like to share contract provisions that have served you well, please let us know in the comments section below.

 

Source: The Essentials of Commercial Real Estate Sale and Purchase Agreements

https://www.creconsult.net/market-trends/the-essentials-of-commercial-real-estate-sale-and-purchase-agreements/

Essentials of Tenancy in Common (TIC)

What is a tenancy in common (TIC)? What are its characteristics? Its advantages and disadvantages? If there are multiple owners, who gets the profits, pays the property expenses, makes the decisions? If I decide my co-owners are delusional, can I sell my part? If I do, can I do a §1031 exchange? And, well, how do I finance my part of the deal?

Okay, let’s see if we can find some answers. I’ll tell you though, because the laws governing TICs vary from state to state, before you make any decision on your Class A office dream, it’d be a good idea to meet with your attorney and tax advisor.

What is Co-Tenancy?

First of all, in order to understand tenancy in common, you must first understand co-tenancy. What exactly is co-tenancy? When two or more people own a property, they have a co-tenancy, and are each a co-tenant. Co-tenancy can occur in both residential and commercial arenas, and the two most common forms of co-tenancy are tenancy in common (with the owners referred to as tenants in common, TICs) and joint tenancy with right of survivorship.

Subject to modifications by agreement, co-owners each have a right of access to the entire property, a share of the income generated by the property (including proceeds from a sale), and a duty to share in expenses related to the property. Co-owners may not have to share in the costs of improvements, but if one owner makes improvements at his cost, and the improvements increase the asset’s value at sale, this owner may be able recover his contribution.

Lastly, a party considering co-tenancy will be happy to note that co-owners owe each other a duty of fair dealing.

What is Tenancy in Common and What is a Tenant in Common (TIC)?

As noted above, tenancy in common is a type of co-tenancy, and a tenant in common is each co-owner holding an interest in a single tenancy in common. So, what are the primary characteristics of a tenancy in common? The primary characteristics of a tenancy in common are:

• Each tenant in common holds a separate and undivided interest in the property
• Tenants in common may, but are not required to, hold different percentages of ownership in the property
• There are no rights of survivorship among the co-owners, and
• Each TIC may transfer or encumber their property interest without the consent of the other TICs (though this right may be modified by agreement of the co-owners)

Let’s walk through these TIC characteristics one by one and then cover some other common questions and issues regarding tenancy in common.

Each Co-Owner Has an Undivided Interest in Property

If property is held as a tenancy in common (the structure of ownership is made when the property is acquired), each owner owns a separate and undivided interest in the property, meaning not only that they have the right to access, possess and use all of the property, but also that they may sell their individual ownership interest.

TICs Can Have Different Ownership Percentages

Tenants in common may have different shares of ownership in the whole, typically based on their contribution to the property’s acquisition. For example, if you, your bartender, and one of the conventioneers acquired the Class A building under a TIC structure, you could have a 60% share, the auctioneer a 30% share, and your bartender a 10% share. These ownership shares then determine how you distribute the costs and benefits of the property, such as common area expenses and sale proceeds. The deeds under which TIC acquires their interest will show their ownership percentage.

What Happens When I Die? (Survivorship)

If you’re a dog, you go to this big farm where it’s always sunny and the water bowls are always full…

If you’re a tenant in common, there is no right of survivorship. This means that if a TIC dies, its interest passes to that co-owner’s heirs by will or inheritance laws. Of course, if the co-owner desired, it could provide in its will that upon her death her ownership interest would pass to the other TIC owners.

Does Every Co-Owner Get to Use the Entire Property?

Yes, unless they agree not to.

As noted above, as holders of an undivided interest in the property, each TIC has the right to access, possess and use any portion of the property. Access to all is typical where friends or family acquire property together and where parties purchase an interest in property for passive investment purposes.

However, TICs may also agree to use only assigned portions of the property, e.g., a floor of an office building, residential unit, retail space, storage unit, etc. For example, a TIC can be formed to acquire an industrial park, with each co-owner using only a specific building within the park. Co-owners can also then agree that each has the exclusive right to income generated from the use of their assigned space.

As an aside, a timeshare is an assigned-use TIC structure, but instead of an owner’s use being limited to a certain space, it is limited to a certain time.

The assignment of use and income rights are set forth in a TIC agreement, which, as discussed below, spells out the rights and obligations of the co-owners.

Can I Sell My TIC Interest?

