Chapter 13
In This Chapter
Honing your negotiating skills
Understanding how to make an offer
You and your real estate team log many hours in locating and valuing property. Then comes the moment when you must decide whether you want to try and buy a particular property or keep looking for a more attractive opportunity. In this chapter, we discuss how to negotiate a deal that meets your needs as well as the seller’s. Finally, we cover the all-important details of real estate investment contracts.
You make money in real estate when you purchase your investment property. If you buy a well-located and physically sound property below market value and replacement cost, the property will provide you with excellent returns for many years. This is why smart negotiating is so important to being successful with your real estate investments.
Superior knowledge combined with superior negotiating leads to superior returns. This section explains how to be a champion negotiator.
Although everyone approaches negotiating from their own perspective, we think that it’s important to understand that the real estate community in most areas is actually a close-knit group of professionals who network. Thus, word of mouth referrals and a reputation for honesty and integrity are critical elements to your long-term success. Patience, vision, and perseverance are also great virtues when it comes to making the best real estate deals. Hard driving, one-sided transactions may make you some extra money in the short-run, but word travels fast.
A university study indicates that people who have a favorable experience share their positive feelings with an average of four others. However, those who’ve had a negative experience go out of their way to tell more than 20 people how they feel about you. Human nature also indicates that they likely embellish the story with each conversation.
Here’s what we don’t recommend:
The problem with many aggressive negotiating techniques is that you can get so wrapped up in just making the deal that you forget what you’re doing. You can make some serious mistakes and buy properties that you should’ve eliminated during your pre-offer due diligence. Don’t get emotionally involved in any potential property. You’re buying investment real estate, not your dream home.
The most important negotiating tool in an investment property purchase is superior knowledge — if you’re unwilling to do the homework necessary to justify the right price, you’re almost guaranteed to overpay for real estate. Your goal as an investor is to set the maximum price that you can pay and still receive a solid return on your investment in light of the associated risks.
In order to achieve this goal, you need to know more about your proposed property acquisition than anyone else, especially the seller. You need to know about the property, neighboring properties, local and state laws, and all of the economic data we discuss in Chapter 10 that can help foretell which properties are in the path of progress versus those that have already seen their best days. Although an occasional seller dramatically underestimates the true market value of the real estate, the vast majority of properties you see offered for sale are overpriced. That is true regardless of where the real estate market pricing cycle is, including after a downturn in prices. You may encounter some sellers who enjoyed significant price appreciation over the preceding years but stubbornly refuse to accept that demand for their property has fallen and that prices must adjust to the current market reality. Of course, some of these sellers aren’t really motivated and are just hoping to find an uninformed buyer. Don’t let that be you!
We don’t suggest that you mislead anyone, but an amazing number of current property owners just don’t pay attention to even the most basic publicly available information. Nothing is immoral or illegal about having vision to upgrade and renovate a property to achieve its full value because your research with local agencies indicates that a major new employer is moving into the area, dramatically increasing demand for half-vacant and tired commercial properties — like the one you’re considering for purchase.
You’ll be extremely successful in negotiating great real estate deals if you not only know the right people and have a good real estate investment team but also know the important factors that affect supply and demand in the local market.
Maybe you’re seeing local companies growing rapidly and hiring lots of new workers. You know that because of a local housing shortage, the many new families moving into the area will be unable to afford a new home and will need to rent instead. That’s a good sign that rents will increase and the demand will be high for nice three- to four-bedroom rental homes located in quiet cul-de-sacs near the best schools. Clearly, you can use this information to properly negotiate the purchase of prime rental homes in such a market.
Or perhaps the final approval by the local transit district to extend a new light rail line into and through a rundown area of the community may really be a catalyst for positive change. So you do your homework and find an older couple who has lost interest in their commercial property in that area. You purchase and renovate this small retail strip center across from the new station because you know it’s an attractive location for retail tenants targeting commuters.
Determine the current supply and demand in the marketplace so you know whether it’s a buyer’s or seller’s market. That doesn’t mean you can’t still make some great real estate investments, but you need to be realistic. Buying in a seller’s market at prices above replacement cost can be dangerous. Don’t even consider it if your goal is a short-term hold on the property.
