The Purchase and Sale Agreement (“PSA”) is the game plan and overarching playbook to the transfer of a commercial real estate asset. The PSA is the critical contract between a Purchaser and Seller and is legally binding.
Some Purchasers draft a PSA without a Letter of Intent (“LOI”) if they are confident they are aligned with a Seller. I still recommend to clients who are less sure to start with a LOI as it is a not a legally binding document that is significantly shorter and can more quickly expose if the two parties are not on the same page.
This post describes the drafting process and what changes are necessary for unique commercial real estate types. At the end of the article + video, you can download a template Purchase and Sale Agreement for an apartment (i.e. multifamily) property.
Note from Spencer: This is another post in a growing section we call ‘A.CRE Legal‘. One of Texas’ top real estate attorneys, Ronald Rohde, has graciously offered to share his time, expertise, and open his library of real estate legal templates for the A.CRE audience. Click here to learn more about Ron or to contact him directly.
Role of Purchase and Sale Agreement
The purpose of a PSA is to allow a Purchaser to take control of the land, building improvements, and assignment of leases which all combine to produce a net operating income (NOI). A valuation or a purchase price takes the combination of the NOI with a cap rate. In order to accurately estimate the value of these discounted future cash flows, it is imperative that your assumptions on the asset are true.
Looking to analyze the acquisition of a multifamily investment? Check out Spencer’s Value Add Apartment Acquisition Model.
Assumptions on the Leases
The biggest and most important “Seller representation” is what the current, in place leases are. As a Purchaser, you want to have confidence in future rent production from existing tenants. You obtain such information through reviewing the actual executed Leases, Tenant applications, annual statements submitted to the Landlord/Seller, and through Tenant Estoppel letters.
An Estoppel letter is a statement made by each Tenant verifying the current Lease in effect. It usually includes the monthly base rent, total square footage, and affirms that they are in good standing with the Seller. These are not used in residential acquisitions due to the volume and inability to collect the document from the tenants.
Lease review is often neglected by Purchasers who assume that “all property leases are the same.” However, in poorly run properties, residential leases will vary between tenants; therefore you must review each lease to discover such differences. As a prudent Purchaser, you should evaluate the terms such as a deposit, guaranty, relocation, use, renewal, and other terms which may have been modified by tenants.
Residential Tenant Lease Review
On the opposite side of the spectrum, a multifamily property often has hundreds of tenant leases. It is imperative that the Seller provide copies of all leases to ensure uniformity and confirmation of tenant rents, increases, expiration dates, and security deposit amounts.
These leases can consume significant time and energy, therefore it is important to implement a system to review and summarize the findings.
Assumptions on the Physical Building
The Purchaser will want to understand the condition of the building. As a multifamily owner, the tenants are provided with a gross lease. The primary areas are the parking lot, common areas, roof, lighting, HVAC, plumbing, electrical. These are common expenses which may have significant deferred maintenance.
The PSA will permit Purchaser’s agents onto the property in order to inspect these systems. Speed is often a vital element to both the Purchaser and Seller; the Purchaser wants additional time to complete a thorough inspection while the Seller wants a fast closing. If underlying faults are discovered, contingency language in the PSA permits additional inspections or releases for the Purchaser.
Whether these discoveries trigger a full release or an extension, are up to the Purchaser at the time of drafting. Understanding the likely results, coupled with a clear process and decision making analysis will assist the Purchaser in drafting these clauses.
Assumptions on the Land
Once you review income production and the physical state of the building, let’s analyze the clauses for the Purchaser to evaluate the land.
The value of the dirt under the improvements can represent either a significant percentage of the purchase price (think: San Francisco) or a relatively low percentage, i.e. <10% (think: Lubbock, Texas). To evaluate the land, consider the following:
One of the major concerns for any Purchaser is the underlying soil and potential contaminants. A Phase I Environmental Site Assessment, or Phase I ESA, will conduct a site visit and measure the soils for pollutants that could impart liability to the future owner.
In addition to testing the soil, an ESA will evaluate federal, state, and local databases for storage tanks, petroleum product usage, and any other potential use which could impact the land. Nearly every lender and government agency will require a Phase I including their own requirements.
In any case, if a potential parcel has signs of issues, the vendor will suggest a Phase II ESA which greatly expands the exploration of the potential issues. A Phase I is normal, while a Phase II costs more money and more time.
Federal, State, and Local Compliance
The parcel will likely fall under a complex web of overlapping federal zones, state designations, and local city ordinances or zoning restrictions (unless you’re in Houston!). The interplay between these governing bodies can present hazards to the unwary Purchaser.
However, the PSA can specify what the Seller has knowledge of and which violations, if any, he has received for conducting the prior or existing use. Be sure to add contingency language providing for extensions or cure periods if you suspect zoning or expanded development issues.
Another common source of Purchaser surprises manifest through deed restrictions. Incorporated by prior owners, the restrictions limit the rights of future owners.
For example, a Land Use Restrictive Agreement (LURA) encumbers the multifamily real estate when the owner gives up land use rights in exchange for tax credits. These may take the form of subsidies for meeting certain affordable housing goals. But they typically will all have expiration deadlines. It is key for the Purchaser to review these documents and require the Seller to clear title prior to closing.
We have largely focused on the Purchaser given the natural burden on this party to demonstrate confidence to close. However, the Seller will also carry certain obligations and can push back on many Purchaser requests before signing the agreement.
Seller Obligations in the PSA
The Seller has two main obligations: production of due diligence items and signing over the property at closing. In both categories, the PSA outlines penalties for failing to perform as outlined in the PSA.
If a Seller does not provide a document, the Buyer typically holds the option to waive such a requirement or can terminate based upon that missing document. The Seller also has a broad range of representations and warranties as to the condition of the building, the risk of outstanding liabilities, or the future collection of rents.
When the Seller breaches by failing to execute a Deed or Bill of Sale, the Purchaser will have a remedy of specific performance and request that a judge order the sale of the property. While this is an extreme outcome, you should be prepared.
Video Walkthrough of a Multifamily Purchase and Sale Agreement
A Purchase and Sale Agreement is a powerful tool drafted in lieu of or after a Letter of Intent. As a legally binding document between the Purchaser and the Seller, both parties align on detailed terms. As properties often have unique circumstances, contact an experienced commercial real estate attorney to ensure the agreement meets your specific needs.
In the following video, I walk you through my template Multifamily Purchase and Sale Agreement. Download the template (link below) and follow along. This video is based on v1.0 of the template document.
Download the Multifamily Purchase and Sale Agreement
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- Initial release