To a developer, affordable housing means lower rents than a market-rate project, lower net operating income, and thus lower returns on their investment. Accordingly, without any outside incentive a developer has little motivation to build affordable housing.
Unfortunately, the need for affordable housing is significant. 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.”
Recognizing the need for affordable housing, and the fact that few developers would pursue these projects when market-rate developments offer a higher return, the federal government looked for ways to make affordable housing projects financially attractive to developers. The Low Income Housing Credit (LIHTC) program is one of those ways.
This article details how the program works, including:
Let’s start with the big picture.
The LIHTC was created as a part of the Tax Reform Act of 1986, is found in Internal Revenue Code § 42, and was designed to incent developers and investors to create and operate affordable housing. Under the program a developer receives federal income tax credits over a 10-year period in exchange for (i) acquiring, rehabbing or newly constructing rental housing for low-income households, and then (ii) operating the project under LIHTC guidelines for a certain compliance period.
Unlike a tax deduction, which only reduces taxable income, the LIHTC credits offset dollar-for-dollar a party’s tax liability.
Developers sell the right to use these credits to investors who want to reduce their federal taxes. The investor’s payment for such right, its “capital contribution” to the project, reduces the developer’s need to use other financing. This then reduces the developer’s debt-service costs, allowing the development to be financially appealing even with below-market rental income. This formula has been successful in attracting private dollars to create affordable housing.
According to the U.S. Department of Housing and Urban Development (HUD), as of 2016 the LIHTC program was authorizing the use of $8 billion in tax credits annually, and has resulted in the creation of approximately 2.8 million affordable housing units.
As with all development, the opportunity to create affordable housing doesn’t always present itself in the same manner. Sometimes a developer has to build a project from scratch. Sometimes they find a suitable existing building, but need to acquire and modify it to accommodate rental units. And sometimes a developer owns an existing building, but needs to rehabilitate it to offer affordable units.
The LIHTC can be used for all three situations: new construction, acquisition and rehabilitation, and rehabilitation of a property already owned by a developer.
It should be noted that LIHTC can also be used to preserve projects funded or supported with other affordable housing programs, including, for example Federal Housing Act (42 U.S.C. § 1437f) Sections 8 (Rental Voucher Program), 236 (Rental Assistance Program), 221(d)(3) (Rent Supplement Program), 202 (for elderly households), 515 (for rural renters) and 514/516 (for farm workers).
Although the credit was authorized by federal law, and reduces federal tax liability, the federal government has put the administration of the program in the hands of the states. Each state has created a housing finance authority (HFA) that allocates credits to developers, administers the state’s criteria and bidding process for projects, and monitors developer compliance with program regulations.
A state’s criteria and regulations are set out in its Qualified Allocation Plan (QAP). While the QAP must contain certain federal law provisions, these provisions are viewed as minimums, and the states’ rules may be stricter. Additionally, a state’s QAP establishes a prioritization for the types of projects it wishes to incent. Although the goal of the LIHTC program is to create more affordable housing, each state’s housing needs are different, and their QAP priorities reflect this. For example, in Colorado, the state will generally grant credits to new construction projects before awarding them to acquisition and rehab projects.
By allowing states to create their own priorities, not only can a state address its unique housing needs, but it also encourages developers to commit to more than the minimum federal requirements. For example, if a state prioritizes new construction projects over rehabs, a rehab developer may still be able to move up the priority ladder if it offers other desirable commitments like lower rents, a higher percentage of affordable units, or that the low-income units will be available for a longer period. Of course, such factors are specific to each state’s QAP.
That being said, even though there is significant flexibility in what a state’s QAP may include, the program does require that a QAP’s priorities serve the lowest-income households for the longest period of time and that at least 10% of the credits awarded must be given to projects with non-profit developers.
To see an example of a state’s plan, take a look at Missouri’s 2015 QAP.
Because a state is allocated a limited number of credits, and the amount of credits sought by developers almost always exceeds the allocated amount, the award of credits is highly competitive. How does a developer make their project more attractive to a state, and thus more likely to receive credits? Look at the state’s QAP.
