LAND CONTRACT FINANCING IN OHIO COMMERCIAL REAL ESTATE TRANSACTIONS

Alternative Real Estate Finance

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Abstract

In a tight credit market, a little assistance from the seller might make the deal happen.

Introduction           

    Although mortgage interest rates have declined recently, some potential buyers of office buildings, industrial sites, or other commercial properties may find it difficult to raise the necessary equity to obtain a favorable interest rate from an institutional lender.  Likewise, some sellers of office, industrial, or other commercial properties are having difficulty attracting creditworthy buyers that are willing to invest cash in today’s depressed real estate market.  
 
            Some buyers and sellers are considering various forms of seller financing to consummate the sale of such properties, including transfer by land contract, sometimes called a “land installment sale.”  Land contract financing for the sale of single-family homes was common in the 1970’s, when mortgage interest rates were high and first time homebuyers found it difficult to obtain mortgage loans from traditional lenders.  As interest rates declined and many lenders began to offer attractive first-time homebuyer programs, the use of land contract financing became less common.  Given the current credit crunch, the time might be ripe for potential buyers and sellers of office, industrial, or other commercial properties to utilize land contract financing to convey real estate.
 

            In a land contract transaction, initially the purchaser obtains possession of the property but not title.  With each periodic payment of the purchase price, the purchaser’s “equity” or beneficial ownership of the property increases.  Upon the final payment of the purchase price, the purchaser receives a deed from the seller and thereby becomes the legal and equitable owner of the property.

            In Ohio, land contract transactions that involve property with a dwelling, and also are not required to be completed in a year or less from the date the contract is executed, are governed strictly by Chapter 5313 of the Ohio Revised Code (the “Ohio Land Contract Statute”). [1] 
 

The Land Contract 

            The terms of a land contract transaction are set forth in the written land contract between the seller, or “vendor,” and the purchaser, or “vendee.”  A land contract is sometimes called a “contract for deed” or a “land installment contract.”  The provisions of a land contract are a hybrid between a real estate purchase and sale agreement and a ground lease with an option to purchase.  A land contract for the sale of an office, industrial, or other commercial property will most likely include some or all of the following provisions: 
 
(1)        a legal description of the property,
(2)        the duration of the contract period;
(3)        a due diligence period for the purchaser;
(4)        closing dates for the payment of the down payment and the balloon payment, when the purchaser obtains the deed,
(5)        the conditions precedent to the second closing;
(6)        provisions for the payment of the purchase price;
(7)        a requirement that the seller provide to the purchaser annual or biannual statements indicating the amount paid toward the purchase price;
(8)        representations and warranties as to the status of title and the authority of each party to validly enter into the transaction,
(9)        the allocation of responsibility for maintenance of the property,
(10)      provisions for the direct or indirect payment of taxes and insurance by the purchaser,
(11)      the division of insurance proceeds resulting from damage or destruction of the property,
(12)      the division of an eminent domain award if all or a portion of the property is taken by a public authority,
(13)      events of default and remedies;
(14)      a covenant by the seller to convey a deed for the property to the purchaser upon completion of all installment payments; and
(15)      the seller’s consent to the purchaser’s recordation of the land contract.
 

Payment of Purchase Price 

            In the typical land contract transaction, the purchaser will make a non-refundable down payment to the seller at the closing, usually less than 20% of the total purchase price.  The monthly or quarterly installment payments could consist of principal only, or principal and interest.  The purchase price is usually not fully amortized over the life of the land contract period, resulting in a balloon payment at the end.  The duration of the typical land contract is five years or less, the idea being that the purchaser will have accumulated sufficient equity in the property to be eligible for institutional financing, or market conditions will be better at the end of the contract period, when the balloon payment is due.   
 
            The completion of the land contract transaction usually involves two closings (the closing on the down payment and the closing on the balloon payment).  If the land contract is comprehensive, however, a subsequent agreement governing the balloon payment and the transfer of deed should not be necessary.  
 