As the potential purchaser, discover as much as you can about the property and the owner before making an offer. How long has the property been on the market? What are its flaws? Why is the owner selling? The more you know about the property you want to buy and the seller’s motivations, the better your ability to make an offer that meets everyone’s needs.
Most real estate investors utilize the services of a real estate agent, who usually carries the burden of the negotiation process. Even if you delegate responsibility for negotiating to your agent, you still should have a plan and strategy in mind. Otherwise, you may overpay for real estate.
Some listing agents love to talk and will tell you the life history of the seller. Encourage this free flow of information. The goal for you and your agent is to get the seller or his agent to reveal helpful information (without sharing any pertinent or strategic information about yourself). Always seek the answer to the most important question: “Why is the property owner selling?”
The more you know about the seller’s needs and motivation, the better you can structure your offer to best meet the needs of the seller while still providing yourself with a great investment opportunity. You can also avoid wasting your time negotiating with a fake seller who isn’t motivated to sell. Some sellers are really just testing the market or only willing to sell if they can get a price well over the market value.
Figure out how to spot these fake sellers early on. Look for the warning signs such as unexplained delays in responding to offers or questions, a reluctance to answer questions or give you access to the property, and a generally uncooperative attitude. If you see these signs, don’t make an offer on the property.
Information is a two-way street. Don’t give out any information about your motivations that gives the seller added negotiating leverage. The less you say about how much you like the property or your reasons for making the offer, the better. For example, many sellers are able to stick to their full price terms and as-is condition of the property if they know that the buyer is in a tax-deferred exchange (see Chapter 18) with its tight time restrictions. A buyer facing the possibility of paying significant capital gains taxes if she doesn’t close the transaction within 180 days may suddenly be agreeable to almost any reasonable condition requested by a seller if she’s down to her last week.
Information is the heart of negotiating. Bring facts to the bargaining table. Get comparable sales data to support your price. Too often, investors and their agents pick a number out of the air when they make an offer. If you were the seller, would you be persuaded to lower your asking price? Pointing to recent and comparable investment property sales to justify your offer price strengthens your case. Rarely do you find a seller of investment-grade real estate who doesn’t have access to plenty of market data. But sellers often don’t select the right comparable properties — preferring to creatively use just those comps that provide for the highest possible asking price.
If the property needs repairs, never rely on bids provided by the seller. You must independently verify the numbers with licensed professional contractors. You can also use these written proposals to support your position regarding the true cost to make needed repairs instead of just making verbal representations. Always leave yourself a little cushion or wiggle room. We have found that even with the most comprehensive bids from the top industry professionals, any significant renovation or remodeling project is likely to take longer and cost more than is estimated.
In this chapter, we cover and hopefully dispel many of the negotiating theories or fallacies of the get-rich-quick gurus. We don’t want to just tell you what not to do, so here are some examples of realistic and creative ways to negotiate and structure a real estate offer that accurately reflects the value of the property but also provides you with a reasonable return on your investment.
Say you come across an opportunity to buy a great three-bedroom, two-bath house. You live close by, and you know the area is terrific. The house would be an ideal rental because it’s two blocks from an excellent school. You estimate that the property will rent for $1,750 per month, and there’s strong demand for rental homes. The seller is asking $200,000, which appears to be its market value — based on the home having no deferred maintenance. But you know that no rental property has no deferred maintenance, so you call your home inspection contractor. His report indicates that overall, the property is in decent condition, and the big-ticket items of appliances and flooring have recently been replaced. But he also has some bad news: The roof needs to be replaced before the next winter. You contact three reputable roofing contractors, and the best value bid for a roof replacement that’ll last 20 years is $8,000. You also estimate that you’ll need about $2,000 in minor repairs and upgrades to the landscaping and the irrigation system.