The first step in the program is the federal government’s allocation of credits to each state. The allocation is determined according to a state’s population and an annually determined percentage multiplier. Because populations change, and the percentage multiplier changes, the allocation amounts change each year.
For example, the percentage multiplier recently increased from $2.30 to $2.50. What was the impact on a single state? Well, between 2015 and 2016 the population of California grew from 39.15 million to an estimated 39.35 million. Accordingly, the credits allocated to this would increase as follows:
An increase in credits available to California affordable housing projects of $2.42M.
Note though that in order to protect small-population states from receiving very low credit allocations, there is a minimum allocation amount (currently that amount is $2.69M). For example, in 2015 Wyoming’s population was only 0.59M (as compared to California’s 39.15M), and would have, without the minimum protection, received only $2.30 x 0.59M = $1.36M in tax credits to award.
The general sequence of events in an LIHTC project involves a developer:
Additionally, as a developer is preparing its initial proposal, it typically engages in negotiations with investors to purchase the credits if the project is approved.
As mentioned above, investors make a capital contribution to a LIHTC project in exchange for the right to use the credits to offset their tax liability. In order to do so, the investor must join in the ownership of the project, typically through the formation of a limited liability company (LLC) or a partnership with the developer.
The investor purchases a share in the partnership, typically approaching total ownership (e.g., 99%). This is done because the greater the investor’s ownership share, the greater its ownership of, and right to use, the LIHTC credits. The developer also wants to grant this near-total ownership because the more credits the investor can claim, the greater the contribution the investor will make.
Of course, an investor won’t buy credits unless it is profitable to do so. Accordingly, their capital contribution is less than the total amount of credits. To determine what contribution is appropriate, the developer projects the total credits its project is expected to generate, multiplies that amount by the investor’s partnership share, and then applies a discount rate agreed to by the parties.
In an example below, a developer projects its total credit as $450,000. If the investor’s partnership interest was 99%, and the parties agreed to a discount rate of 80%, the investor would make a capital contribution of $450,000 x 99% x 80% = $356,400. The difference between the total projected credits and the contribution to buy the credits is one of the investor’s primary motivations to make the deal: it is the investor’s profit (in this example the spread is $450,000 – $356,400 = $93,600).
Additionally, an investor will require a discount to reflect the time value of money. If the projected total tax credit was $1,000,000, an investor wouldn’t pay $1,000,000 up front for credits they could only claim $100,000 a year (recall that the LIHTC tax credits awarded are claimed over 10 years). All of this is to say that an investor’s capital contribution will be for some amount less than the credits reserved for the developer.
As an aside, an investor doesn’t have to make a single up-front contribution. Often, in order to maximize its profit they will make multiple contributions over time as certain project milestones are met. As with the discount rate, the number and timing of payments are terms negotiated between the developer and investor.
Lastly, while many investors are individual institutions (e.g., a bank), a developer may market their credits with the aid of a syndicator. Syndicators combine multiple projects into a single fund, and then offer shares in the fund to individual investors.
A developer’s application will include not only a project description and estimate of its cost, but also an election of one of two “set-aside” conditions. The set-aside chosen dictates (i) the percentage of units and square footage the developer commits to renting to low-income tenants, and (ii) the level of income of those tenants. The two set-aside options are referred to as the 20% at 50% and the 40% at 60%.
If the developer elects the 20 at 50, it’s committing to renting 20% of its below-market rent units to residents whose income is no greater than 50% of the area median gross income (AMI). Similarly, if the developer elects the 40 at 60, then 40% of the rent-restricted units must be occupied by residents with incomes no greater than 60% of the AMI. It should be noted that these percentages are federally required minimums, and states are free to require higher set-asides.
Because these percentages are used in the calculation of the tax credits granted to developers, many choose to increase the percentage of low-income units to maximize credits. A simple example is helpful: If two projects are identical, and Project A commits to 50% low-income units while Project B commits to 100%, Project B will be eligible for twice the amount of credits. And the greater the amount of credits, the greater the investor contribution, and the more profitable the project.
However, because states are allocated a limited amount of credits, in order to ensure the cumulative credits awarded to all developers doesn’t exceed the federal allocation, states often limit the maximum percentage of affordable units each developer can provide. Once the state and developer agree on a set-aside commitment, the percentages are memorialized in the project agreement.
