This article outlines the contractual provisions that are involved in a purchase of real estate for syndication.
The benefits of group investments
For syndication purposes, real estate can be broken down by type into five basic categories:
existing residential and nonresidential income-producing properties, called rental property;
yet-to-be-built construction and subdivision projects;
pre-builder land;
agricultural land; and
remote, unusable land.
This discussion assumes the limited liability company (LLC) will be formed to acquire existing income-producing property, which is the category of property most prudent for real estate investment groups to own.
The benefits derived from the co-ownership of existing rental property include:
an initial capital investment without the expectation of future additional contributions;
minimal involvement by the investor;
spendable income distributed periodically;
equity buildup due to amortization of the loan amount through monthly payments paid for from rental income;
value increase brought about by monetary inflation and asset appreciation; and
tax benefits provided by depreciation and reinvestment on a sale of the property.
The other categories of real estate investment properties do not offer all of these advantages.
Also, group investments in construction projects and agricultural or business opportunities automatically contain corporate securities risks. These “quasi-real estate” investment programs require the expertise of the manager in an ongoing business-related service or trade that must create value for the co-owners after acquisition of the property through development, production, sales or husbandry of crops before a return on the investment can be expected.
The co-ownership and operation of existing rental properties does not create a securities risk since the investors receive an ownership interest in existing land and improvements that represents the full present value of their contributions at the time of closing – the moment their funds are placed at risk. Also, rental property acquired with a sufficient down payment can be held without further capital contributions, eliminating the risk that co-investors might default on periodic advances needed to maintain ownership.
Yet-to-be-built construction projects expose the investors’ contributions to all the risks of loss inherent in a real estate development, an activity that creates a risk of loss controlled by securities law.
An infinite number of persons and factors – contractors, subcontractors, laborers, material suppliers, architects, construction lenders, building permits, insurance, costs, etc. – must be coordinated to complete the improvements, without which the investment program cannot succeed.
On the other hand, remote, unusable land does not make as attractive an investment as do other types of property, even though its co-ownership does not create a securities risk since it is purchased merely to be held for profit on resale. Remote, fallow land is unlikely to see its value increased by surrounding development or economic activity any time in the near future.
Also, remote land can be difficult to own. Since the land lacks any use and generates no income, investment groups tend to grow tired of the constant contributions for insurance premiums, taxes and loan payments required of owners of unusable property.
Undeveloped land that is not remotely located can make a successful investment if the syndicator correctly anticipates the land will appreciate in value due to local economic conditions and surrounding development.
However, the members of the LLC must be willing to make periodic contributions of additional funds to carry the property since undeveloped land generates no income. If the LLC is formed to purchase undeveloped land, the operating agreement will include a provision requiring members to make additional cash contributions based on assessments set by the manager.
Escrow period
After entering into a purchase agreement to acquire property for syndication, the syndicator should wait 120 days or more before closing escrow. A typical 120-day timetable of events following the syndicator’s entry into an agreement to purchase an existing income-producing property, comprises the following periods of activities:
First 30 days: The completion of a due diligence investigation of the property and clearance of contingencies.
Next 15 days: The completion of the investment circular, articles of organization (LLC-1) and LLC operating agreement.
Next 45 days: The solicitation of investors and full subscription of the membership in the LLC.
Remaining 30 days: Extra time, if needed, to fund and close escrow.
If the LLC is not fully subscribed within 45 days after the investment circular is first presented to investors, it thereafter becomes increasingly unlikely that the LLC will ever be fully subscribed. Without investors, the syndicator will not be able to close the purchase escrow.
Taxwise, escrow should be opened in the name of the syndicator for the same reason the syndicator makes the offer to purchase in his name – to establish his ownership of property rights in the form of a contract right to purchase real estate in his name. Before closing, the syndicator will file an LLC-1 with the California Secretary of State and assign his purchase rights to the newly formed LLC.
To accomplish the assignment and fund the closing, the syndicator should consider opening two separate escrows. The first escrow is the purchase escrow, in which the syndicator as an individual is initially named as the buyer. During the escrow period, the syndicator’s right to purchase the property is assigned to the LLC in exchange for a Class B membership interest in the LLC.
Thus, the purchase escrow is opened by the syndicator (as an individual) and closed by the LLC. Title to the real estate will be vested in the LLC.
However, neither the LLC nor the members should initially deposit funds in the purchase escrow. The deposit of funds is the function of the second escrow, known as a funding escrow. The sole purpose of the funding escrow is to hold the funds contributed by the LLC members in a separate escrow from the purchase escrow until the purchase escrow can be closed.
