Many contracts and leases leave the parties to determine a future purchase price or rent between themselves as set by the then “Fair Market Value” (FMV). The crafty draftsperson will often try to sneak in language “as determined by seller (or landlord)”. But smart buyers and tenants won’t stand for that unilateral determination. A more concrete method of determining the FMV needs to be added to the document to set the future purchase price, option price or renewal rent. FMV is then usually determined by an appraisal. Sometimes the seller or landlord will obtain the initial appraisal, with the buyer/tenant having the right to challenge the initial appraisal by obtaining its own appraisal. If the 2 appraisals don’t agree, the appraisers choose a 3rd appraiser whose appraisal would then be binding. This process can be time consuming and costly. Other times, the buyer and seller or landlord and tenant agree in advance as to who the appraiser will be and jointly pay for the appraisal prior to the time the purchase price, option price or rent is to be set. The appraiser’s determination of FMV would be binding and the purchase price or rent is set based on such determination.

It is important to understand what you are getting when you add this appraisal language to a contract or lease. Otherwise, when the time comes, the appraisal you obtain might not fit your needs and the FMV could cause you to overpay, as tenant or buyer, or receive, as seller or landlord, less than FMV.

The Uniform Standards of Professional Appraisal Practice, as developed by the
Appraisal Standards Board of the Appraisal Foundation, has 3 approaches in determining a property’s value:

  1. Cost Approach: Under this approach, a property’s value is determined by adding the estimated value of the land to the current cost of construction of the replacement for the improvements on the land and subtracting depreciation (land value + construction cost – depreciation). The appraiser must obtain cost estimates from builders and contractors. Appraisers must do research as to depreciation. Land value is established separately.
  2. Sales Comparison Approach: this approach is useful when several similar properties have sold or are for sale in the subject market. The value of the subject property is determined by comparing comparable sale and a price range is given.
  3. Income Capitalization Approach: Value under this approach is reached as the present value of future benefits of property ownership. There are 2 methods, direct capitalization and yield capitalization. Direct capitalization is the relationship between 1 year’s income and the value of the property that equals a cap rate or income multiplier. Yield capitalization is the relationship between several years of stabilized income and a reversionary value at the end of a defined term.

 

Most appraisals determine value using at least 2 of the methods. Income producing property will almost always use an Income Capitalization Approach. Where 2 of the approaches conclude virtually the same value, it is safe to assume that the appraisal is fairly accurate. However, it is important to review the appraiser’s assumption. How old are the comps used? What is the supply of like properties currently for sale? What is the absorption rate? What are area cap rates? What is the condition of the subject property and what was the condition of the comps? What is the vacancy rate and what vacancy rates were used? There are many other assumptions to consider that could affect the appraiser’s conclusions as to FMV.

At contract/lease drafting time, sellers and landlords want as much flexibility as possible to raise the purchase price or rent in the future. At this point, FMV is a very loose term. Buyers and tenants want caps. Efforts to cap an increase are sometimes futile, especially following a lengthy initial lease term with small rent increases. That is why it is essential that the parties work to ensure that FMV actually be fair at the adjustment time.

We’ve been discussing it for well over a year. My wife has wanted to sell the house. It’s time to downsize, she argued. Let’s get out of the suburbs and get more urban, she said. But, in this case, I was the more emotional one. I wasn’t ready to let go. The roof leaked, so we put on a new one late last year. She reasoned that would increase the value and make it easier to sell. Finally, in January, she convinced me. We would sell. But, now, my experience and expertise would have to take over. We would wait until school let out to catch the right time for buyers. That would also give us time to clean up and make a few more cosmetic repairs. We were in agreement and moving forward.

During this time, the discussions were intense. How much could we get, she pondered. I had been watching property values for years and I gave her my reasoned opinion. “No way” she contended. We had no pool, there was so much that she would do to our house and therefore, any buyer would do, that no one would pay that much for the house. I responded that we had kept a clean house, fresh paint, new appliances and air conditioning units, modern kitchen and bathrooms. The house was move in ready. Aside from carpet cleaning or replacement, there is nothing to do that would affect the value, no pool and “ugly” back yard notwithstanding.

