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.