Escrow is instructed to transfer the funds deposited in the funding escrow to the purchase escrow only when the purchase escrow can close and vest title to the property in the LLC.
The purpose of the two escrows is to allow for the release of the investors’ capital in the event any complication interferes with the closing of the purchase escrow. The investors can recover the funds deposited in the funding escrow without the consent of the seller in the purchase escrow.
Alternatively, when investors deposit funds directly into the purchase escrow for the benefit of the LLC, some escrows allow a return of those funds. Escrow receives the funds under a “receipt of third-party deposit,” stating the conditions for use or return of the funds. The investors are third parties, the seller and the LLC (by assignment from the syndicator) being the contracting parties.
Another option for investors is an interest-bearing bank account in the name of the LLC that will hold the investors’ funds until disbursement to the purchase escrow when it can close.
Controlling the property
Consider a syndicator who locates an income-producing property that appears suitable for an LLC investment program and can be acquired on acceptable terms.
However, the syndicator initially will not enter into a purchase agreement, an arrangement that would commit him to the unconditional purchase of the property. Only after he has fully investigated and approved the condition of the improvements and operations of the property, called a due diligence review, will he be willing to commit to the purchase of the property. Also, the syndicator needs time to prepare an investment memorandum, which he will use to solicit and subscribe investors to contribute to the purchase and joint ownership of property.
To control the property without unconditionally committing himself to its purchase, the syndicator has a variety of contract forms to choose from, including:
a purchase agreement with contingencies;
an option to purchase the property; or
escrow instructions with contingencies, but without an underlying purchase agreement or option to purchase.
A contingency is a provision in a purchase agreement setting forth a condition that must be satisfied or waived by the syndicator. If the condition is not satisfied, the syndicator can cancel the agreement and avoid any obligation to purchase the property.
Contingency provisions the syndicator must approve of should include the condition of the property’s improvements, leasing income and operating expenses, financing, title condition, natural hazards and conditions surrounding the location. [See first tuesday Form 159]
The purchase agreement or escrow instructions should include a contingency that allows the syndicator to cancel if he is unable to fully subscribe an LLC investment group to fund the acquisition of the property.
Escrow instructions entered into in lieu of an option or purchase agreement must include the contingency provisions necessary to the syndicator. When a written purchase agreement does not exist and written escrow instructions are the only documents entered into by the syndicator and the seller, the escrow instructions take the place of a purchase agreement as the contract binding the syndicator and seller. [Tuso v. Green (1924) 194 C 574]
Thus, any contingencies in the escrow instructions, when an underlying written purchase agreement does not exist, have the same effect as contingencies in a purchase agreement. However, if a purchase agreement exists, the contingencies stated in it do not need to be restated in escrow instructions unless they are of concern to the escrow officer since escrow instructions merely carry out the performance by each party to close the transaction as agreed to in the purchase agreement.
The syndicator, as the buyer, should also include a vesting provision in all purchase offers he makes, allowing him to assign his rights under the purchase agreement to the LLC and receive the seller’s cooperation to deed the property directly into the LLC vesting. [See Form 159 §§10.6 and 13.3]
Purchase options
Sellers tend to be uncomfortable with purchase agreements loaded with contingencies. The contingencies could interfere with the seller’s ability to cancel the transaction should the syndicator be unable to close the purchase by the scheduled date and be unwilling to cancel the transaction.
Also, a seller might not want his property subject to a binding purchase agreement that may ultimately be rendered unenforceable by the syndicator’s use of contingency provisions to cancel the transaction.
An acceptable alternative for the seller might be to grant the syndicator an option to purchase the property. In an option agreement, the seller grants the syndicator an irrevocable right to purchase the property within a fixed time period, called the option period. [See first tuesday Form 161]
After the option period expires, the seller will be able to sell the property to another buyer, unaffected by the expired option. If the option is recorded, the option will not expire as a cloud on title until six months after the expiration date stated in the recorded option agreement or memorandum. [Calif. Civil Code §884.010]
For the syndicator seeking to buy suitable property, the option imposes no obligation on him to purchase the property. The seller, conversely, is obligated to sell, but only if the syndicator decides to buy the property by exercising the option during the option period, which is an acceptance of the seller’s irrevocable offer to sell.
