There are several ways to add value to commercial real estate, but one of the least known is by adjusting the language of the contract of sale in order to ensure you have the least risk possible. This is done by adding contingencies to the contract which allow you control of the property with as little financial investment as possible.
While you’ve probably heard of mortgage contingencies, there are other types of contingencies that can help you make the BEST of the risk-reward equation.
What Is Your Goal?
Before you decide what contingency to implement, you should first examine your goals for the property and decide what outcome is most important to you. For example, if you’d like to renovate a warehouse facility, but there was an environmental spill on an adjacent property that affects this property, then you’ll first want to know if it’s possible to clean up the contaminants for a reasonable price.
In that case, you’d want a contingency that allows you to back out of the deal if the cost of cleanup is more than you’d like to pay. By adding a clause that specifies the limit of what you’d be willing to pay for cleanup in order to the deal to go through, you give yourself time to address the issue thoroughly.
Even if it costs you a certain amount of money to determine whether or not the property can be cleaned up – for example, for an initial evaluation of the area by a specialized cleanup crew – you’ll know the cost beforehand, preventing costs from spiraling out of control.
Zoning contingencies can be an excellent way of finding a property that isn’t being put to best use. For example, let’s say you find a warehouse at the edge of a popular urban neighborhood that has a mix of baby boomers and millennials. All of your data shows that the nearby neighborhood has almost no vacancies, and tenant demand is starting to push the edges of the area outwards.
This means that if you can change the zoning of the warehouse, which is located in a primarily industrial area but is right next door to some of the hottest real estate, you’ll be able to renovate a depressed property and see a significant PROFIT.
In this case, you can approach the owner with earnest money and an offer to purchase the property if the zoning goes through. When wording the contingency clause, here is what you should include:
- You agree to purchase the property only after a zoning exemption or change is obtained, and the period of time for making an appeal has passed.
- The deposit is given as part of the contingency clause, not as an option payment. This means that if the deal goes through, the money is counted as part of the payment, whereas if it does not, the money is returned to the seller. This differs from option payments, where the money goes to the seller even if the sale doesn’t go through.
Don’t forget that the contract will continue to be in effect even if you meet all these conditions, so you need to cancel the contract in writing.
Another type of contingency clause is one that rests upon the purchaser’s ability to acquire another property.
In this case, the investor would like to purchase an adjacent property with the intention of either tearing down both buildings and re-building on the property or of renovating both buildings as one unit. A savvy investor would make sure to ensure to set a ceiling on how much they are willing to pay for the second property; otherwise, the seller can legitimately say that they have an opportunity to acquire the property but chose to forego it.
This is the most common contingency. Most investors think of mortgage contingencies from the buyer’s side. However, there are certain clauses that can be included from the seller’s side that ensure the buyer is serious about purchasing the property.
In a standard mortgage contingency, the purchaser states they will purchase the property if they receive a mortgage on the property. However, as a seller, you need to clarify several questions first:
- How much of a mortgage will they be asking for?
- Is it reasonable to assume they will actually get that amount?
- If the amount they are asking for is reasonable, what about the mortgage terms?
As an investor, you would also want to ensure the purchaser can’t tie up your property indefinitely. You want to make sure the purchaser doesn’t decide to invoke the contingency and get the down payment back without having made a serious effort to fulfill the clause. Language that specifies EXACTLY how much time they have to seek a mortgage would PREVENT this.
Realize that not all sellers will be keen on using a contingency. Some will reject them outright, while others will waffle on exactly what the clause should say. However, if you choose sellers of distressed properties who are looking to sell, you can take advantage of the opportunity to add value to a property before you even own it.