Yes. A TIC has an undivided interest in the property. They may sell, transfer or encumber their interest (e.g., borrow funds secured by their interest) without the approval of the other owners.

However, because such an unfettered right could drastically increase the risk of ownership to the non-selling parties, TIC agreements typically limit co-owners’ rights of transfer. The agreement may, among other limitations, grant owners a right of first refusal on any sale and the right to vet and approve potential buyers. If at first blush this seems unreasonable, remember that a buyer will step into the shoes of the selling co-owner, and all of their rights and obligations.

Imagine if you bought a duplex with your quiet, mild-mannered, and dutifully bill-paying former college roommate, with each of you residing in one of the units. Now imagine your ideal co-owner decided to move to Peru and sell his interest in the duplex to a family of chain-smoking, saxophone and bagpipe players who believe timely loan payments are more of a suggestion than a duty.

Think it might have been a good idea to have a TIC agreement giving you the right to approve buyers?

Now imagine you bought that Class A office space, financed in part with a $20M loan to the three of you, and your bartender wanted to sell his interest to a party with a history of serious financial instability and litigation…

So, yes, tenants in common may sell their interests, but co-tenants may contractually limit this right.

When is a TIC Created?

A TIC is created when owners take title to a property, with the deed indicating each owner’s percentage interest. While it is wise to create a TIC agreement prior to the tenancy in common structure, it is not required. If no TIC agreement exists at the time title is vested, the characteristics of the TIC will be established by state statutes and common law, e.g., each TIC has the right to possess the entire property, each may transfer their interest without consent of other TICs, and each will share the total property income and expenses according to the ownership percentages indicated on their deeds.

Note though, not all of the co-owners must exist at the outset. They can be created at different times. For example, where the owner of an apartment building sells TIC interests to individuals, assigning them use rights as to single units, there could be years between the first TIC owner and the last.

Lastly, a TIC can be created by operation of law when a joint tenancy with right of survivorship (discussed below) is severed.

Is a TIC Different From a Joint Tenancy?

Joint tenancy, or joint tenancy with right of survivorship, is typically used when property is owned by husband and wife, parent and child, or any other group that wants each individual ownership interest to pass to the other in the event of death. This “right of survivorship” allows the deceased owner’s interest to be transferred automatically to the survivor without going through probate. TICs on the other hand have no right of survivorship.

Additionally, while tenants in common can have unequal interests in the property, joint tenants must have equal shares. Because the tenants have equal shares, if there is a partition by sale of the property, the proceeds must be divided equally regardless of the parties’ contributions to the property’s purchase.

Lastly, while tenants in common can transfer their interests, if a joint tenant sells or mortgages their interest without the consent of the other, the joint tenancy is converted into a TIC.

Who Manages a TIC?

The management of a TIC is determined in the TIC agreement. Often TICs with few co-owners and relatively simple management needs are managed by the co-owners themselves, while the management of more complex TICs are handled by separate management companies. Either way, the role and duties of management are set forth in the TIC agreement. And who creates the TIC agreement? Whoever creates the tenancy in common, whether that is a single party or multiple co-owners.

What is in a TIC Agreement?

The purpose of TIC agreements is to (i) clearly spell out the rights and duties of all parties, (ii) to anticipate potential issues with the property and its co-ownership, and (iii) to give definite procedures for how conflicts will be resolved. Where a deal is particularly complex, and the risks high, a well-crafted TIC agreement can, and should be, lengthy and detailed. Any costs saved by drafting a simple or one-size-fits-all agreement will be lost ten-fold if the agreement doesn’t provide clear answers when inevitable disagreements between co-owners arise.

Generally a TIC agreement will give direction on the following items:

Assignment of Usage: Describe what portion of the property each co-owner has the exclusive right to use, as well as areas available for all owners’ use.

Determination of Ownership Share: Describe the method by which a co-owner’s share of ownership is determined, e.g., by space, value, contribution, etc.

Permitted Uses: Identify permissible uses for each assigned space, and any limitations on such uses, e.g., noise, number of tenants, pets, etc.

Property Management: Detail how all aspects of the property will be managed (e.g., common expense accounting, maintenance, repairs), whether the co-owners perform particular tasks themselves, or a third-party manager handles all items.