What should you pay? If you said $190,000, you aren’t necessarily wrong, but you’re not providing any room for unforeseen events — or any compensation or reimbursement for your time and the risk involved in overseeing and coordinating this work. We suggest that you take your actual conservative estimates for all repairs and add at least 50 percent. Cover those surprises that are likely to occur, plus compensate yourself for the time, effort, and risk associated with renovations. Contractors and other professionals always allow for contingencies, overhead, and profit when they present their bids, so why should a real estate investor who invests her sweat equity utilizing her own handyman or contracting skills not be equally compensated? This is one of the biggest (and most avoidable) mistakes that novice real estate investors make.
Price is only one of several negotiable items, but it’s the first item the seller reviews in a purchase offer. Because many sellers fixate on the price they receive for the property (perhaps they want to get at least what they paid for it themselves several years ago), you can offer the full price but seek other concessions in order to reduce the effective cost of buying the property. These creative offers allow you to pay what the property is worth, and the seller can feel satisfied that he held firm and received his full asking price:
The time that you need to close on your purchase is also a bargaining chip. Some sellers may need cash soon and concede other points if you can close quickly. And the real estate agent’s commission may be negotiable too. Finally, try as best you can to leave your emotions out of any property purchase. This is easier said than done, but try not to fall in love with a property. Keep searching for other properties even when you make an offer — you may be negotiating with an unmotivated seller.
The purchase and sale of real estate are always done in writing. The most critical document in any transaction is the sales contract, which is referred to as the purchase agreement in real estate transactions. After you have found a property that meets your investment goals, have your real estate agent prepare a real estate contract for presentation to the seller or her agent. Refer to
www.dummies.com/extras/realestateinvesting for a sample purchase agreement.
A real estate contract is a legally binding written agreement between two or more persons regarding an exchange of some sort. These contracts are legally enforceable sets of promises that must be performed and that rely on the basics of contract law. (Contracts may also be oral, but as we discuss later in the section “Elements of a contract,” oral contracts should be avoided.)
Real estate contracts can be either bilateral or unilateral:
A legally binding contract is valid because it contains all of the necessary elements that make it legally enforceable. In the following list, we outline the basic elements of a legally binding and enforceable real estate contract. The terms may sound a bit technical, but you need to be familiar with them.
Virtually all offers have a specific expiration time. (“This offer is valid until Friday, January 19 at 5 p.m. EST only.”) You want to allow the seller a reasonable time to receive, consider, and evaluate your offer, but enforce the expiration clause to minimize the seller from using the offer as a negotiating tool with other interested parties, shopping your offer around, or trying to entice another buyer to raise her offer. Also, if the offer is open-ended, the buyer has to affirmatively rescind the offer, which is more work and trouble than simply having the offer expire after some passage of time.
Agreements for the sale of real estate must be in writing or they’re unenforceable. Never make an oral agreement of any type regarding real estate no matter how convenient, expedient, or reasonable it may seem at the time. The Statute of Frauds is a legal concept that requires all transfers of real estate to be in writing to be enforceable in a court of law. Real estate–related contracts that must be in writing include sales contracts or purchase agreements, leases for more than one year, real estate loans secured by a mortgage or note, listing contracts and commission agreements with agents, and an employment agreement with an agent to locate property.
A failure to meet all of these essential elements can lead to the contract being declared void. A void contract has no legal force or effect and is unenforceable in a court of law. A voidable real estate contract is one that may be treated as legally unenforceable at the option of a party (usually the injured party) but remains enforceable until that party exercises her option. An example is a real estate contract with a minor that is voidable only by the minor.
Besides all the legal elements, real estate sales contracts specify the sale price and the terms and conditions as well as any contingencies (see the “Using contingencies effectively” section later in the chapter). The contract must be signed and include a standard statement that “time is of the essence,” which ensures that all dates and times of day noted in the contract are important and can’t be ignored by any of the parties without the written consent of the other party; otherwise, there is a breach of the contract. If the contract is breached, the other party may be entitled to monetary damages or can sue to force the seller to complete the sale.
The purchase agreement is the legal document that outlines the details of the transaction for your proposed purchase of the subject property. Depending on where you live, there are other terms for a contract for the purchase of real estate, such as a sales contract, an offer to purchase, a contract of purchase and sale, an earnest money agreement, and a deposit receipt.
