Flipping Commercial Real Estate
Assignment Rights and Damages.
Recently, a couple of our law firm’s clients entered into flipping transactions for commercial real estate. In each instance, our client was dealing with the “original buyer” (or “flipper”). The original buyer tied up the property and sought to make a profit by assigning their purchase agreement to our client, who would become the “ultimate buyer.” In one transaction, the original buyer was successful flipping the real estate, making nearly $200,000 with zero money down, but, in the other transaction, the original buyer lost its $150,000 earnest money deposit.
A flip transaction generally takes one of three forms:
1) Assignment. The original buyer (a) enters into a purchase agreement with the seller, and (b) prior to the closing, assigns the purchase agreement to the ultimate buyer who closes the transaction.
2) Double Escrow. The original buyer (a) enters into a purchase agreement to buy the property from the seller, (b) enters a second purchase agreement to sell the property to the ultimate buyer, and (c) closes both transactions simultaneously.
3) Buy/Sell. The original buyer (a) executes a purchase agreement with the seller, (b) closes the transaction, (c) increases the property’s value, and (d) promptly resells the property.
Purchase Agreement Provisions for the Original Buyer.
To be able to assign the purchase agreement and protect its downside risks, the original buyer should focus on the assignment and damages provisions in its purchase agreement with the seller.
Assignment. As a general rule of law, purchase agreements may be assigned unless the contract contains a provision that limits or prohibits the right of assignment. Notwithstanding this general rule of law, many purchase agreements identify the buyer by adding the tagline “or assignee” after the buyer’s name. The addition of the “or assignee” tagline confirms the intentions of the contracting parties and the general rule of law favoring unrestricted assignment rights. But, buyers beware: inclusion of the tagline and the presumptive right to assign may be subject to other contract provisions that limit or restrict the buyer’s right to assign. Such restrictive provisions must be analyzed to determine if the addition of “or assigns” truly gives the buyer an unfettered right to assign the contract. If not, the original buyer should address these provisions to its satisfaction. As will be discussed in a subsequent article, adding “or assigns” may also help satisfy the ultimate buyer’s closing requirements in a manner that increases the odds for a successful closing.
Damages. The assignment of the purchase agreement to the ultimate buyer will not release the original buyer from liability unless the contract contains a provision specifically releasing the original buyer from liability upon assignment, or the seller subsequently agrees to release the original buyer from liability, both of which are very rare occurrences. In most instances, therefore, the original buyer will remain liable under the purchase agreement for breaches by the ultimate buyer.
The original buyer should seek protection against two primary liabilities:
1. Damages in the event the ultimate buyer breaches the purchase agreement and fails to close; and
2. Damages to the property or personal injuries caused during the ultimate buyer’s inspection of the property.
The best way for the original buyer to limit its liability in the event of an ultimate buyer breach (failure to close) is to negotiate that liquidated damages equal to the earnest money deposit will be seller’s sole and exclusive remedy under the purchase agreement. With this accomplished, the original buyer’s and ultimate buyer’s liability for failing to close is limited to the amount of the earnest money deposit. Since most assignment agreements require the ultimate buyer to substitute its funds in place of the original buyer’s earnest money deposit, the liquidated damages will be covered by the ultimate buyer’s earnest money deposit, effectively limiting the original buyer’s risk. There is, however, a risk that the original buyer could be liable for seller’s attorneys’ fees in the event the ultimate buyer disputes the right of the seller to receive liquidated damages and the seller prevails. (Methods to minimize the original buyer’s liability for attorneys’ fees and techniques to reduce the original buyer’s liability for property damage and personal injuries, which may include insurance and indemnification, will be discussed in more detail in subsequent articles.)
Sellers generally loathe dealing with flippers. First, the original buyer, if successful, makes a profit that the seller believes they should be pocketing. Second, if the flipper is not capable of closing the transaction on its own, there is a higher probability that a transaction will not ultimately close, which will result in a waste of seller’s time, resources and money.
Sellers of commercial real estate generally loathe dealing with flippers. First, the original buyer/flipper, if successful, makes a profit that the seller believes he or she should be pocketing. Second, if the flipper cannot close the transaction on its own, a higher probability exists that the sale will not close at all, resulting in a waste of seller’s time, resources and money. This article, the second in a series, examines ways in which a seller can defend against its property being tied up by a flipper. (The first article in this series analyzed the needs and concerns of the original buyer in a flip transaction).
In order to profit from flipping by assignment, the flipper must be able to assign the purchase agreement to the ultimate buyer. The right for an original buyer to assign the purchase agreement is not inherently harmful to a seller. In fact, prior to the closing, most original buyers (who are not flipping) assign the purchase agreement to a new entity formed by the original buyer solely for the purpose of acquiring and owning the property. Such newly formed entities are often created to shield other assets from risk or to satisfy a lender’s requirements for the property to be owned by a single purpose/single asset entity.
Crafting a Protective Assignment Provision for Sellers.
A well-crafted assignment provision allows the original buyer to assign the purchase agreement to a new entity formed by the original buyer solely for the purpose of acquiring and owning the property, and prohibits the original buyer from flipping the purchase agreement to an unrelated third party for a profit.
In order to protect against the flip, Sellers should craft an assignment provision in the purchase agreement that:
1. Permits assignments by the original buyer to an entity owned and controlled by the original buyer (or, if the original buyer is an entity, to an entity owned and controlled by the owners of the original buyer).
Drafting Tip: Sellers should not agree to add “or assigns” after the name of the original buyer. Inclusion of “or assigns” language could be interpreted to be in conflict with restrictive assignment provisions in the purchase agreement. This could result in the original buyer having the right to assign the purchase agreement.
2. Prohibits assignments by the original buyer to an entity not owned and controlled by the original buyer (or, if the original buyer is an entity, to an entity not owned and controlled by the owners of the original buyer).
3. Prohibits, if the original buyer is an entity, the transfer of ownership interests in the original buyer as a subterfuge to avoid the restriction provisions described in paragraph 2, above.
4. Prohibits the original buyer from entering into an agreement to sell the property prior to the closing.
Note: Without this prohibition, the original buyer could enter into an agreement to sell the property to a cash buyer who would make an acquisition loan (secured by the property) to the original buyer, enabling the original buyer to close on the purchase of the property. Then, after the first closing, the cash buyer would acquire the property from the original buyer in consideration for the release and satisfaction of the acquisition loan.
5. Recites that the seller entered into the purchase agreement and agreed to the purchase price based upon the unique qualifications and abilities of the original buyer to close the transaction.
6. Requires the original buyer, as a condition to seller’s obligation to close, to certify its compliance with the assignment provisions in the purchase agreement.
There may be circumstances where a seller actually intends to deal with a flipper. For example, a seller might want to sell to a syndicator with a strong track record for closing transactions, even though an assignment to unrelated third parties will be required for the transaction to close. Still, regardless of the circumstances, it’s wise for a seller to start negotiations with a purchase agreement containing a strong “anti-flipping” assignment provision. If the assignment restrictions are objectionable to the original buyer, the seller can quickly flesh out the original buyer’s true intentions regarding the acquisition. Also, as with all negotiations, the parties can always agree to modify the “starting” assignment provisions in a manner that makes sense for the transaction.
Call DeVries & Associates today for a free consultation! 808-465-2500