As further discussed below, TIC interests qualify for IRS Code §1031 tax-deferred treatment if they meet certain conditions. As to the management of a property, these conditions require that (i) the manager disburses to the co-owners their shares of net revenues within three months from the date of receipt of those revenues, (ii) management fees do not depend on income or profits derived from the property, and (iii) management fees do not exceed the fair market value of the manager’s services.

Maintenance: Describe each owner’s duty to maintain its space, and how common space will be maintained.

Expenses: Describe how all property costs will be allocated among owners. Typical shared costs include real property taxes, maintenance and repair of shared areas, shared utilities and insurance.

Because a TIC doesn’t divide ownership of a property, each co-owner will not receive a separate real estate tax bill for their ownership interest. Rather, the taxing authority will issue a single bill for the entire property, holding each co-owner responsible for the entire amount.

Additionally, the agreement should describe how tax deductions should be allocated among the owners, e.g., mortgage interest on a collective loan, property tax, etc.

While the method of claiming a mortgage interest deduction doesn’t need to be a part of a TIC agreement, it is an interesting process. On residential property, where a co-owner’s loan is secured by a mortgage on its property interest alone, the process is simple: it receives a 1098 form from its lender, and claims this full deduction amount. Where there is a group loan among the co-owners secured by a mortgage on the total property, a few extra steps are required: (i) the lender sends the 1098 to the first borrower listed on the loan, (ii) this first-named borrower identifies on its Schedule A only the interest allocated to him under the TIC agreement, (iii) the remaining owners identify (A) their respective allocations on their Schedule A’s as a home mortgage interest not reported on form 1098, and (B) the first-named borrower on their return.

Financing: Describe how acquisition is funded. All owners may be parties to a single note secured by all of their interests, or each co-owner may obtain their own financing secured by their fractional interest. All financial obligations should be spelled out, such as requisite initial deposits, reserve accounts, calculation of loan payments and potential adjustments to payments.

Sale or Transfer of Interest: Outline the rights of tenants in common to transfer their interests, and any conditions on these rights. For example, transfers may be subject to the other owners’ right of first refusal or approval of potential buyers. Note that an outright prohibition on an owner’s right to transfer may be unenforceable as an unlawful restriction on the alienation of property, or may prevent a TIC from enjoying §1031 treatment.

Additionally, TIC agreements may want to consider what rights potential lenders may demand of new co-owners. For example, a borrower may be required to collaterally assign its transfer rights to its lender.

Decision-Making: Detail how decisions affecting the property are made. This can include agreeing upon which decisions will require a majority (e.g., day-to-day operations), super-majority (e.g., repairs or improvements over a certain dollar amount) or unanimous approval of the co-owners (e.g., change to assigned uses or spaces).

Default and Dispute Resolution Provisions: Define what constitutes a default under the TIC agreement, what remedies available to the non-defaulting owners, and a dispute resolution procedure to resolve defaults (e.g., informal negotiation, mediation, arbitration and litigation).

Financing of TIC Property

As briefly mentioned above, typically financing for TIC property is accomplished either (i) by the group of owners holding one or more loans secured by the group’s total property interest, or (ii) each co-owner having their own loan secured only by their property interest.

In the case of a group loan, the payment amounts due from each owner must be agreed to among the owners. One method is to take the amount a TIC paid for their ownership interest, and subtract the amount they put down, resulting in the amount of the group loan attributable to that owner. Then divide this amount by the total group loan amount to determine the percentage of loan payments that owner is responsible for.

One of the primary risks of a group financing is that when one co-owner doesn’t meet their payment obligations, and there are insufficient funds among the other owners to make the total payment, the lender may foreclose against the entire property. To mitigate against this risk, owners (i) vet the financial strength and history of their co-owners, (ii) ensure that the TIC agreement gives them this same vetting right for any potential new co-owners, and (iii) require co-owners to contribute to reserve funds.

In the case of individual loans, because the loan is secured only by the individual owner’s interest, their default does not directly obligate the other TICs. If an owner defaults, the lender may foreclose only on the owner’s share, and not the property. Where this occurs, the lender may sell the foreclosed interest, subject to any limitations the TIC has on transfers (e.g., a right of first refusal).

One other financing structure, sometimes referred to as “wrap-around” financing, occurs where, before the TIC structure is created, the original property owner (often the developer of a project) carries a single loan secured by the entire property, and makes all the payments on this loan. As new co-owners purchase TIC interests in the property, the original owner makes them individual loans. The new co-owners make their loan payments to the original owner, and who then pays its lender.