No matter what you call it, the purchase agreement is the most important document in the sale of real estate. It includes the basic info — the names of the sellers and buyers, a description of the property, and the proposed financing terms — and indicates how much you pay, when you pay, the terms and conditions that must be met to close the transaction, and the conditions under which the agreement can be canceled and the buyer’s deposit returned.
Don’t let a real estate agent tell you that your offer must be on a certain form, because although many purchase agreement forms are available, none are required. Which form you use is up to you — we recommend that you use a purchase agreement form that’s easy to read and understand. The more complicated the language, the more likely it is that the parties get confused or disagree on the meaning of the terms of the offer.
To find forms to use in your real estate investment activities, look to local title and escrow companies and your local association of realtors. Although legally up-to-date and often very thorough and excellent, most of these firms and Realtor boards don’t offer their proprietary forms to the public. Robert’s good friend, the late California real estate attorney James B. McKenney developed plain-language forms used throughout the country by real estate investors and property managers. The sample purchase agreement in the appendix was provided by Cari Lynn Pace, the current owner of Professional Publishing, LLC; website:
www.trueforms.com.
Go over the form in detail with your real estate broker or agent and carefully consider the terms that you want to offer in each paragraph. Don’t leave any blank spaces, and have your attorney mark through any clauses that you feel aren’t appropriate. Just because a certain clause is preprinted doesn’t mean that you can’t cross it out or modify the language to suit your needs. Make sure that you clearly initial any changes and require the other party to also initial every single change and the bottom of each page to ensure that you agreed on the specific terms.
Some of the terms are at your discretion, but your real estate agent can advise you as to the local custom and practice concerning issues such as the standard for earnest money deposits (see the next section) or the length of contingency periods for inspections of the property, books, and records. Your agent can also inform you about local standards for prorating the closing agent costs and the other miscellaneous costs of the transaction.
The following sections cover other key provisions you should carefully evaluate, because you must make many decisions about your offer before the purchase agreement is ready for your signature.
Right after the purchase price, one of the most important terms that can set the emotional tone for further negotiations is the amount of the earnest money deposit you’re willing to submit with your purchase offer. The earnest money deposit is usually fully refundable for a defined time period. Your deposit is held in trust by either the seller’s agent or a title or escrow company. Never make an earnest money deposit payable directly to the seller.
The purpose of the deposit is to show good faith by the buyer and the intention to follow through with the terms of the purchase agreement. The amount of the deposit varies in different areas depending upon local custom or the specific needs of a particular transaction. Also, depending on state law, the earnest money deposit may or may not go into an interest-bearing account. If you can, always insist that your earnest money be placed in an insured trust account that bears interest and that the purchase agreement clearly spell out that you (the buyer) are credited with all interest earned.
Some psychology is involved because the size of the deposit has an effect on the desirability of the offer. An offer with no earnest money or a nominal amount may be interpreted by the seller as coming from a buyer who isn’t serious about the transaction or lacks the cash to make a meaningful deposit. From the perspective of the seller, with occupied rental income properties, the tenants are often disrupted or inconvenienced with any potential sale of the rental property. The seller rightfully won’t want to bother his tenants with a buyer and his due diligence unless he is confident that the buyer has every intention of going through with the transaction if the property checks out. The size of the earnest money deposit can often separate the sincere buyers from those buyers just looking.
A lousy recommendation suggested by some real estate investment gurus is for the buyer to offer a promissory note with her offer. That’s a sure way for a seller to identify that you’re not a serious buyer. Such no-money-down seminar graduates may be classified as bottom-feeders or opportunists who are really only interested in properties with desperate and uneducated sellers.
When determining the earnest money deposit, remember that if you don’t live up to the agreement or don’t cancel it within the allowed time frames, you forfeit the deposit to the seller. The forfeiture of the earnest money deposit for nonperformance is called liquidated damages, which is essentially the payment for any and all damages incurred by the seller as a result of you not completing the purchase as proposed. Under the terms of most purchase agreements, a seller who keeps the earnest money deposit can’t sue for any further damages.