In exchange for the seller’s grant of an irrevocable offer to sell the property, the syndicator pays the seller some consideration for the option, called option money. The option is not enforceable unless the seller receives some consideration, although the amount of the consideration may be as little as $100. [Kowal v. Day (1971) 20 CA3d 720]
Syndicators typically use options with short option periods – three to six months – to control the property and provide time to investigate the property and form an investment group to fund the purchase. The option money might be set at an amount that will compensate the seller for his inconvenience since the property will be off the market during the option period. [See first tuesday Form 161]
Often, a small amount of option money is paid for a short, initial option period, sometimes called a “free-look” period, in which the syndicator completes his due diligence investigation. The term of the typical free-look option is 30 to 60 days, for an option money payment of as little as $100.
However, the syndicator will need more time after the free-look period to decide whether he wants to or can acquire the property. Thus, the syndicator should negotiate an option with one or more extensions following the expiration of the initial option period. More option money would be paid by the syndicator as the need arose to extend the closing date and provide more time to close escrow. [See first tuesday Form 162]
Any number of additional option periods may be agreed to, one following the expiration of the prior period. The number of option periods depends only on the seller’s willingness to grant extensions and the syndicator’s willingness (and ability) to put up more option money.
The seller, for his part, not only receives the option money, but also is assured the syndicator will no longer have the right to acquire the property after the option period expires, even if the option is recorded.
Liquidated damages and liability limitations
Without a purchase agreement or escrow instructions with contingencies allowing for cancellation or an option to buy, the syndicator’s failure to close the transaction exposes him to liability for money losses incurred by the seller.
Usually the only loss a seller incurs on a failed transaction on income property is due to a decline in the value of the property between the time of entry into the purchase agreement and the syndicator’s breach. Money lost by the seller is generally reflected as a reduction in net proceeds on a prompt resale of the property.
Two types of money-damage provisions in purchase agreements address the seller’s losses on the syndicator’s wrongful cancellation or failure to close:
a liquidated damages clause, also known as a forfeiture provision; and
a liability limitation provision.
A liquidated damages clause sets out a fixed sum of money the syndicator will pay the seller in the event he breaches the purchase agreement. The syndicator agrees to pay the amount whether or not the seller lost money due to the breach.
However, liquidated damages clauses are unenforceable by sellers in real estate transactions, as liquidated damages constitute a forfeiture, which is barred by law. [CC §3275]
To recover money damages on a wrongful cancellation or unexcused failure to close, the seller must first prove he sustained actual money losses (the amount he may recover) as a result of the syndicator’s breach. A liquidated damages clause allows a seller to claim money without having to prove he sustained any losses, thus, the clause is unenforceable by law.
As an alternative to a liquidated damages clause, the syndicator and the seller may agree to limit the syndicator’s liability in the event of the syndicator’s breach of the agreement. If agreeable, a purchase agreement is used which contains a liability limitation provision stating the maximum dollar amount of seller losses the syndicator could be liable for. [See first tuesday Form 159 §10.7; see Figure 1]
With the liability limitation provision, the seller is limited in his recovery of money losses to the actual amount of losses incurred due to the syndicator’s breach, but the amount may not exceed the agreed-to limitation.
Thus, if the syndicator wrongfully fails to close escrow on a purchase agreement he entered into and a drop in the property’s value occurs before his breach, the limitation on the syndicator’s liability has already been set, no matter how far the property value has declined after entering into the purchase agreement.
A purchaser’s lien for the deposit
The syndicator generally makes a cash deposit, called a good faith deposit, as part of his offer to purchase a property. Occasionally, the deposit is in the form of a postdated check or promissory note, payable into escrow after due diligence contingencies are eliminated and the syndicator intends to close escrow.
If the syndicator breaches the purchase agreement after making a deposit, he is entitled to recover the deposit, less money losses actually sustained by the seller due to the breach.
For example, a syndicator breaches a purchase agreement at a time when the rental property’s value is equal to or greater than the price agreed to by the syndicator in the purchase agreement. Thus, the seller has lost no money on the value of the property due to the syndicator’s cancellation and is entitled to recover nothing, unless the seller altered the property’s occupancy, reducing his rents at a loss, as called for in the purchase agreement.
Since escrow is not going to close, the syndicator demands the return of his deposit. The seller refuses to authorize the release of the syndicator’s funds, claiming the deposit is forfeited, as agreed, due to the syndicator’s failure to close escrow.
Since forfeitures in real estate transactions are barred by law and the seller will not return the syndicator’s funds, the syndicator is entitled to a purchaser’s lien on the seller’s property for the amount of the good-faith deposit. The purchaser’s lien is enforced by filing a judicial foreclosure action and recording a lis pendens on the property. [CC §3050]