Protection for the Land Contract Purchaser

            As with any other purchaser of commercial real estate, a land contract purchaser should obtain title insurance and a survey of the property as part of its due diligence before paying the down payment.  The title insurance policy should be in the full amount of the purchase price and be effective as of the date of the initial closing.  The purchaser should obtain a “date down” lien search of the property, shortly before the scheduled date for the final balloon payment, to disclose any lien or other encumbrance against the seller’s interest in the property since the initial closing.  The land contract should provide that the balloon payment will be used to pay off all liens or mortgages against the property created by the seller, before the seller receives any of that payment. 
 
            If the property is subject to an existing mortgage granted by the seller, the purchaser should require the seller to obtain the lender’s consent to the execution of the land contract.  The lender may require the satisfaction of certain conditions before granting consent, for example:
 
(A)              the purchaser’s execution of a subordination agreement to affirm that the purchaser’s equity interest in the property will be subordinate to the lender’s first mortgage;
(B)              a requirement that the purchaser pay the monthly mortgage payments directly to the lender during the land contract period, with the seller to receive any remainder of the monthly payment set forth in the contract for deed; 
(C)              the seller’s assignment of the land contract to the lender[2]; and
(D)              an agreement by the purchaser not to allow any lien or other encumbrance to be placed against the purchaser’s equity interest in the property. 
 
            Generally, the lender under an existing mortgage against the property will probably not oppose a sale by land contract, because the lender will receive the monthly mortgage payments from the purchaser while the seller remains liable for those payments if the purchaser defaults. 
 
             It is absolutely essential for the purchaser that the land contract be recorded with the recorder of the county where the property is located.  By so doing, the purchaser establishes his or her priority over any subsequent lien creditor, or subsequent mortgagee, of the seller. If the land contract is subject to the Ohio Land Contract Statute, the seller must record the land contract within twenty days after it has been signed by the seller and the purchaser.[3]  
 

Protection for the Land Contract Seller

            The seller should include in the land contract a statement that the seller retains a lien against the property for the unpaid purchase price.  That provision establishes the seller’s priority over any subsequent lien creditor of the purchaser.  Alternatively, the seller and the purchaser could execute a separate “vendor’s lien” document containing similar language.[4]  The seller should record the vendor’s lien immediately after the recordation of the land contract, to establish the seller’s priority over lien creditors of the purchaser.    
 

Default by Purchaser

            What if the purchaser fails to submit a periodic payment to the seller, or commits another default on the land contract?  If the land contract is subject to the Ohio Land Contract Statute, the seller’s remedies to recover possession of the property are limited, and may involve a judicial foreclosure, depending on when the default occurs in the contract period and what percentage of the purchase price the purchaser has already paid.[5] 
 
            For Ohio land contracts not governed by the Ohio Land Contract Statute, absent a limitation of remedies in the land contract, upon the purchaser’s default, the seller may terminate the contract and regain possession of the property through an eviction/restitution (forcible detainer) action,[6] a foreclosure action,[7]  a quiet title action,[8] or an ejectment action.[9]  
 

Eviction

            An eviction action is an appropriate remedy if the land contract includes a forfeiture provision and no creditor has filed a lien against the purchaser’s interest in the property.  Under a forfeiture provision, the land contract terminates, and the seller has the right to possession of the property, upon the purchaser’s default on the land contract, notwithstanding that the purchaser may have already paid a substantial portion of the purchase price and thereby acquired “equity” in the property.
 