During the 6 month lead in to the time to sell, she insisted we call our real estate agent to give her a “heads up”. She was so anxious to get this done. “Why?” I asked. So she could prepare. I assured my wife that the agent didn’t need 6 month prep time. So, a couple months ago, we called our handy man to do some repairs and when he was finished, we made the call. On the Sunday before Father’s Day, our agent came to the house armed with comps and statistics. What she told us was that our house was beautiful and in perfect shape to show. The comps were even higher than I thought they would be and that she believed we could get AT LEAST $5,000 more than I had estimated that we could get. She suggested listing the house slightly higher than the highest comp. We were exactly on the same page. My wife was surprised but very pleased.

The house would go on MLS sometime Thursday. I told my wife that the house would be shown that very weekend – Father’s Day weekend. She said absolutely not. It was too quick and it was Father’s Day. The listing hit about dinner time Thursday. The first showing was Friday morning. There were 3 or 4 more showings Saturday. Our agent told us that we would have an offer by Monday. I told my wife that this would be over by the middle of the week, as did the agent. The offer came in higher than either of us predicted and we countered so as to get nearly our asking price.

While my wife was surprised, our agent and I knew all along how this would play out. There was almost no inventory in our neighborhood, which is a very desirable area for families. Schools are great. Young families want to be here. Our new roof and appliances add tremendous value. Our agent recognized this and highlighted the listing to reflect this.

We have a very short time to get our act together and find a new place. But because we were so much in synch with our agent, I am confident we will be on this process as well. I am a real estate attorney and I know the business as well as anybody. Realistically, I could have sold our house with anyone doing the listing and handling the contract. But the truth is, having a good agent who understands you, your needs and your property can make the process so much easier and stress free. And, from my perspective, it gave me validation and will continue to give me validation as we get through the closing. Choose your agents wisely. They can be gems.

When 2 parties sign a real estate contract, they generally do so with the expectation that the seller wants to sell and the buyer wants to buy. Basically, at the time that the contract is signed, both parties want to close. However, sometimes, things happen and one of the parties changes their mind and decides they don’t want to close. Now what?

There is no right or easy answer to this question. Who is attempting to terminate the contract and their reason for doing so are important factors in determining what to do. A common occurrence is when a buyer decides not to proceed at the end of the due diligence period. Most commercial real estate contracts and many residential contracts provide the buyer a time, following contract execution, to inspect the property and determine whether it is suitable for buyer’s use. Sometimes the inspection paragraph is broadly drafted and sometimes it is narrow in scope. At the end of the due diligence period, the buyer, if not satisfied, may provide notice of termination to the seller and the deposit is to be released to the buyer. Most of the time, this goes without a hitch.

But things don’t always go smoothly here, even though the provision has been negotiated and is clearly spelled out in the contract. Sellers have waited through the due diligence period patiently (or not) and want to proceed to closing and object to the termination. I had a case where my buyer client requested several extensions of the due diligence period, purportedly to complete zoning review. When the buyer ultimately terminated the contract, seller objected arguing fraud because the buyer had never made application for approval and failure to give timely notice of termination. The due diligence provision was broad and allowed the buyer to terminate for any reason. But, seller refused to consent to the release of the $50,000 deposit. When no agreement could be reached, my buyer client sued for release of the deposit. The escrow agent placed the deposit in the court registry. We prevailed at summary judgment with the court finding that the seller had voluntarily executed each amendment extending due diligence and buyer’s notice of termination was timely. Seller had to release the deposit and pay buyer’s attorney’s fees. Whether the buyer had made application for the zoning approval was not relevant.

A buyer might also attempt to terminate a contract because of a failure to satisfy other contingencies such as financing or government approvals. From the buyer’s perspective, it is important that, regardless of how the contract is drafted, the buyer document its efforts to timely satisfy the contingencies and keep the seller advised of all its efforts. If buyer does not keep the seller informed and then is unable to satisfy a contingency, seller could have grounds to object to buyer’s attempt to terminate the contract and recover the deposit. If not expressly stated, buyer has an implied covenant of good faith which means that the buyer must use its best efforts to satisfy the contingencies. If the seller isn’t in the loop, the seller can also allege that the buyer has not reasonably attempted or used best efforts to do so.

Sellers, likewise, fail to close from time to time. Buyers’ remedies are usually clearly spelled out – specific performance being the most common. To assure that a buyer can pursue specific performance as a remedy, buyer must demonstrate that it was “ready, willing and able” to close on the closing date and seller failed to perform.