Whichever set-aside option is chosen, the developer must meet it within the first year of the 10-year credit period, and maintain it for the entire compliance period, or else lose its credit eligibility.
Many LIHTC projects include a mixture of rent-restricted units for low-income households and market-rate rental units. While there is no restriction on the amount a developer can charge for market-rate units, as to the affordable units, rents can’t be more than 30% of the income ceiling below which tenants are eligible for a low-income unit. This income amount is either 50% or 60% of the Area Median Income (AMI) depending on whether the developer committed to the 20 at 50 or 40 at 60 set-aside.
Note that the low-income rent isn’t based on an individual tenant’s income, but rather on the 30% ceiling. An individual tenant’s income is relevant only to (i) determine if they initially qualify as a low-income tenant, and (ii) determine if the developer needs to make more affordable units available if the tenant’s income increases.
If a low-income tenant increases its income up to 140% of the income limit, it may still stay in the unit at the below-market rate with no other consequences to the developer. However, if its income rises to more than 140% of the limit, then the “next available unit rule” comes into play.
Under this rule the developer must rent the next available unit (of comparable size or smaller) to a new low-income qualified tenant at the below-market rate. This is done because the program wants to encourage low-income tenants to increase their incomes (which may not occur if they knew a higher income could cost them their below-market rent), while at the same time still making the same number of units available to low-income households.
Once a project is built, the LIHTC property must comply with all LIHTC and project agreement terms for a 15-year compliance period. If the property falls out of compliance, investors can be subject to the recapture or loss of credits, including credits that were claimed while the project was still in compliance. For example, if non-compliance occurred in Year 14, credits in Year 1 may be subject to recapture.
Following the initial compliance period, a project operates under an “extended use period” (EUP) of at least 15 years (states’ QAPs may require a longer EUP, e.g., California has a 55-year EUP). During this period the project must continue to provide affordable housing, but the definitions of affordable housing and compliance may differ from the definitions required during the initial 15-year period. Such definitions and other terms are negotiated and included in an EUP agreement between the state and developer.
The LIHTC program also allows a developer the opportunity to sell the project following Year 14. To do so, the developer asks its HFA to find a buyer that will continue to operate the project as an affordable housing project through the full compliance and extended use periods.
If such a buyer is found, the developer can sell them the property. If a buyer is found, but the developer refuses to sell to them, then the developer must continue to meet its LIHTC obligations through the full period. Lastly, if the HFA can’t find a buyer, the developer is released from LIHTC requirements. However, as a condition to awarding tax credits, many states require developers to waive this right to request a sale.
How much a developer receives in credits involves the consideration of (1) the investment the developer made in the project, (2) the percentage of low-income units it creates, (3) type of project (i.e., acquisition and rehab, new construction, or rehabilitation of a developer-owned property), and (4) whether the project is also funded by tax-exempt, private activity bonds.
The first step is looking at the developer’s investment, or its “eligible basis.” The eligible basis is the total depreciable costs of completing the project, such as the cost of acquiring and rehabbing an existing building or constructing a new building. Additionally, certain soft costs related to the project, such as architectural, engineering, legal and reasonable developer fees, may be included in the eligible basis. Notably, because the value of land is not depreciable, land acquisition costs cannot included in the eligible basis. Further, if the developer receives a federally funded grant before its compliance period starts, then the developer’s eligible basis is reduced by this amount.
A quick example: Developer buys an existing building for $1M, of which $200,000 is attributed to the purchase of the land. It then spends $1M on construction hard costs, $100,000 on architectural, engineering and legal fees, and pays itself a $300,000 developer fee. Under the state’s QAP, the maximum developer fee for a project of this size is $200,000. What is its eligible basis?
Its total project costs are:
But only the following costs are included in its eligible basis:
Once the eligible basis is determined, it’s multiplied by the percentage of low-income units (calculated at the end of the project’s first year under the program) to determine the project’s “qualified basis.” Let’s look at an example where a developer applies for tax credits for two buildings.