To avoid any expensive lessons about earnest money, follow this advice:
Many purchase agreements specifically include a clause giving the buyer the ability to assign his interests to another party. Assignment is the transfer of the right or duties under a real estate contract by the buyer to a third party. This is an extremely important clause for buyers, and we strongly encourage you to include the right to assign the contract as a term of your purchase offer. In the contract, simply include the language “or assignee” after the name of the legal entity indicated as the purchaser. Of course, if the preprinted purchase offer has a clause that prohibits assignment, you need to cross out that language and have both parties initial the change.
Even though we’re not ardent promoters of the buy-and-flip strategy, the ability to assign or transfer your purchase agreement to another real estate investor gives you the opportunity to realize a profit without ever having to close on the deal yourself. When the real estate market is appreciating rapidly, some real estate investors have found that the property has increased in value so significantly that they can sell their contractual position.
In the early- to mid-2000s in certain really hot housing markets, some real estate speculators went to new housing tracts and signed contracts with builders — up to a year or more before the property was built. Then, during the extended contract and escrow period, the value of the property being built went up, so the buyer was able to merely transfer their contractual rights to buy the property at the locked in price and terms to another buyer for a profit.
The reality is that profiting from speculating on new housing tracts isn’t guaranteed or easy. Builders aren’t naïve, and many don’t allow the assignment of the purchase agreement — so the buyer must actually complete the sale and then resell the property to earn their profit, if they actually turn a profit after deducting the costs of two transactions. Also, many builders specify that they don’t sell to buyers from out-of-state or who won’t occupy the homes. Some simply require larger earnest money deposits for speculators, and others actually require the buyer to contractually agree to not sell the property for at least one year. If housing prices fall rather than rise (as they did in the late 2000s in Las Vegas, where it has been conservatively estimated that more than 40,000 homes were previously purchased in this manner), the buyer may have to complete the purchase or lose his earnest money deposit. These facts haven’t stopped many of the late-night infomercial kings from promoting the idea that fantastic returns can be achieved by simply placing nominal deposits on homes to be constructed. We’ve even heard of some charlatans who hold seminars to attract investors willing to fund these speculative ventures or worse yet, use
www.craigslist.com or cardboard roadside signs seeking “real estate apprentice” with the implication that easy money can be made. Often they’re a form of scheme and should be avoided. Our advice is to never invest in real estate with partners that you just met at, or that invite you to attend, a nonaccredited real estate seminar!
The ability to assign your interests in a purchase agreement can be a lifesaver in another scenario. Many savvy investors have gotten into a real estate transaction in which the due diligence time frames have passed and their earnest money is at risk — and they’re unable or unwilling to complete the transaction. This situation typically happens because the buyer has second thoughts, doesn’t have enough money to close, finds a better deal, or doesn’t have the capability to handle the problems with the property. In this scenario, an assignment would allow the buyer to potentially recover his earnest money deposit or even his due diligence costs from another interested buyer rather than walk away and let the seller take the earnest money (and then turn around and sell the property to another party). The buyer who has the property under contract controls the property and can make a deal with other parties.
An important term of your purchase offer is the proposed closing date for the transaction, which determines the anticipated escrow period (see Chapter 14 for escrow information). The length of the escrow period is a matter of negotiation between the buyer and seller, with consideration given to the length of time needed to obtain financing and the amount and complexity of due diligence necessary to complete the sale. A complicated financing transaction, a property in need of a zoning change, or possible environmental issues require a much longer escrow period than a simple transaction.
Of course, the seller is usually interested in selling the property as soon as possible and wants a short escrow period and a fixed closing date; the buyer generally wants as much time as the seller will allow, some flexibility on the closing date, and the unilateral right to close the transaction earlier if he’s completed his work. But the lack of a specific time line can create problems for the seller, particularly if she’s trying to buy another investment in a tax-deferred exchange (see Chapter 18) or has tenants in place who need to be vacated.
The more time for the buyer, the better opportunity he has to make sure he’s not making a mistake — and the seller knows that. But, the seller also knows that many buyers aren’t serious about purchasing the property or use an extended due diligence period to find problems with the property and try to wear down the seller into granting concessions or lowering the purchase price.
