Leveraging a Sale: Case Study
In a depressed real estate market, sellers must be willing to offer inducements to buyers that in “normal” markets would not be contemplated. Such inducements can be viewed as “leverage” in the broadest meaning of that term, i.e., giving something extra to the buyer just as financial leverage in the form of borrowed funds gives the buyer a higher return than in an all-cash deal. The following shows how a "leveraged sales contract" can provide both buyer and seller exactly what they are looking for and allow the transaction to proceed.
Excess Space for Sale
Consider this example: A retail chain undergoing a consolidation sought to
sell well-located retail space for a relatively high asking price, all cash.
The sale would include an adjacent parcel of raw land. After several months,
the property was still available and came to the attention of an investor
with experience in retail operations who believed the recession was coming
to an end. She was able to negotiate a contract calling for a price
acceptable to the seller but with an unusual degree of leverage that made
the contract desirable to her.
The essential terms of the contract were these:
| Purchase price | $400,000 |
| Cash | $100,000 |
| Purchase money mortgage | $300,000 |
In addition, the contract of sale had the following provisions:
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The down payment was to be $10,000 (10% of the cash price), and in the event the buyer failed to go through with the purchase, her liability would be limited to the down payment (i.e., no personal liability).
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Closing of title was to take place eight months from the date of contract, with the buyer to have the right to accelerate the closing on 30 days' notice.
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The purchase-money mortgage was to be for 10 years at an interest rate of two percent above the prime rate of XYZ Bank. The mortgage would be standing (no amortization for the entire term). A release clause in the mortgage would permit the buyer to sell the parcel of vacant land separately from the building upon the payment of $50,000 to the seller in reduction of the mortgage. The mortgage also would be pre-payable at any time without penalty.
The buyer was to have the right to market the property during the eight-month contract period. This included the right to put signs on the property, advertise and give interested persons the right to inspect the property. If the buyer found a third party who wished to buy the property, the seller would extend the same purchase-money mortgage terms.
Varieties of Leverage
Each contract condition above represented a different aspect of
leverage; together, they added up to a satisfactory risk-reward relationship
for the buyer, even in a poor market.
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The first provision, 10% down payment as liquidated damages upon default, gave the buyer control of a $400,000 parcel for $10,000, only 2.5 % of the purchase price.
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The second provision, a delayed closing, gave the buyer eight months during which she could arrange a resale or find a tenant.
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The third condition, purchase money mortgage, created traditional financial leverage, particularly at a time when the prime rate was low and trending lower, since this would reduce the already-low interest rate. In addition, the absence of any amortization reduced debt service payments.
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Finally, the right to sell the vacant land (then worth $100,000) upon payment of only $50,000 in reduction of the mortgage also created a leverage factor. By selling the land for all cash, the original cash investment of $100,000 would be reduced by half.
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The fourth and fifth provisions gave the buyer the right to market the property during the contract period, together with a right to pass along the benefits of the purchase money mortgage to a new buyer.
Why Seller Agreed
From the seller's point of view, there were several good reasons for
agreeing to the terms the buyer wanted:
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The seller had been unable to sell or lease the property for several months.
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The contract price was reasonably close to the original asking price.
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The seller was a professional investor with a record of success.
What Happened
After three months of intense effort, the buyer negotiated a 21-year net
lease with a retail chain. The tenant would pay all operating costs, but not
the debt service on the purchase money mortgage. As an inducement to the
tenant, the initial rent was set relatively low to step up in stages over
the first ten years of the lease. The figures worked out as
follows:
| Net rental | $60,000 |
| Mortgage interest – (8.0% of $300,000) | $24,000 |
| Net cash flow | $36,000 |
| Cash-flow return on $100,000 | 36% |
The investor in this example
could have used a long-term option rather than a sales contract. Two reasons
for preferring the contract approach are: (1) an option expires
automatically at the end of its stated term, whereas the purchaser under a
sales contract has a right to an adjournment for a reasonable time (unless
the contract specifies that "time is of the essence"); and (2) a sales
contract signed by the parties lessens the likelihood that disputes may
arise later as to the terms of the deal or the intentions of the parties.
Real Estate Focus is provided by Somerset’s Real Estate Team for our clients and other interested persons upon request. Since technical information is presented in generalized fashion, no final conclusion on these topics should be made without further review. For additional information on the issues discussed, please contact Michael Fritton, CPA. Whether you are a building owner, building manager, real estate developer, real estate professional or an investor, we hope to provide you with timely information so you may be proactive in making your business decisions.
This article was written by and published herein with the permission from professionals of BDO Seidman, LLP. John Tax is a Director in the Real Estate and Hospitality Services practice in BDO Seidman’s New York office. Somerset is a member of the BDO Seidman Alliance, a nationwide association of independently owned accounting and consulting firms.
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