If Building 1 had an eligible basis of $500,000 at the end of Year 1, and was to be 100% affordable units, its qualified basis would be $500,000 x 100% = $500,000. Whereas if Building 2 with a $1M eligible basis at the end of Year 1 was to house only 40% low-income qualified tenants, its qualified basis would be $1M x 40% = $400,000.
The next step in determining the projected amount of annual tax credits is multiplying the qualified basis by the applicable tax credit percentage. The applicable percentage depends on the type of project and whether it is receiving other federal subsidies.
A 9% credit percentage is available for new construction or rehabilitation projects, so long as it isn’t also funded with tax-exempt, private activity bonds. The 9% credit is designed to compensate the developer for 70% of the building’s qualified basis over the 10-year credit period (sometimes referred to as the 70% subsidy). So how does 9% x 10 years = 70%? Good question. It doesn’t.
And why not?
Let’s ask the Congressional Research Service (CRS) (they’re the folks who prepare explanatory materials for members and committees of Congress):
“The so-called 9% credit is generally reserved for new construction. Each year for 10 years a tax credit equal to roughly 9% of a project’s qualified basis (cost of construction) may be claimed. The applicable credit rate is not actually 9%; instead, the specific rate that a project will receive is set so that the present value of the 10-year stream of credits equals 70% of a project’s qualified basis. The formula used to ensure the 70% subsidy is achieved depends in part on current market interest rates that fluctuate over time. These fluctuations have also caused the LIHTC rate to change over time. Since 1986, the 9% credit has ranged between 7.89% and 9.27%.”
A quick aside: to qualify for rehabilitation credits, a developer must meet certain spending requirements, including (1) spending at least $6,500 rehabbing each affordable unit, or (2) spending at least 20% of the building’s adjusted basis, whichever is greater.
A 4% credit percentage is available for the acquisition of an existing project, and for those new construction and rehabilitation projects that are funded in part with tax-exempt bonds. If no bonds are involved, such new construction and rehabilitation projects would otherwise be eligible for the 9% credit percentage. The 4% credit is designed to compensate the developer for 30% of the project’s eligible basis over the 10-year credit period (sometimes referred to as the 30% subsidy).
As with the 9% credit, the CRS explains why the 4% credit is not actually 4%:
“Like the 9% credit, the 4% credit is claimed annually over a 10-year credit period. The actual credit rate fluctuates around 4%, but is set by the Treasury to deliver a subsidy equal to 30% of a project’s qualified basis in present value terms. At one point, the 4% credit rate had fallen to as low as 3.33%. For both the 4% and 9% credit it is the subsidy levels (30% or 70%) that are explicitly specified in the Internal Revenue Code (IRC), not the credit rates.”
As the 9% and 4% credits aren’t fixed at 4% and 9%, but rather float monthly with interest rates, an applicant will lock in a credit percentage during the allocation process based upon the then-current rate.
Continuing our sample scenario, if Building 1 was the construction of a new building, and not funded by tax-exempt bonds, its projected tax credits for Year 1 would be the qualified basis x the applicable tax credit percentage: $500,000 x 9% = $45,000. If Building 2 was the acquisition of an existing building, its projected Year 1 credit would be $400,000 x 4% = $16,000.
To project the total tax credits available for each building, the Year 1 amount is simply multiplied by 10 to reflect the program’s 10 years of credit eligibility. Accordingly, the total credits available for Building 1 is the Year 1 credit of $45,000 x 10 years = $450,000.
The developer makes the above calculation based on its expected costs and percentage of low-income units, and then includes its projected credit amount in its application to the HFA. The actual credits awarded, however, are based upon the actually certified eligible costs and actual low-income unit percentages.
When an application is approved by the state, it reserves the amount of projected credits for the developer. This amount then reduces the amount of credits it can award to other developers. For example, if both Buildings 1 and 2 are approved, the state will reserve $450,000 + $160,000 = $610,000 in credits for the developer. If the project was in Wyoming (which receives the minimum $2.69M credit allocation from the federal government), then the state would have $2.08M in remaining credits to award to other projects.
Following the construction/rehabilitation and lease-up of a building, the developer submits a placed-in-service certificate to its HFA showing that it has complied with its application and project agreement. The certificate typically includes such items as the qualified costs actually incurred, construction and design agreements, and the percentage of units reserved for low-income qualified tenants.
