I’m Thinking of Buying a Rental Property…What Now?

real estate attorneyIf you are thinking about buying real estate that has rental units or tenants already on the property, you really should give some strong consideration to reviewing the leases ahead of time.

This applies to residential properties (i.e. apartment units) and commercial properties (i.e. retail, industrial, etc.). Before signing a formal agreement of sale, or even putting an offer in to purchase a property, I recommend that you work closely with your realtor and your real estate attorney and insist upon the following:

Due Diligence

If possible, the buyer should insist upon reviewing all of the leases at the subject property even before making the initial offer. The seller may not be willing to share this information without you making a formal offer and putting a deposit down on the property.

In the latter case, you should make your offer contingent upon a due diligence review of all of the leases within the first seven (7) to ten (10) days of signing the agreement of sale and being satisfied with what you see.

Too often, I hear a buyers say they aren’t going to bother with this due diligence as they intend on changing the terms of the leases once they purchase the property anyway.

This is a huge mistake, as the buyer is subject to/stuck with the terms of an existing lease and cannot force the tenant to change just because there is a new owner. The potential buyer should examine the leases to confirm the monthly rent and if/when the amount changes, the amount of the deposit, the term and renewal options, responsibilities for maintenance and repairs, etc.

If the potential buyer is satisfied with the terms, and the leases fit the buyer’s business plan, then the buyer can proceed with the transaction with a lot more confidence.

If the potential buyer is not satisfied with the terms of the existing leases, and is not confident that he/she can make the transaction profitable with the existing terms, then building a due diligence period into the agreement of sale will allow that potential buyer to terminate the transaction and retrieve his/her deposit.

Estoppel Certificates

In addition to the aforementioned due diligence, a potential Buyer should make his/her offer, and agreement of sale, contingent upon the landlord not only delivering copies of all leases but, just as importantly, delivering statements from each tenant regarding the terms of the said leases (i.e. “Estoppel Certificate”).

In an Estoppel Certificate, tenants sign a form that confirms the terms of the existing lease (i.e. monthly rent, term, security deposit, whether or not the rent is paid to date and the lease is in good standing, etc.).

In addition, the tenants will confirm that they do not have any existing/potential claims against the landlord (the present owner) for alleged violations of the lease. This way, the potential buyer is satisfied that he/she is purchasing the property without, at the same time, purchasing problems, unhappy tenants, etc.

The new buyer will step into the shoes of the existing landlord and will take both the bad with the good with the existing tenants. Requiring that the seller have the existing tenants sign an Estoppel Certificate, and making the transaction contingent upon the delivery of same prior to closing, will provide the buyer with substantial protection; and

Assignment of Leases and Security Deposits and Pro-Ration of Rents

Armed with the above information, the buyer and his/her title insurance company can properly allocate the security deposits with the existing tenants on the settlement sheet at the closing table.

The seller will “pay” the buyer all of the security deposits at the closing table by the title insurance company reducing the seller’s proceeds, and crediting the buyer’s cash requirements, with the amount of all of the deposits. The settlement sheet will document this assignment.

In addition, the buyer’s title insurance company will account for the fact that the seller (i.e. existing landlord) has received rent for the entire month in which settlement occurs and will pro-rate/credit the buyer with that amount of the rent that was pre-paid from the date of the closing to the end of the month.

This way, the buyer is compensated for the rent paid by all of the tenants from the date of closing through the end of the month and will have received all of the deposits (as an additional note, the buyer should then establish his/her own accounts for the tenants’ deposits so that the buyer is prepared to return the deposit if/when the existing tenants properly vacate the subject rental units at the termination of their leases).

Finally, the buyer’s real estate attorney should prepare assignment of leases to be signed by the seller of all of the rights and responsibilities in the subject leases. The assignment should also include an additional notice from the seller to each and every one of the existing tenants notifying that the subject property has been sold, there is a new landlord (with the exact name and address of that new landlord) and that rent due for the next succeeding month should be paid to the new landlord at the address indicated thereon.

The seller should sign the assignment of lease, and notice, at the settlement table and deliver same to the buyer as a condition of closing. That requirement should also be built into the agreement of sale as a contingency.

I have talked to too many buyers of rental properties who have either not been aware of the above, or were advised by their attorney to proceed with same but ignored the advice, and then ended up “buying” problems with existing tenants. The above is also a good way to “test” the organization and credibility of the seller. If the seller is organized and forthright with the existing tenants, the above should not be a formidable task.

Please talk to your real estate attorney about these items to provide you with as much protection as is possible when purchasing rental properties.

— written by David A. Megay, Esq.