Gimer Law

MD and DC real estate law

Tom Gimer

Novations — what most investors do not know

Most investors can’t accurately describe what a novation is. Of the small percentage who can, only a handful know how to properly structure and conduct a transaction involving one. This post should hopefully help you understand better when and how a novation could be used in your investing, and therefore improve your REI business.

The primary thing most investors don’t understand about novations is that a novation, when used as a real estate investing method, is a three (3) party agreement. Through the execution of a novation agreement, the original contract between Seller A and Purchaser B is replaced… with a new contract between Seller A, Purchaser B and Third Party Purchaser C. In the terms of the novation agreement between these three, Purchaser B’s rights and responsibilities under the original contract are terminated (conditionally, more on that later) and Third-Party Purchaser C becomes obligated to close with Seller A. Without the agreement between all three parties, the original contract between A and B would remain in force, creating a clear title issue.

So when might a novation be the preferred structure? Then answer is when some material element of the original contract between A and B, other than the total purchase price to be paid by C, has changed or must change to make the deal work. If nothing other than the price was changing, B would simply assign his contract rights to C for an assignment fee… and no novation would be necessary. But let’s say the contract between A and B contains some terms that C either cannot or will not take on, such as paying all transfer and recordation taxes (a very common element of investor offers), making repairs to the property, or paying real estate commissions. A straight assignment of the original contract would not allow C to change any of the terms that A has already agreed to… but by using a novation structure those issues and more could be addressed in a new agreement in such a way that A and C can now move forward (with B patiently watching and waiting to make sure all goes well).

So through a novation, A, B and C enter into a new agreement that works for all of them… A gets the price it wanted, B earns its profit, and C gets the property on its terms.

I’m sure you are now wondering how you can possibly change the structure of an existing transaction through a novation. Well of course Seller A has to agree to do so. And the easiest way to make sure that can happen is to include a provision permitting such a change in the original contract. Having the seller agree up front to accept a particular net purchase price but also allowing the flexibility for the original contract to either be assigned to an end buyer OR novated with a third-party purchaser is critical. You need a seller that is happy taking $X dollars from closing, and they don’t care HOW that occurs, only that IT DOES.

An important thing to keep in mind is that your contracts must be iron-clad to stand up to title insurer scrutiny. And what that will require is full disclosure, full transparency. The seller must execute all agreements personally (certainly not through an attorney-in-fact related to Buyer B!) and the agreements must be unambiguous. Of particular importance to consider, through the novation structure the responsibility for any payment to B (the investor) may need to be shifted to the Seller. That fact must be made clear — including the dollar figures themselves — or the deal may blow up at the settlement table. Since the Third-Party Purchaser C may be unable to pay an assignment fee to B (think of this in the context of the end buyer turning out to be a first-time retail homebuyer with little to no cash) and any lender involved may be unwilling to factor the full increase in purchase price between the original contract and the novation into their underwriting, the increase in the purchase price in most novation arrangements results in the Seller A paying Investor B the spread. If that last point comes as a surprise on closing day, everything could fall apart.

So as to this last point, what happens when our Third-Party Purchaser’s financing goes sideways late in the transaction? By only conditionally terminating the A–>B contract in the novation agreement, this allows B to step back into the deal if/when C defaults. So B reserves the right to close (or even re-assign the deal) and still make money. Are you starting to understand now why a solid three-party agreement is essential?

As an investor, unless your contracts are perfect, there are numerous ways your novation is going to fall apart at or prior to getting to the settlement table. So don’t wing it! You need solid agreements and guidance when this may be the correct way to structure a deal.

The top 3 reasons your closing isn’t happening

All 3 of the top 3 reasons your closing isn’t actually going to close relate to the seller being unaware of liens on the property (or unaware of the true payoff amounts).

Reason 1: Loan modifications. When someone gets a loan modification, they are often unaware of the new second mortgage that becomes attached to the property as a result. Many owners are understandably eager to complete the loan modification process and reduce their monthly payment, but they don’t actually understand what they are agreeing to. No, the lender doesn’t just lower the rate and monthly payment… more often than not there is a federal program that allows the loan mod to happen. Through the modification process, the original loan balance and the monthly payment are reduced… but those funds are not forgiven — they don’t just disappear. Instead, a portion of the principal amount due under the first mortgage is taken away and a second note is created which is secured by a junior, federally insured mortgage, in that amount. There are no monthly payments on this second mortgage, and no interest accrues on the balance. However, the second is a lien on the property that must be paid in full when the property is sold or refinanced. Since they haven’t been making payments, sellers can forget about the open second mortgage when they sell. And when they sign a sales contract for less than is owed, the deal can fall apart late in the title process. If you want to learn more about this topic, search for HUD partial claim mortgages.

