While it continues to be a buyer’s market when it comes to commercial real estate in West Michigan, one giant caveat stands in the way of many purchases: securing a loan.
Today’s current lending environment continues to make it difficult for buyers to obtain the financing needed to acquire commercial real estate. As a result, sellers needing to move distressed property are often left wanting for buyers.
All of this is with good reason: Traditional banks are still reeling from the write-downs they have taken on bad loans over the past several years. Many banks continue to hold non-performing and under-secured loans in hopes that the market will recover, or merely to postpone taking a loss.
Banks have tightened credit and underwriting standards and reduced the available pool of money for new loans. This is compounded by the continued depression in the market value of real estate, which makes it less viable as loan collateral. Often, sellers and buyers are unable to put together a deal that both would want because they cannot navigate the financing process.
Rise of the land contract
Deals are being done — and one increasingly popular method of selling commercial real estate in this market is by land contract.
A land contract is an executory contract under which the seller retains legal title to the property, but the buyer immediately obtains possession and equitable title to the property. In essence, a land contract is a seller-financing tool that anticipates that the seller will continue to own the property until the contract is paid in full.
The buyer agrees to purchase the property for a contract price, often makes a down payment to secure the deal, and then pays the contract in installments. As with a traditional bank loan, each payment is a combination of interest and principal.
Under this arrangement, the seller remains liable to its initial mortgage lender and remains responsible to make mortgage payments as they become due. The seller takes payments received from the buyer and then turns around and pays its lender. When the contract is paid in full, the seller — who has retained title to the property — conveys the title of the property to the buyer free and clear of seller’s original mortgage.
Selling property on land contract that is encumbered by an existing mortgage requires the review and approval of the mortgage lender. The lender may be willing to consider a land contract sale because such an arrangement may increase the chance that the lender will be paid in full on its loan. As part of any such land contract sale, however, the lender will demand assurances that its security will not be compromised by the transaction.
Buyers in such arrangements will want to know that if they perform their obligations under the land contact, they will be able to obtain marketable title to the purchased property. Typically, the lender, seller and buyer enter into a separate agreement under which they address how the relationship will work and how the land contract will work in the context of the existing loan documents.
Three goals, one agreement
To minimize or avoid disputes, the buyer, seller, bank and their respective counsel need to consider each party’s hopes and fears while negotiating the land contract and related consent agreement.
To address the needs of the seller:
- Seller should perform a thorough review of the background and credit-worthiness of the buyer to ensure that the buyer is a suitable party. Practically everything bad that can happen to the seller will likely result from a buyer breach of the land contract. Under the land contract, the buyer takes custody and control of the property from the seller. The seller needs to have comfort that the buyer will not act in a manner that will violate seller’s covenants under the existing loan documents.
- Seller needs to make sure that its lender consents to the land contract and will not consider the agreement a breach of the existing loan documents or an event that will cause the acceleration of the existing loan indebtedness.
- Seller should insist on adequate remedies in the land contract so that the seller can require buyer’s performance in a manner that is acceptable to seller and its lender. If the buyer breaches its obligations under the land contract, the seller should have the right to accelerate the indebtedness under the land contract.
- Seller should also insist that the buyer properly maintain the property and appropriate insurance on it so that seller’s collateral for buyer’s performance under the land contract is preserved.
To address the concerns of the buyer:
- Just as the buyer may cause significant problems for the seller, the seller may also cause trouble for the buyer, particularly if the seller is under financial distress. The buyer should insist that all sums under the land contract payable to seller be made either directly to the charging party or to the lender. This increases the likelihood that seller will be able to deliver marketable title at the end of the contract term. The parties could also establish a monthly escrow account, controlled by the lender, for property taxes and insurance premiums.
- The buyer must secure consent from the original mortgage lender and its agreement that, if the buyer satisfies the terms of the land contract, the lender will discharge the mortgage. Not only will this require the buyer to make timely installment payments under the land contract, but also to carry the appropriate insurance, pay taxes, etc.
- The buyer must obtain from the original mortgage lender a non-disturbance agreement, under which the buyer may remain in possession of the property even if the bank takes steps to foreclose against the seller. This agreement often allows the buyer to bypass the seller and continue to pay the loan amount directly to the bank.
- Just like any other purchase, the buyer must perform appropriate due diligence on the property to ensure that the asset being purchased is suitable for its purposes. While the seller may make representations and warranties as to the condition of the buildings or other improvements, the buyer should perform its own environmental assessment, building inspection, title search and related research before signing a contract.
- To avoid title issues, including those unrelated to the existing bank financing, the buyer should insist upon obtaining a vendee’s policy of title insurance at the time the buyer executes the land contract.
To address the needs of the bank:
- The bank must insist that the buyer perform the obligations necessary to preserve its collateral. Specifically, the bank needs the right to enforce the buyer’s obligations under the land contract including the duty to maintain the property, pay taxes, pay utilities, maintain insurance, etc.
- The bank should also insist that the land contract remain subordinate to its mortgage and that the mortgage should be paid in full before the bank has duty to discharge. Note: Since the buyer may not wish to be liable for every obligation under the existing loan documents, the bank may need to allow for a discharge of the mortgage if its principal balance, accrued interest and protective advances are all paid.
To be successful, land contracts require good dialogue between all three parties involved. Recognizing and addressing potential stress points at the outset will increase the likelihood that the deal, when complete, will benefit all parties involved.
James J. Rabaut is a partner at Warner Norcross & Judd LLP. Rabaut practices in all areas of real estate law, including commercial lease negotiations, commercial construction programs, economic incentives, acquisitions and related areas. He can be reached at firstname.lastname@example.org or (616) 752-2178.