Some buyers also use a long escrow period to tie up the property, hoping to find another investor who will pay more for it. If they find one, they can then close escrow and immediately flip the property in a double escrow, which is actually two separate transactions done at the same time. The investor purchases the property from the original owner and simultaneously sells the property to a new buyer, usually at a profit, without really even taking possession of the property other than for possibly a matter of minutes between the recording of the two transactions.
Ultimately, what you agree on in the purchase agreement is legally binding, but it’s really just an estimated closing date because so many different moving parts can affect when you close the sale. The closing date should be met unless both parties agree to an extension with a written addendum or escrow instruction (see “Ironing out straggling issues” later in the chapter).
A contingency in a real estate purchase agreement is simply a condition that must be fulfilled or an event that may or may not happen in the future before a contract becomes firm and binding. Contingencies can be for the benefit of either the seller or the buyer; if the contingencies aren’t met, the deal doesn’t go through. The seller of an estate property, for example, may require a contingency that the probate court approves the sale. Buyers often have contingencies for financing, physical inspections, the review of the current tenant leases and service contracts that will run with the property, and other items. Naturally, sellers attempt to eliminate unreasonable contingencies. For instance, most purchase agreements include contingencies that ask for 10 to 30 days to conduct the physical inspection and/or approve the books and records. If you request 60 days to conduct these items, the seller may reject your offer as unreasonable.
Contingencies are escape clauses that can protect the buyer from purchasing a property that doesn’t meet his needs. Without contingencies, purchasing a property would be extremely risky because you’d have to be sure that you had all of the financing in place and that the property was in good condition, met your needs, and the terms and conditions were acceptable before you even made the offer. Few buyers would be willing to do this, or they’d do it but discount their offer to account for the additional risk.
Although legally different from an option, contingencies can have a similar effect by allowing a prospective buyer the exclusive opportunity to buy the property in a limited time frame but not obligating the buyer to complete the transaction.
The terms of most purchase agreements provide that by certain defined dates, all of the contingencies must be resolved one way or another by the beneficiary, or party that stands to gain from the contingency. After it’s in place, a contingency has one of three outcomes:
Although the list varies depending on the property type, size, and location, here are contingency clauses that we recommend:
In addition to the contingency clauses, many buyers negotiate a separate clause giving them the unilateral right to extend the closing date under certain conditions. For instance, the lender may require an environmental report, which when received indicates that further investigation is necessary before it can make a loan commitment. Or you may need legal action to get access to a stubborn occupant’s property. A well-written purchase agreement provides for an extension of the closing date under such circumstances. Be sure that all parties agree to any such extension in writing prior to the closing date indicated in the purchase agreement to avoid any potential disputes.
Be sure that your purchase agreement clearly indicates what personal property is included. The personal property can be a significant factor in large apartment buildings because it can include the appliances and window coverings, plus common area furnishings and fixtures, as well as parts, materials, and supplies for future maintenance and repairs.
Depending on your plans for the property, you may want the property transferred with or without tenants. If the tenants aren’t on valid and enforceable long-term leases, and you can increase the property value by renovation and gaining new tenants, requiring the seller to deliver the property vacant and what’s called broom clean (free of debris, dirt, personal property, furniture, and so on) at the close of escrow can be prudent. This is also true if you buy a seller-occupied property. Either include a clause requiring that they vacate prior to the close of escrow or negotiate a lease with them for continued tenancy at mutually agreeable terms.
After you and your agent are comfortable with the purchase agreement you’ve prepared, insist that the offer be presented by your agent in person. Although much business today is transacted electronically, the best negotiation is done eyeball-to-eyeball, and your agent can get a much better sense of the other party’s personality and needs and wants through an in-person meeting.
Your offer should include a set time limit for response. Depending on the type of property and the size of the transaction, give the seller 24 to 72 hours from when you believe that he will actually first receive your offer to respond to the offer. The larger and more complicated the transaction, the more time the seller needs to evaluate your offer. The seller can accept your offer as presented, respond with a counteroffer, or even outright reject the offer or simply let it expire. After your offer for the property is accepted, you control the property and you have it under contract.