This article discusses the liability of a breaching seller for any increase in the interest rate on a buyer’s purchase-assist loan and the buyer’s attorney fees incurred to enforce their purchase agreement.
Future shock in a recovery
A buyer and his agent have been working for over a year to locate and buy a home at the lowest possible price. They have observed sales volume, loan originations, property prices and construction starts decline without an increase for the past three or four years.
However, interest rates are now falling from their highs during the past two or three years, as are foreclosure rates and the level of unsold inventory of listed and newly constructed homes.
The buyer senses the lull forming the bottom of this real estate recession is about to end. A comparable market analysis for properties the buyer is interested in indicates prices are no longer dropping, but are firming. Construction starts are even beginning to turn up and lenders are reported as being more lenient on credit scoring, qualifying buyers who a year ago could not qualify for financing.
Realizing that the dynamics of the local real estate market are changing and the prices will soon start to rise due to a reduction in available properties from which to select a home, the buyer decides now is the best time to make an offer. The buyer and his agent review the properties they have determined would be a suitable residence for the buyer. Offers will be made at the best (lowest) price possible for a purchase at the end of this recessionary phase in the real estate sales cycle.
Soon after making a few offers, the buyer enters into a purchase agreement with a seller to acquire a property. The purchase agreement contains a provision which conditions the close of escrow on the buyer arranging and recording a purchase-assist loan to fund his acquisition of the property.
Prior to the date for the close of escrow, the seller discovers real estate values have surged upward, driving up the value of his property beyond the price the buyer has agreed to pay. Seeing he can get a much greater price from a flood of prospective buyers in the suddenly competitive market, the seller cancels his sale escrow instructions days before the scheduled closing.
The buyer makes a demand on the seller to close escrow as agreed in the purchase agreement and escrow instructions, which the seller rejects. The buyer files a specific performance action to enforce the purchase agreement and require the seller to close escrow. At trial, the buyer prevails and the seller is ordered to close escrow.
An offset for increased interest
To continue with the prior example, interest rates offered by lenders on the purchase-assist loan called for in the purchase agreement have increased during the time lapse between:
· the date scheduled for performance (close of escrow) in the purchase agreement breached by the seller; and
· the date of the specific performance judgment ordering the seller to convey title and close escrow.
Can the buyer recover as part of his specific performance judgment the amount of the increased interest the buyer will pay on the purchase-assist loan he must now arrange to pay the purchase price and close escrow?
Yes, the cost of increased interest is recovered as a direct offset on the purchase price. When a seller breaches, it is foreseeable interest rates on purchase-assist financing called for as a condition for payment of the purchase price will rise by the time the seller is ordered to convey the property to the buyer. Thus, it would be unreasonable for the buyer to pay both the original purchase price and the increase in the interest rate on a fixed rate loan when the increase is brought on by the seller’s delay in conveying title until the time of a court ordered specific performance. [Hutton v. Gliksberg (1982) 128 CA3d 240]
If the interest differential in the increased rate on the purchase- assist financing available at the time the purchase agreement is enforced by specific performance was not borne by the breaching seller, the buyer would be economically deprived of the benefit of the lower interest he arranged at the time escrow was originally scheduled to close.
Conversely, if interest rates were to drop by the time the buyer is awarded ownership of the property in a specific performance action, none of the buyer’s economic windfall due to the financial benefits of lower interest rates becomes a credit to the seller since:
· the seller cannot benefit from his misconduct which prevented the timely closing [Calif. Civil Code §3517]; and
· the buyer has incurred no loss.
The price paid and attorney fees
Consider a buyer who enters into a purchase agreement with a seller to buy real estate. Prior to closing, the seller cancels the transaction. The buyer files a specific performance action to enforce the purchase agreement and acquire the property. The buyer prevails and the seller is ordered to deed the property to the buyer.
Having prevailed at trial on his specific performance action, the buyer now takes steps to enforce the attorney fees provision in the purchase agreement. The buyer seeks to directly offset the amount due on the price he will pay for the property by deducting the amount of the attorney fees he is awarded.
Can the buyer deduct the attorney fees award directly from the purchase price of the property?