What is Lending Like Now for TICs? And What is a Section 721 Exchange?

Following the IRS’s issuance of Procedure 2002-22, clarifying that properly created TIC interests were eligible for § 1031 exchanges, investors flocked to TIC deals. Assembled and marketed by “syndicators” or “sponsors,” investors bought fractional interests in TIC-owned CRE assets.

When the recession hit, banking regulations tightened, and banks’ distressed property holdings increased, loans to TIC deals slowed. Put simply, where a financial institution had the choice between dealing with a single party or with a TIC of up to 35 co-owners, the choice was easy. Because the current banking environment remains disenchanted with the multi-party ownership structure, current investors in TIC projects may have trouble finding new capital or refinancing for the loans secured during the boom.

Accordingly, for TIC co-owners an obvious solution to attract new funds is to become more attractive: simplify the multi-party ownership. Tenants in common may do this by “rolling up” their interests into a single, new LLC through an IRS § 721 exchange.

Like a § 1031 exchange, § 721 exchanges, if structured properly, can enjoy a deferral of capital gains tax. Historically, Section 721 has been used by REITs when buying from parties wishing to avoid such gains tax. The process starts with the property owner exchanging its real estate for ownership units in the acquiring REIT’s operating partnership (OP Units). The operating partnership (also referred to as an umbrella partnership) is an entity separate from the REIT, which holds the REIT’s assets. The OP Units may then be transferred, on a tax-deferred basis, to shares in the REIT. Under this process, the real estate owner converts its real property interest into a private or public security.

In the case of a TIC, a Section 721 exchange starts with the tenants in common contributing their TIC interests into a new LLC, or “rolling up” their interests. Following these contributions, the LLC becomes the sole owner of the real estate, and each tenant in common an equity owner in the LLC. This simplified ownership structure makes attracting financing easier. While this exchange can enjoy tax-deferred treatment, tax counsel should be used to carefully structure the refinancing and avoid unanticipated taxable income to the former TICs.

Does a Tenancy in Common Qualify For a §1031 Like-Kind Exchange?

TIC property interests can be exchanged in an IRS Code §1031 tax deferred like-kind exchange. This allows property owners to defer capital gains when replacing a fractional interest in a cash flowing property. A partnership interest, however, cannot enjoy this treatment. Accordingly, a TIC owner intending to use its interest for such tax deferred treatment must be careful that the TIC is structured and operates as an ownership in real property, and not a partnership. To give guidance on what the IRS considers a TIC, it issued IRS Procedure 2002-22, detailing 15 conditions a tenancy in common must meet to qualify for §1031 treatment.

IRS Procedure 2002-22 conditions include, among others, that (i) there be no more than 35 investors, (ii) each co-owner has the right to transfer, partition, and encumber their own undivided interest in the property without the agreement or approval of any person, and (iii) restrictions on the right to transfer, partition, or encumber that are required by a lender and that are consistent with customary commercial lending practices are permitted.

How Many Tenants in Common are Allowed?

Unless the co-owners want to be eligible for §1031 tax deferred treatment, there can be anywhere between two and infinity minus one tenants in common. While there are no limits on how many TICs can have an interest in a single property, if §1031 eligibility is sought, there can’t be more than 35 co-owners.

What are the Major Advantages of Tenancy in Common (TICs)?

One of the primary benefits of TICs to buyers is highlighted in the example of you, your bartender and the conventioneer wanting to buy a Class A office property. While none of you could have acquired the building on your own, a TIC allows you to pool resources and maximize your buying power.

On the flip side, TICs can benefit sellers by giving them greater flexibility in the marketing of their property. They can sell the whole or pieces as the market demands. Often when selling portions of a property, the total income from these sales is greater than if the property had been sold to a single party. In this case, the whole is not greater than the sum of its parts…

What are the Major Disadvantages of a Tenancy in Common (TICs)?

As with any co-ownership, a tenant in common accepts the risk that its co-owners will not meet their obligations. Bartender doesn’t pay his share of the property taxes? You get to. Doesn’t make his share of the group loan payment and didn’t fund his reserve account? Get that checkbook out.

Additionally, because of the complexities of financing group loans and potential risks to a lender of multiple, and possibly changing, borrowers, TICs may face higher lending costs. Further, over the years, financial institutions’ desire to fund TICs has ebbed and flowed. If these complex ownership structures are out of favor with lenders when a TIC needs to refinance, they may face an uphill battle. There may be methods to simplify an ownership structure to facilitate refinancing or sale (e.g., a 721 Exchange where a commercial property is performing well), but the risk of financing availability and cost should be considered.