Reason 2: Lender write-offs/charge-offs. During the great recession of ~2008, most residential property values plummeted. Owners who had purchased their properties using high leverage (for example, using 100% financing via an 80% first mortgage and a 20% second mortgage), found themselves way underwater. Many simply stopped paying the second mortgages… and lenders stopped pursuing them for payment. Eventually those second mortgage lenders faced a tough decision — either foreclose their junior lien on an upside-down property (not smart) or write off the debt. Writing off the debt was an easier, less costly decision. Many owners, however, did not understand that the second mortgage, even though the lender was no longer trying collect, was still a valid lien against the property. These non-performing seconds were often sold for pennies on the dollar to creditors. Yes, they are still accruing interest and yes, they still need to be paid off. Charged-off and forgotten second mortgages can be a grenade waiting to blow up your transaction.

Reason 3: Old judgments and liens. Depending upon where the property is located, a judgment may be a lien against real property interests of the owner for twenty or more years. And certain liens — such as some state tax liens — they never expire. So for a seller who has held a property for a long time and has forgotten about old debt, things like this can ruin a planned settlement. The interest rate on judgments can be 10 percent or more (check local law on post-judgment interest) so with an unexpired judgment lien from 10-20 years ago, the seller may be facing a payoff that is now double or even triple the original amount. That can be a shocking disappointment when discovered after going under contract… because it can create a scenario where the seller is unable to close.

Sub-to: protecting the seller

One topic that does not get much coverage is how to protect the seller in a subject-to transaction. There are several ways.

1 – A wrap. A wrap mortgage (also known as a “wrap-around” mortgage) is a type of lien that gets recorded in the land records as security for the seller. It’s a junior lien, meaning it is subordinate to the existing financing that has been left in place but it is called a wrap because it wraps around or includes the current note. The wrap often consists of the balance of the original loan plus an amount to cover the new purchase price for the property if that difference (which equals the seller’s equity) is not paid at settlement. Wraps can be either at the exact same interest rate as the existing financing or at higher rate. In the latter scenario the seller would make monthly money on the spread. In this context, see my message below regarding note servicing companies.

2 – A subordinate lien with balloon payment. If the sub-to purchaser does not have the cash to pay for the seller’s equity at settlement, the seller may instead decide to take its equity in the form of a second trust with a balloon. For example, let’s say the seller has $50,000 in equity at the time of the subject-to purchase. To get the deal done the seller may agree to finance that $50,000 at a reasonable interest rate but with a balloon payment due in 1-3-5 years. This arrangement enables a purchaser to get into a property with less out of pocket and enough time to renovate or improve the property. The plan would then be to either sell or refinance to get the seller paid when the balloon becomes due. The difference between this and a wrap is the wrap would typically be payable over the full term of the underlying mortgage… i.e., there would be no balloon payment. This method gets the seller paid out earlier.

Whether a wrap or stand-alone subordinate lien are used to secure the seller, a note servicing company should be engaged. This is very important. Note servicing companies handle the collection of funds, make loan and other payments, and take care of reporting. The use of a third party also allows the seller to monitor things at a distance and make sure the underlying mortgage is being timely paid.

3 – A performance deed. A performance deed (also known as a “pocket” deed) is a deed from the buyer back to the seller that is executed at settlement but held in escrow. The deed is not delivered to the seller — delivery being a requirement for a valid conveyance in most jurisdictions — unless and until the buyer defaults. If the buyer never defaults, the deed is destroyed in accordance with the agreement between the parties and the escrow agent. While I don’t recommend this method because it creates issues relating to the future insurability of the property (from a title insurance perspective), it can achieve at least one desired result. Ordinarily a seller would need to bring an action to foreclose their lien against a defaulting sub-to purchaser in order to repossess the property. Foreclosures take time and foreclosure attorneys cost money. Using a performance deed enables a seller to retake title to the property without going through that process and spending those funds. That can of course save the seller big on costs but it can also lead to other problems. I plan to post on this soon in the context of deeds in lieu of foreclosure executed prior to default.

While the above seller protections are certainly useful, none of them will help if a lender invokes the due on sale clause and accelerates the full balance of the underlying mortgage. The only solution in that unfortunate event is money. I discussed that issue in my prior posts on the dangers of subject-to. I recommend you read those posts.