No! An attorney fee award must be collected from the seller after recording the abstract of judgment for the attorney fees. The judgment for attorney fees is separate from the terms for payment of the purchase price. If the amount of the attorney fees were to reduce the purchase price of the property as an offset to the amount due the seller, that enforcement of a money judgment for attorney fees would function retroactively as a super lien on the seller’s property. As an offset to the price to be paid, an award of a money judgment for attorney fees would have priority over any liens recorded on the property prior to receiving the judgment for attorney fees, as well as priority over the amount of the seller’s homestead exemption.
Additionally, the amount due the seller for his price as called for in the terms for payment of the purchase agreement would be improperly altered by an offset. The buyer must pay the total amount due the seller on the purchase price and then, on close of escrow, collect the money due to him for his attorney fees by recording and executing on an abstract of the money judgment based on the priority status of the abstract to other liens on title. [Behniwal v. Mix (2007) 147 CA4th 621]
Unlike the interest rate differential on the purchase-assist loan which was part of the terms for payment of the purchase price in our prior example, the recovery of attorney fees for enforcing a purchase agreement is separate from the price paid for the property. A judgment for attorney fees cannot take priority over liens and homestead claims arising before entry of the money judgment for those attorney fees. Hence, the issue of priority of claims on the price paid to the seller.
Calculating interest losses
Two accounting formulas exist for calculating future money losses a buyer will incur due to the interest differential in the increase in interest rates on his purchase-assist fixed-rate loan:
· the loan-term formula, based on the dollar amount of increased interest the buyer will pay over the full term of the loan, discounted to its present value based on current capitalization rates [Hutton, supra]; or
· the ownership-term formula, based on the dollar amount of increased interest the buyer will pay over the buyer’s anticipated holding period before a refinance or resale, discounted to its present value. [Stratton v. Tejani (1982) 139 CA3d 204]
A buyer financing his purchase with a variable or adjustable rate loan (ARM) is not likely to incur unexpected interest rate loss when interest rates increase. The buyer’s bargain for ARM financing is to pay the prevailing short-term rate, adjusted monthly, quarterly or semi-annual, for the duration of the loan.
For example, monthly payments on a loan origination at a fixed interest rate of 14% with a 30-year maturity on a principal of $400,000 would be $4,739.49. The same loan amount and amortization period at 9.25% carries a monthly payment of $3,290.70.
The difference in the monthly payment resulting from the increase in the interest rate is $1,448.79 per month. Over 30 years, this difference will cost an additional $521,564.40 in actual out-of- pocket dollars.
Discounting the dollar amount of the increase in payments at the then current rate of 14% over a 30-year period results in a present cash value of $122,274. Thus, under these loan conditions, awarding the buyer $122,274 now indemnifies the buyer for the increase in monthly payments he will later pay due to the seller’s breach.
The loan-term formula indemnifies the buyer for future losses over the entire life of the loan. The likelihood the buyer will refinance or resell before the loan term expires calls into consideration the ownership-term formula.
The alternative ownership-term formula of accounting requires a determination of how long the buyer intends to retain ownership of the property subject to the high interest rate loan. Does the buyer intend to retain the property or the fixed-rate financing for a short-, medium- or long-term period?
The ownership period during which the seller will pay an increased interest rate under the ownership-term formula runs until the date it is anticipated the buyer will resell or refinance the property. Thus, the buyer is not awarded a windfall if the interest rate in the mortgage market drops and the buyer refinances or he resells the property, putting an end to his payment of the higher interest rate. In this instance, the ownership-term formula is more equitable and economically prudent than the loan-term formula.
To establish the buyer’s probable ownership period before a refinance or resale would likely occur, consider:
· whether the property is the buyer’s principal residence, business or investment property;
· the cyclical nature of the rise and fall of interest rates on ten-year treasury notes;
· the buyer’s prior ownership history;
· the ratio of the monthly payments to the buyer’s income; and
· the buyer’s employment history.
A persistent high level of interest on fixed-rate mortgages eventually translates economically into lower property values. This reciprocal movement between rates and values is due to the sympathetic and concurrent rise in capitalization rates used by real estate investors when interest rates rise. Thus, a court award of the present worth of the increase in interest payments during a buyer’s ownership functions in all respects as a discount on the price the buyer and seller agreed to in the purchase agreement.
These same financial and economic arguments apply to lower pricing when a buyer makes a decision about financing a property acquisition during a period of high interest rates on long-term mortgage financing.