3 Tips For Stronger Real Estate Contracts
If you are getting into the business of real estate investing sooner or later you will need a contract. You are spending your hard-earned money to invest in a valuable asset. A strong contract is your shield and one of your strongest lines of defense. Your first should be due diligence. A weak contract can be the difference between you making an outsized profit or being left holding the bag on behalf of someone else’s negligence.
In the ideal world we could rely on credibility or reputation to make a binding verbal agreement. All involved parties would keep their word, and all expectations would match reality. Unfortunately in the real-world “life” happens. And when reality falls short of expectations, blame gets thrown around and it is easy to forget what expectations even were. Written contracts bridge this gap.
Contracts are a series of lessons
When people say “life happens” this often carries the negative connotation of a failure or mistake. In reality, it is not a failure but rather a lesson, an opportunity for growth. In reality “lessons happen!” Contracts are built on summaries of these many lessons and precedents. Lessons someone else has already learned so you do not have to learn them the hard way.
The next time “lessons” happen, take notes and update your contracts so you will be better prepared for future transactions. It’s a good idea to have a standard contract that you use and update with each transaction and can draw from when the other party is providing the contract.
Reading someone else’s contract may give you some clues as to lessons they may have learned (keep this in mind when negotiating). Having a trained attorney look over your contracts will help as attorneys are reviewing many contracts, have learned many lessons and can clue you in on the most important high yield lessons. Ones that you may not have even thought of.
Plan for the worst-case scenario
With contracts being a series of lessons there are definitely some lessons that you do not want to learn the hard way. To improve your odds, imagine the worst-case scenario. (This is harder than it sounds, especially if you are in an unfamiliar transaction). Once you’ve imagined this nightmare scenario, bolster your contract so that you are protected in the event that this worst-case scenario becomes reality. It is also important to plan for the most common outcomes. These are usually included in the standard boilerplate contract.
It is impossible to predict everything that can happen as there will be external forces out of your control. Anticipate that transactions may take longer than expected or cost significantly more than expected. How will you protect your interests if this occurs? If you are having trouble seeing potential risks ask yourself “How could this go wrong?” Warning: Don’t dwell too long here though, if your mind goes too far down this rabbit hole you may start wanting to back out of the deal. Don’t panic, plan-it! Instead of backing out, prepare a plan for these situations. Taking on risk is what makes investors rich. No risk, no reward.
There will always be risk going into a real estate transaction, known and unknown. Even when you imagine the worst-case scenario there may still be other scenarios that you overlook. To offset this, ensure your contract is structured with built-in alignment of interests.
Ensure alignment of interests
What does alignment of interest mean? Simply, that outcomes of a transaction affect participating parties equally. For example, if an action benefits one party it should also benefit the other. Some common ways to do this are through withholding of payments or imposing monetary penalties based on failure to perform. Or a more positive psychology would be built-in rewards or incentives for both parties to perform.
For example a contractor receiving a bonus for finishing a job within budget and timeframe constraints. This benefits you as the property becomes profitable sooner, you make more money and save money by staying within budget, and benefits the contractor who also makes more money. The alternative would be to deduct payment for work that runs beyond deadlines. This decreases your profit as well as the contractor’s profit.
Removing the bonus is a good start as it removes a potential benefit the contractor may earn. However it is not fully aligned. If the contractor receives his full pay for the prolonged project he has not suffered any loss while you have lost marketing time, and have incurred additional expenses. Deducting payment is more fully aligned as both parties are taking a loss. This structure encourages both parties to take actions that promote mutual success.
A note about monetary reinforcement/ penalties. The dollar amount should be high enough that it will affect both parties. This should be relative to the value of the transaction and the net worth of the parties involved. If you are selling a $5 million dollar apartment community and someone escrows only $5000, if that $5000 is an insignificant amount to that investor relative to their net worth there will be limited motivation for them to act (from a monetary penalty standpoint exclusive to this single transaction)
Don’t agree to terms that unevenly benefit the other party and increase risk for you and your partners. If any clause of the contract has this effect then it does not align the other party’s interest with your own. Think of a potential worst-case scenario and renegotiate this clause so that it will be better aligned.
Bonus tip: Take it Slow
In the sage words of John Legend, Take it slow. Take your time- if it feels like a transaction is moving too fast, you are no longer in control. It is entirely possible for a transaction to move quickly (and sometimes they must, think motivated sellers) and not feel rushed. How you feel about the pace of a transaction is an intuitive indicator about how in control you feel and how in control you are.
If you are not in control of the transaction the risk of you making a compromising decision will increase. This is a common manipulative tool some investors use to either get bigger discounts or more profitable sales. For instance, the use of phantom offers, creating a sense of urgency during a purchase to make you overbid in desperation.
The next time you are staring down that 8.5 x 14 inch legal size paper remember these tips to strengthen your real estate contracts:
1-Contracts are a series of lessons
2-Plan for the worst case scenario
3-Ensure alignment of interests
4-Take it slow
They will help mitigate your risk going into any contract related transaction. Interested in learning more about investing in multifamily apartments? Give us a call or check out some of the other free resources we have available at Investupmultifamily.com.