            Ohio courts have held that, for land contracts not governed by the Ohio Land Contract Statute, a forfeiture provision is enforceable if the resulting benefit to the seller “is not extravagantly unreasonable or manifestly disproportionate to the actual damages sustained” by the seller.[10]  Before filing the eviction complaint, the seller must first serve a “3-day notice” upon the purchaser, as in the typical tenant default situation under a lease.[11]  If the purchaser fails to vacate the property within three days after receipt of the notice, the seller can file the eviction action to recover possession.  The action then proceeds in an expedited fashion, as in the case of a landlord attempting to evict a tenant from rented premises.  If the seller is successful in proving a breach of the land contract and his or her right to forfeiture, the court will terminate the land contract and grant a writ of execution to the seller, which gives the seller the right to regain possession of the property.[12] 
 

Foreclosure

            If the purchaser has defaulted on the land contract and one or more of the purchaser’s creditors, for example, a judgment lien creditor, has filed a lien against the property, the appropriate remedy for the seller is to file a foreclosure action to have the property sold at a sheriff’s sale, free and clear of the liens against the purchaser’s interest.  In such a case, the seller (or the seller’s mortgagee) would receive the sheriff’s sale proceeds, up to the unpaid balance of the land contract price, and the sheriff’s sale buyer would take title to the property.  The title of the sheriff’s sale buyer would be subject to any unpaid mortgage granted by the seller and recorded before the recordation of the land contract.  
 

Quiet Title Action

            The seller may bring a quiet title action if an escrow agent, or the purchaser, filed the deed in favor of the purchaser before full payment of the land contract price.[13]  If the seller prevails in the action, the court will terminate the land contract, strike the deed from the chain of title, and restore the seller to possession of the property.
 

Ejectment

            Upon the purchaser’s default under a land contract not governed by the Ohio Land Contract Statute, in lieu of filing an eviction action, the seller may bring an “ejectment” action to terminate the land contract and remove the purchaser from possession of the property.[14]  Like a forcible detainer action, an ejectment action operates as a forfeiture of any equity the purchaser may have in the in the property.
 

Action for the Contract Price

           If the purchaser fails to pay the balloon payment, or commits another default on a land contract, but the seller does not wish to terminate the contract, the seller may bring an action to recover the balance of the purchase price from the purchaser.  In that action, however, if applicable, the purchaser may assert as a defense that the seller breached a covenant of good title in the purchaser, if the seller has allowed a mortgage or other lien against the property subsequent to the execution of the land contract.  If such is the case, the purchaser could join as additional defendants any person asserting an interest in the property through the actions or inaction of the seller.[15]  For example, if in the land contract the seller covenanted that no creditor of seller will file a lien against the property, but a mechanic’s lien claimant filed a lien because of seller’s non-payment to that claimant, the purchaser could name the claimant as a co-defendant in the action, and set off against the purchase price the unpaid balance of the judgment lien.  
 

Default by Seller

            Absent limitations in the land contract, the purchaser has several available remedies against a seller that breaches the provisions of a land contract.  If the purchaser has performed all of his or her obligations under the land contract, including the payment of the purchase price, the purchaser may file an action for specific performance to compel the seller to deed the property to the purchaser.[16]  Alternatively, under those circumstances, the purchaser could sue to rescind the contract and recover that portion of the purchase price already paid to the seller, subject to a setoff for the rental value of the property while occupied by the purchaser.[17] 
 

Mutual Termination of Land Contract

            The seller and the purchaser may, by mutual consent, terminate the land contract, or release a portion of the property from the provisions of the land contract, and, unless prohibited by the terms of the land contract, assign their respective interests in the land contract.  The termination, partial release, or assignment of a land contract is effected through a notation on the land contract in the county recorder’s office (if permitted by that county recorder), or accomplished by the recordation of a deed or other instrument.[18]  
 

Conclusion

    The land contract form of conveyance remains a viable method of selling commercial real estate in Ohio, where the purchaser is unable to obtain conventional mortgage financing or the seller and the purchaser do not desire to involve a third party lender in the transaction (for example, an intra family transfer). The purchaser, however, must protect its nterests by obtaining title insurance and by recording the land contract with the county recorder.  The seller must also protect its interests, by including appropriate remedies in the land contract itself and by enforcing those remedies upon the purchaser’s default in payment or other default on the land contract.
 
Donald E. Miehls, Esq.
 
Walter & Haverfield LLP

 

This overview is intended as general information only.  Please note that this information is not legal advice.  The reader should consult an attorney with knowledge in this area of the law to determine how the information applies to any specific situation

 

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