A Self-Storage Investment Journey – Chapter 3
A Self-Storage Investment Journey – Chapter 3
The Purchase Agreement
CHAPTER 2 RECAP
In Chapter 2, I wrote about how I found a property, different classes of commercial real estate and how I structured my current deal. I decided to follow-up quickly with an overview of the Purchase Agreement (PA), primarily because it’s fresh on my mind. However, I’m also writing it because it’s not something to take lightly and needs some focus. Make a mistake with the PA, and you can pay dearly! I want to help you avoid some common traps, so here we go.
** DISCLAIMER** This is neither legal nor financial advice. It’s simply me sharing some knowledge. I could be right, I could be wrong…but it’s how I operate and it works for me.
WHAT IS A PURCHASE AGREEMENT?
I know that seems like an obvious question, but I want to spend some time talking about it. You aren’t buying a house, you’re buying commercial real estate so you won’t be using a standard residential contract. In fact, if there are brokers involved, they probably won’t be residential brokers (I’ll talk about brokers in a later chapter). You will need an asset purchase agreement that is specific to the same state as your property. If the seller has a broker, then you should probably get a buyer’s side broker as well. The fees for your broker will be paid by the seller, so there’s no additional cost to you. As a side note – these transactions can easily be done without brokers and can save both sellers and buyers thousands of dollars. Title companies are your friend! Either way, you’ll need a good local CRE attorney who can move fast and offer good advice. I want to stress this, however. You pay a lawyer for advice, NOT to make business decisions for you. You will have to make those yourself, and if you aren’t prepared to do that then you probably shouldn’t be investing in this type of asset. Attorneys are paid to make sure they cover your interests in excruciating detail, and can be extremely conservative and, quite frankly, unreasonable in their requests for terms and conditions. You need to know what’s important to you, and what is just a negotiation. It really comes down to risk vs reward you are willing to take.
Remember, you aren’t buying a business – you are buying the assets of a business. This is a really important concept to remember. If you purchase the business, all the liabilities associated with that business come with it. For example, if there is a judgement pending against the business and you acquire the business, you assume the liability of the judgement. If there is a future employee claim against the business, you are now responsible for the claim, even though you didn’t own the business at the time. It’s extremely important that you execute an Asset Purchase Agreement, and nothing else.
I’m going to take some key components of a PA and break them down so you can be aware of some of the traps and issues involved. But you must HIRE YOUR OWN ATTORNEY.
The first section will identify the buyer and the seller. Seems simple enough, however there is one thing I will recommend. If the seller is an entity such as an LLC, you should identify them as a seller, but you should also try to include the Manager of the LLC individually as a seller. For example, Seller: ABC Storage, LLC and John D Manager, an individual. Why? Because the seller is going to make representations and warrants in the contract about the assets. If they misrepresent the assets, either intentionally or unintentionally, you’ll want to have somewhere to go for recourse. Once ABC Storage, LLC sells the assets to you they will most likely have no other assets and might very well even dissolve as an entity. You’ll want to have someone to go to for your claims. This is pretty important to me, but it’s not a deal killer. If I were a seller, I wouldn’t agree to it but many will and it doesn’t hurt to just throw it in the first draft and see where it goes. An alternative to naming an individual is to establish an escrow account through a separate escrow company where a portion of the purchase price is held for some period of time to act as sort of an insurance for the buyers. If there is a claim, it is made against the escrow account. It’s typical to have these escrow agreements dissolve as the risk of claim goes down over time. For example, you might escrow 10% of the purchase price at closing, and release half of it after 6 months and the remaining half after a year. That gives the buyer plenty of time (and protection) to discover any misrepresentation. I’ve used this arrangement several times, and it works pretty well.
PURCHASE PRICE / TERMS
This is where you can save yourself a LOT of money. You’ll want to work with your CPA, but you will need to break down the purchase price into Land, Buildings and other items such as goodwill, personal property, transition assistance, non-compete agreement, etc. All of these items have value and potentially impact taxes. For example, if you purchase a property for $1M and just allocate it all to the land/buildings, then that’s what the local property taxing authority will base your new property taxes on the next time they assess it. If you purchased the property assuming the current property tax expense and the property was assessed at $500k, then you are going to have a big surprise when the new tax bill comes after being assessed for $1M. All of the sudden your high cash flowing storage business is barely scraping by.