If the HFA approves the certificate, it sends the developer an IRS Form 8609 authorizing the use of the credits. Under the agreement between the developer and investor, the credits are then claimed by the inventor on its federal tax return, offsetting its taxable income.
The LIHTC program has successfully attracted private equity to affordable housing projects, and increased the number of units available to low-income households. However, receiving the program’s tax credits, and staying in compliance with a state’s requirements is not a simple endeavor. Accordingly, if you have any specific LIHTC issues, please talk with a lawyer well versed in the intricacies of the program.
Source: A Complete Guide to the Low-Income Housing Tax Credit Program
https://www.creconsult.net/market-trends/a-complete-guide-to-the-low-income-housing-tax-credit-program/
Multifamily sellers: How to qualify a buyer before going under contract
As the seller of a multifamily asset, it’s crucial that the buyer you select is the best possible prospect for your property. Don’t waste time, money, and opportunities: you must ensure they’re qualified and can close and execute the contract as signed.
Keep reading to learn why it’s essential to qualify a buyer before going under contract on your multifamily property and how to do it.
Why do I need to qualify a buyer?
It’s important to close with the first buyer you select. If you don’t, each buyer after that will ask themselves, “What did that other buyer discover about this property that I am missing?”.
When you enter into a contract with a refundable deposit, you’re basically giving your chosen buyer a free option on your property for a period of time, typically 30–60 days. Before you proceed, you must be confident that they can close and execute the contract as signed.
What’s more, your tenants and staff will be disturbed throughout the contract process. To minimize the period of disruption, you should do all you can to ensure the transaction will close successfully at the end of the contract process.
As a seller, you’re required to provide due diligence information to the prospective buyer. When you qualify your buyer, you’ll greatly reduce the risk of wasting a lot of time and doing a lot of work only to not close on the property.
How do I qualify a buyer?
Before you sign the contract, make sure that your prospective buyer can provide certain items. Always ask them for the following:
– Proof of funds
– Lender pre-qualification
– A list of the other properties they own
– A list of the sellers and agents that they have worked with
For added reassurance, it’s recommended that you call the buyer’s lender to confirm their pre-qualified status. You can also call the agents, sellers, and buyers they’ve closed with in the past to enquire about how the transactions went.
Has the buyer toured the property in person before making an offer? Have they reviewed the due diligence information beforehand? If they have, this is a great sign. It’s proof that they have seen and have taken into account any issues with your property, and this greatly reduces the chances that they may later want to back out of the sale, saying they were unaware of the building’s condition. Be very wary of a buyer who doesn’t tour your property in person.
A prospective buyer who shows they’re motivated and wants to move quickly is also a great sign for a successful closing. The shorter the due diligence period, the better, and the larger the deposit, the better.
When you spend the time making sure your prospective buyer fulfills these criteria, you’ll put yourself in a great position to close successfully and ensure a quick and smooth transaction.
If you need help selling your multifamily property, eXp Commercial is here. Our objective as your multifamily advisor is to help you achieve your investment goals: from determining the listing price to selecting the best buyer and handling the sale process through to the closing, we’ll facilitate a smooth transaction for you.
Source: Multifamily sellers: How to qualify a buyer before going under contract
https://www.creconsult.net/market-trends/multifamily-sellers-how-to-qualify-a-buyer-before-going-under-contract/
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:
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 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.
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.
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.
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:
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.
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:
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.
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.
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.
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:
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.
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:
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:
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.
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.
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:
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.
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.
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.
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.
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.
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.
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.
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.
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:
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.
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.
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.
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:
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.
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/
https://www.creconsult.net/market-trends/the-definitive-guide-to-understanding-section-8/
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.
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.
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…
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…”
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.
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.
Real, personal and other property are transferred by different instruments, so let’s take a look at possible issues with each.
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.”
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.
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.
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.
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:
For a comprehensive checklist for commercial property due diligence items, check out our due diligence checklist
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.
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:
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.
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.
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:
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
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.
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.
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.
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
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:
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.
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.
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.
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:
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”
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.
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.
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:
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/