Additionally, TIC ownership can also expose a co-owner to actions by another owner’s creditors. For example, assume your bartender owes $100,000 to VISA relating to an impromptu trip to Nepal. VISA looks to his interest in the Class A office property. Now, they can only make claim against your bartender’s fractional interest, and not your, or the conventioneer’s, TIC interest. But, they may be able to force a sale of the entire building to satisfy the bartender’s personal debt. While you and the conventioneer could recover your fractional share of the proceeds from such a sale, you would still lose your dream property.

What’s the Difference Between a TIC and an LLC or Partnership Structure?

Limited liability companies and partnerships are business entities in which one or more parties share ownership. LLCs may generally be comprised of one or more owners (members), while partnerships must have at least two partners. State laws govern both the rules of both entities.

The primary difference between an LLC and partnership is one of personal responsibility for entity obligations. LLC members are shielded from entity obligations. Partners are not. Partners in a general partnership are jointly and severally personally liable for all partnership obligations, and partners in a limited partnership are liable up to their investment in the partnership.

A TIC owner is responsible for the share of TIC obligations as described in the TIC agreement. Personal liability is then a question of each co-owner’s entity structure. For example, if a party forms a single-purpose LLC to hold the TIC interest, then the personal liability of the LLC owner will be limited to the value of the LLC’s TIC interest.

An LLC and partnership share a common taxation structure in that business income is taxed once at the member/partner level. On the other hand, corporations are taxed at the corporate level and then again at the shareholder level.

A TIC is not a taxable entity. Each co-owner is taxed on their own income.

Where an LLC or partnership purchases a property, the individual members do not own a share in the property, but rather a share in the entity. In contrast, tenants in common each own a separate ownership directly in the property. Because of this difference, parties may want to consider how easily they may divest themselves of their LLC interest vs. a TIC interest. Generally the answer to this question will depend on the terms of the TIC agreement and LLC formation documents.

Further, as discussed above, the tax-deferred treatment available under IRS § 1031 is permitted with TIC ownership interests, but not partnerships. So if a party is seeking to purchase property for a like-kind transfer, they may enjoy 1031 treatment if purchasing a TIC ownership, but not a partnership or LLC interest.

How Can a TIC be Terminated? (Partition or…)

If you’ve had enough of your bartender’s shenanigans, you can terminate the TIC through a court-ordered partition. Partitions come in three flavors: in kind, by allotment, or by sale. A partition in kind is an actual division of the property among co-owners, and is only available when local subdivision laws permit. A partition by allotment grants ownership to a single owner (or group of owners), who then compensates the ousted co-owners for their loss of ownership. And a partition by sale is exactly what it sounds like: the court forces the sale of the property, and divides profits among the co-owners. Partition by sale is generally the last resort of courts, and only awarded when a partition in kind is not available.

It should be noted, however, that tenants in common may waive their right to partition under their TIC agreement. A total waiver may be an unenforceable restraint on the alienation of property, but a court may recognize limited waivers, such as where partition rights are waived for a period of time or under certain conditions.

So what was the “or…” method of terminating a TIC? Adverse possession. Property acquired by adverse possession terminates a TIC. And now you know.

Conclusion

If that Class A office building comes on the market, and you just can’t go it alone, a TIC may be the answer. If your bartender and the conventioneer have passed your vetting with flying colors, then pooling your resources under this ownership structure could make your office dream come true.

Of course, because this article is for informational purposes only (and not to give legal advice), and given the complexities we’ve touched on, and the risks associated with TICs, please consult your lawyer and tax advisor if you have any specific co-tenancy questions.

 

 

Source: Essentials of Tenancy in Common (TIC)

https://www.creconsult.net/market-trends/essentials-of-tenancy-in-common-tic/

1120 E Ogden

Retail / Medical Office Space for lease in Naperville, IL
1,500–3,673 SF | $26/SF MG
1120 E Ogden Ave., Suite 101, Naperville, IL 60563
Broker: Randolph Taylor, rtaylor@creconsult.net, 630.474.6441

https://www.creconsult.net/retail-office-for-lease-1120-e-ogden-ave-suite-101-naperville-il-60563/