The price allocation also impacts depreciation schedules, so that’s why you really need to work with your Tax advisor to help you decide what is best for your situation. One side note – In the PA, you will want to make sure that your seller will agree to your allocations because it impacts their ability to use a 1031 exchange, as well as give them a potential depreciation exposure based on how they allocated the purchase when they acquired it. You’ll also need them to sign an IRS form 8594 so that both sides report the transaction the same way.
CLOSING DATE / ESCROW
At this point, a closing date is a best guess, so you’ll use an “on or about” date. The dollar amount for Escrow is just like buying a residential property and can be whatever you agree to. Just be clear that it’s fully refundable if the closing doesn’t happen and everyone is in compliance with the PA.
This is where you’ll define how long sellers have to provide you with your requested items, how long you have to review the documents and how long from that point you have to close. Here’s how it will lay out in some form or another. These timelines are simply examples;
- Contract signing date
- Seller to provide list of requested due diligence information to buyer within 10 days of contract signing
- Buyer has 30 days of receipt of due diligence information to object. During this time, the buyer can cancel for any reason.
- Buyer will also schedule any needed inspections and begin financing process if required.
- Inspection period should also have an out clause for buyer and should be able to be extended if buyer is using good faith to get the inspections completed. This covers you if there is a shortage of people in the area to do inspections, and you can’t get them done in 30 days. On commercial properties, you’ll more than likely do at least a Phase 1 environmental inspection, but sometimes your lender will require a Phase 2. Those are not only expensive but can take time to schedule. Just be aware that these can all have an impact on your diligence period, and you’ll need the ability to extend if they do.
- If Buyer needs financing, there will also be an out clause if they aren’t able to obtain financing that meets their needs. There should also be an extension clause should this process take longer than the contract states but is no fault of the buyer.
You will need to provide a list of due diligence items to the seller that they will be required to provide during the first 10 days after contract signing. These are things like a rent roll, pertinent environment, structural and engineering reports if available, certified copy of the past 2 years P/L, etc…basically, anything you need to help you make the decision to close on the property.
TITLE, BROKERAGE FEES AND OTHER MISC SECTIONS
You’ll want to make sure the seller delivers a marketable title. Sometimes the title will have issues and it’s up to the seller (at their expense) to clean those up. Do NOT close on a facility without a clean, marketable title. I always recommend securing a Title Policy and I always take the stance that it’s the seller’s responsibility – unless I’m the seller, then I always take the stance that it’s the buyers responsibility. The point is that this is a negotiable item and you should start in your favor.
The last thing I’ll mention is the survivability of the agreement. Most standard agreements will state that the agreement does not survive closing. I don’t like that, and in fact, on my last Purchase Agreement I threatened to walk the deal unless they would agree to a 1-year survival. It’s a pet peeve of mine, but it might not be for you so listen to your attorney on that. By the way – be very careful on threatening to walk on issues. Make sure they are really, really important. If you are the “boy who called wolf”, and every item is do-or-die, you’ll probably never get a contract completed.
TIME KILLS ALL DEALS
You’ve worked hard to find a facility and get it under contract. It’s time to accelerate and close, not spend weeks and weeks in the minutia. That’s why you need to be able to make business decisions quickly and have an attorney that can keep pace and keep things rolling. Now, having said that – don’t get so in love with the deal that you end up with a bad one. I’d rather spend $10k to find out the deal isn’t going to work, than to sign a bad deal and it cost me $10k per month until I can dump it! Do the work and get it right. This is no place for egos, so ask for help along the way!
That’s enough on this subject – I could pen another 10 pages and still not cover everything, but I hope this little bit of information gets you thinking.
Until the next chapter – Call or email if you have any questions. I’m here to help. Scott