This can be illustrated in another case I had a few years ago. My client was a tenant under a commercial lease. Under the lease, the client had an option to purchase after the 3rd lease year if exercised between 120 and 60 days before the end of the 3rd lease year. The terms of the purchase were set forth in the lease and the option was to be exercised in writing to landlord by tenant preparing a contract, signing the contract and sending it to landlord. Closing was to occur 60 days thereafter. We prepared the contract and timely exercised the option. The landlord’s attorney responded that the option was not valid for a myriad of reasons and if we wanted to purchase the property, the price would be 2.5 times the option price. The shake down was on.

Though we spent the next 60 days arguing with the landlord’s attorney as to why the landlord was wrong about the validity of the option, we also prepared for the inevitable lawsuit by getting ready for closing. We ordered title and survey. We prepared closing documents. The client sent me the required deposit and I notified the landlord and the attorney that the deposit was being held in my trust account. Upon receipt of the title commitment, I sent a title objection letter. We prepared a closing statement and requested seller documents. The day before the closing, the client wired the net closing proceeds to my trust account.

On the scheduled closing date, I sent the buyer signed closing documents to the landlord’s attorney and advised that all closing proceeds were in my trust account ready to be delivered to landlord/seller upon receipt of the deed and other closing documents. In effect, I “tendered” the closing proceeds. Of course, the seller/landlord rejected our tender and refused to close. We filed a lawsuit for specific performance and, because we took all of these steps, won on summary judgment. After concluding that the option was valid (rejecting all arguments of the landlord), the court cited each step we took to confirm that buyer was ready, willing and able to close and ordered landlord to convey the property to my client. Landlord was also ordered to pay all of my client’s legal fees.

Disputes over closings occur. Attention to detail on both buyer’s and seller’s side is necessary to enforce the contract or to resolve the dispute without litigation. Luckily, I have only had a handful of these cases go to court over the years. Not every deal will close. In fact, most won’t. But no one wants to litigate. Detail starts in the contract and continues as you work through due diligence and prepare to close. If the transaction is not going to close, this attention to detail will help avoid the costs of litigation.

There is an old saying, if God had designed a horse by committee, he would have got a camel. Sometimes, too many people get involved in a project and something that should be simple becomes overly complicated. I have often raised this over the years when serving on non-profit boards and the board is asked to review and approve a contract. So many times, a room full of the community’s brightest business leaders and lawyers will scrutinize a simple document, line by line, and suggest changes after the board’s counsel, executive director and chairman, or all 3, have already carefully reviewed and negotiated the entire agreement. An agreement by committee, I always argued, was a camel.

I was reminded again of the agreement by committee recently as I negotiated the purchase of property from a religious organization. In this case, the organization’s board could not decide what it wanted to do. The organization was represented by 3 or 4 highly qualified brokers and a pro-bono attorney (who did not have a real estate background). So, it became obvious that we were dealing with 2 committees in negotiating the contract: 1) the organization’s board, and 2) the broker/attorney advisers.

We had no direct contact with the board. All communication initially went through one of the brokers. But, communication came back from any one of the brokers and the signals were different. It was difficult to know exactly what the seller wanted. Consequently, negotiations eventually broke off. I thought that there was a price gap. My client thought that the disconnect was something else.

A few months later, the original broker asked me to resubmit the last letter of intent we had provided and confirm the purchase price. I did so. The broker then asked me to confirm a few other terms which were specified in the LOI. I finally told him that the LOI was clear, but perhaps we should present a contract and spell out all the terms to clarify. Instead, we had a conference call with all the brokers. This was the first time I was able to speak to all of them. They explained how they were all “volunteering” to help this organization and how they would appreciate my help in getting the deal done. I said that the best way we could get this done would be to move on to a contract and stop talking about a theoretical deal. They agreed and I finally was able to prepare and send a contract.

However, they were silent for a few weeks. I think that they had a few calls, maybe even meetings with my client as the client told me that the board was concerned about having to vacate the property on short notice since closing was tied to approvals. We weren’t exactly sure, but it would be good to actually talk to someone about this as we could easily work it out. But, the brokers needed to talk to the board and come up with a solution. I wasn’t sure who was going to come up with this solution, but if they asked me, I could do it in a second. The brokers’ solution was for all of us to meet at the property. A meeting was scheduled and then re-scheduled 3 times until it was finally cancelled. No reason for the meeting or the cancellation was ever provided. Finally, the broker emailed me to tell me that they were solving a problem and it would involve my client signing some sort of note at closing.

