The Top Three Reasons for Real Estate Purchase Contract Disputes and How to Avoid Them
Part I: From the Seller’s Perspective
1. Buyer fails to close
A Seller’s primary objective in a real estate purchase agreement is straightforward: To collect the purchase price. The most common impediment to closing on a sale and receiving the purchase price is a Buyer who simply refuses to go through with it. In most cases, Buyers get cold feet because something unexpected comes up after the purchase agreement is signed. The best way to manage this risk is to be clear about the contingencies in the contract.
For instance, the financing contingency. Generally, a purchase agreement will give the Buyer 30 – 60 days to arrange for a loan to pay the purchase price at closing. The shorter the financing contingency, the sooner a Seller will know if there is going to be a problem with this contingency. It’s also a good idea to require the Buyer to be prequalified up front. Most form purchase agreements require the Buyer to deliver to the Seller a “Loan Status Update” within ten days after contract acceptance, and upon request thereafter. Sellers rarely insist on it. But it’s a great tool to ensure that financing is on track.
The inspection contingency also needs careful attention. The inspection period should be well-defined. The best way to avoid having a Buyer cancel during the inspection period is to repair any property defects prior to listing the property and to promptly and fairly disclose any material defects that haven’t been repaired. Generally, if a Buyer fails to give a signed, written notice to Seller of any disapproved items before the end of the inspection period, then the Buyer cannot refuse to close based on the condition of the property.
Of course, setting the earnest money deposit at the appropriate level will go a long way towards avoiding a voluntary default by a Buyer. The amount of the earnest money deposit should be commensurate with purchase price—usually between 5% and 10%. A Buyer offering little or nothing as earnest money is obviously less committed to close on the transaction.
2. Alternative Financing
In a normal real estate transaction, the Buyer pays the entire purchase price at closing. In some cases, however, the Buyer promises to pay the Seller a portion of the purchase price after closing in the form of a promissory note. This is known as a “seller carryback.” Some Buyers favor seller carryback arrangements because they cannot qualify for traditional financing. Some Sellers are willing to do a seller carryback because they are motivated to sell, or so they can earn a favorable rate of return on the loaned portion of the purchase price.
From a Seller’s perspective, it is critical to properly secure a seller carryback loan. The Seller should understand the problems in the Buyer’s credit that presumably precluded traditional financing to complete the deal. If a traditional lender wouldn’t extend financing, why should the Seller? To guard against the obvious risk of default, the property should be pledged as collateral through an ironclad deed of trust signed and notarized by the Buyer at closing. The deed of trust should then be recorded with the County Recorder as soon as possible. This will make the lien on the property public record. That is important so that any subsequent transfer or encumbrance of the property by the Buyer is junior to the deed of trust.
The second critical element in a seller carryback transaction is the promissory note. The promissory note specifies the interest rate, payment dates, and maturity date of the Seller’s loan to the Buyer. To reduce the risk of default, a Seller should include certain provisions to make the promissory note enforceable, such as an acceleration clause, default interest rate, and a late fee clause. Keep in mind that a Seller may be subject to specialized lender obligations under the Dodd Frank Act if the Seller completes more than one carryback loan within a 12-month period.
Another popular form of alternative financing is a lease/option arrangement, sometimes called “rent to own.” This arrangement is most useful when a Buyer is not yet qualified for traditional financing, but expects to be soon. The Buyer simply rents the property until a future date when an option to purchase the property is available. This arrangement should be undertaken in two separate documents: a lease agreement, outlining the parties’ agreement for the Buyer to rent the property for a time; and an option agreement, specifying the Buyer’s right to purchase the property at a future date. Generally, the Buyer pays an option price up front for the right to purchase the property later at a given price. All or part of the option price could be refundable. It is also common for a portion of the rent to be applied to the purchase price if and when the option is exercised. It is critical for the lease agreement to be consistent with the option agreement and for both documents to have appropriate safeguards for the Seller to avoid problems.
Arizona law also allows for a third method to structure a sale of property known as a contract for deed, sometimes also known as a land contract. A contract for deed is essentially a very drawn-out purchase contract. A Seller agrees to deliver possession of the property to the Buyer in exchange for the Buyer’s commitment to make periodic payments towards the purchase price. Once the payments have been made, the Seller agrees to convey legal title to the property to the Buyer. In the meantime, the Buyer has equitable title to the property, which is essentially the right of ownership. If the Buyer breaches the agreement by failing to make the required payments, the Seller must resort to a complex statutory process called forfeiture to recover the property. The Seller under a contract for deed should not risk fraud by borrowing against the property, as some Sellers are tempted to do since they are still the owners of record until the conclusion of the transaction. Rather, a Seller should keep careful records of payments received by the Buyer and respect the limitations of a contract for deed to avoid disputes.
3. Broker Commission Disputes
This third category of dispute relating to purchase contracts involves a third party—the Broker, or real estate agent. In most cases, it involves a former Broker of either the Seller or the Buyer claiming a commission at the conclusion of the transaction. Here, both Sellers and Buyers should be cautious about how they hire and fire their agent. The obligations and limitations of a listing agreement should be considered as carefully as the purchase agreement. In some cases, the resolution of a purchase agreement dispute between a Seller and Buyer can still result in liability to a Broker. Sellers should be cautious about pursuing Buyer leads from a Broker who they don’t intend to compensate. The best way to guard against disputes with a Broker is to be clear in the purchase contract about who the authorized agents are for both parties, and for both the Seller and the Buyer to indemnify each other against the claims of any other Broker claiming a commission as part of the transaction.
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