Remember, each person on this broker committee is well respected and highly qualified. But for some reason, they got brain freeze here and missed the obvious solution. Perhaps they got so confused by their client, the board, in trying to address the issue, that they created a camel. Regardless, after all the delay, I offered a simple, short paragraph to the contract, and buyer agreed to enter into a post-closing occupancy agreement allowing the seller to occupy the property for up to 120 days after closing. Suddenly, we had a horse again.

Working with others to prepare a contract absolutely can be done. Two heads are better than one. But, if you try to do it as a committee where no one takes responsibility or the lead, it isn’t going to happen. Nothing against camels, but they have no place in your documents.

Letters of Intent are often a good place to start negotiations for all types of transactions. I’ve written about this before (see post HERE). They can be very helpful in setting the parties’ expectations and helping to draft the contract.  They work well as checklists for the essential points to be discussed.  However, LOIs should never be considered to be the final contract document, nor should they be considered to be binding on the parties as they do not contain all of the essential terms of the contract.

Most LOIs contain language making it absolutely clear that the LOI is non-binding and is merely an expression or outline of the parties’ interest in entering into a more formal, binding agreement. Until such an agreement is executed, the parties have no formal obligation to each other except perhaps, confidentiality and exclusivity for a specific period of time.

When an LOI gets too specific and a contract is not ever signed, disputes can and do arise. One or both parties might look to the LOI to “enforce” some right or a provision.  But, because the LOI is not binding, there is nothing to enforce.

This situation recently came across my desk. The client signed a LOI to sell the stock of his business nearly 6 months ago.  There were at least 5 occasions in the LOI stating that the LOI was not binding on the parties.  The LOI provided that the parties would “promptly” negotiate and execute a Share Purchase Agreement containing the economic terms in the LOI and regular and customary terms for similar transactions.  It provided that the Share Purchase Agreement would contain a 90 day due diligence period.  And, the LOI stated that if the Buyer “waived Due Diligence” and the Seller thereafter “failed to close,” Seller would reimburse Buyer’s due diligence costs up to $150,000.

Prior to and after the execution of the LOI, the Buyer conducted extensive due diligence on Seller’s company. Negotiations for the SPA began in earnest but were difficult for many reasons.  Both sides felt that the other side changed the business terms.  At the end of about 4 1/2 months, the Buyer agreed to “waive Due Diligence” by amendment to the LOI, yet Seller continued to provide financial records of the company that Buyer requested.  About 2 1/2 weeks later, Buyer broker off negotiations and made demand for reimbursement of its due diligence expenses, the entire $150,000.

Seller retained me to address the due diligence reimbursement issue. What were Seller’s rights?  Seller’s obligation to reimburse the expenses arose under the LOI.  But, the LOI, by its terms was not binding.  Of course, the Buyer could easily argue that this was one of those provisions, like confidentiality, that is binding.  However, Seller’s obligation to reimburse had 2 conditions precedent:  1) Buyer waive Due Diligence and 2) Seller fails to close.

Buyer argued that it had waived due diligence per the 2nd Amendment to LOI. I’m not sure that it did because the parties never entered a contract.  The LOI said that the contract would have a 90-day due diligence period.  Did Buyer waive that provision of the LOI or was it the provisions of the LOI allowing it to conduct due diligence prior to signing the contract?

But, assuming, for argument’s sake, that Buyer did waive due diligence, the 2nd condition precedent was not satisfied. Seller could not have failed to close because Seller had no obligation to close.  There was no binding contract.  No one agreed to anything – not the price, not the terms, not the closing date – nothing.  Therefore, Seller had no obligation to reimburse Buyer.

LOIs can be great. But if you never get to contract, all you have is a piece of paper and no rights.  My client, in this case, looks like it will lose this deal, but it will not have an obligation to pay Buyer.  This is a good result.  The Buyer, who was the more sophisticated party in this transaction and a bit of a bully, blew it.  They should have pushed for the contract ASAP so the due diligence clock would start.  Their strategy, whatever it was, backfired.

    Get Blog Updates

    Get news, insights, and commentary delivered straight to your inbox!
    Click Here

    About Us

    Welcome to Assouline & Berlowe’s Florida Real Estate Law and Investment Blog with news, insights, and commentary for investors, developers, and their advisors.

    Topics

    Recent Updates

    Archives

    Stay ConnectedLinkedIn

    STAY TUNED!
    Get Blog Updates
    We'll send you an email whenever we add a new post.
    Stay Updated
    Give it a try, you can unsubscribe anytime.
    close-link
    Get news, insights, and commentary delivered straight to your inbox!
    Click Here
    close-link