The purchase contract is the document that spells out the deal you’ve cut with the storage facility owner. But there’s certain things it should always contain – and others it should never contain. In this Self-Storage University podcast we’re going to review what these items are and what potential benefits – or pitfalls – they bring to the table when trying to properly structure your deal.
Episode 14: Storage Contract Transcript
How is it possible that a few sheets of paper can change your financial future? This is Frank Rolfe with the Self Storage University podcast. We're going to talk about the purchase contract for self-storage facility, just a few sheets of paper, but it can have a major impact on the success or failure of your deal. Let's talk about things that you want to have in that purchase contract and things that you don't want to have in it.
So let me first say, I am not an attorney. I am just someone telling you my observations as an investor for the last 25 years of the things that I like to see in a contract, but I'll leave it up to you and your attorney, whether you want to abide by these ideas or not.
What do I want in the contract? Well, the first thing I want to have in it obviously is the purchase price. That's why it's a purchase contract. It's an agreement by both parties as to how much you are paying for that self-storage facility. I think everyone knows that. So that's not a big deal. So you got to have the price in there. But also in addition to the price, you want to have who pays the broker because often the deal has been brought to you by a broker. And it's important that you acknowledge who is going to pay that broker because sometimes their commission can be pretty substantial. So that typically also needs to be in the contract, is something reflective of who is going to pay the tab to the broker.
Now, this next one is very, very important. You've got to have a small-ish amount of earnest money. That's because as we'll go over in a minute, your earnest money, even though you don't want it to be, it really truly in America today is always at risk. So don't put it in big earnest money amounts. Typically earnest money in America runs about 1% on these types of transactions. You could go a little bigger if you feel you must, but I would not go big. So if the deal is a million dollars, earnest money might be $10,000. It would never be a hundred thousand dollars. So you've got to keep it at a low amount.
Next, you've got to have a due diligence provision. This is the provision that allows you to conduct whatever studies you want to you to make sure that this storage facility is going to meet your needs. It's probably one of the biggest parts of a successful deal is doing good due diligence. Benjamin Franklin said, "The diligence is the mother of good luck." He was correct back in the 1700s as he would be today. So the due diligence provision has a certain number of days that allows you to make any studies you want. And if you don't like the deal after you get all the facts, you can drop it. So that's the due diligence, you've got to have that in your contract. Nobody can buy a deal without having due diligence, because you don't know until you get into it and do your studies whether or not the deal is as it is presented to you by the seller.
Next, you've got to have a financing contingency. Just like the due diligence, you don't have all the facts. The seller knows much more than you do. Once you gather the facts, if you still want to go forward, you still have to convince a lender to do it. And the lender is going to have to get a successful appraisal. So if you can't get the financing, then you also, again, need to be able to drop the deal. It's also important in that contract, that it explains how you drop the deal. The deal needs to be dropped by you for any reason you want. It can't be open to debate. It can't be that the seller says, "Well, I don't think that's a good enough reason." No, that's not going to work. So you've got to have the ability based on any whim you want. You just wake up one day and don't want to go forward that you have the right to drop the deal in a specified period of time.
This next one is absolutely critical. You've got to have what's called seller specific performance. What that means is if the seller signs the agreement, if you abide by all your terms of the agreement, he must come forward and sell you the property in the end. Sometimes sellers will convince the buyer to strike that from the contract. And here's how it works. So if you strike seller specific performance and they say, "Okay, closing is on Thursday" and it's Wednesday, the seller has the right to just call you up and say, "Nah, I don't want to close after all, I got a better offer or I changed my mind." You can't do that. You've at that point, spent all those money on third-party reports, finding the lender, doing the survey, title work. You can't leave it up to the whim of the seller to drop the deal. So you've got to have seller specific performance. If someone signs that contract, they have to show up at the closing table and sign the agreements to convey it to you.
Now, also, what else do you need in there? You need to have warranties. So what's a warranty? A warranty is where the seller says, "This is the truth. This is a fact that I'm going to stand behind that." if your seller will not warranty anything, if they want to sell that self-storage as is where is, well, that's their right to do it. But that's very dangerous for you as a buyer. The big key question would be, how come? Why can't you warrant anything? Why can't you warrant the amount of revenue you claim it had or the cost you claim it had? Why can't you warrant the condition? Why can't you warrant anything? That's obviously a very big sign of trouble. So someone won't warranty it, then that's scary.
Now I know in single family homes, selling homes as is where is is a popular business model for people. You see it on HGTV flip and flop shows people buying homes, but they can see so much in that home. In those cases as is where is mean structural issues. With a self-storage facility, you're buying an income property. It's not just structural. Structural is one element, but you're also trusting that the seller didn't lie to you about their revenue and their expenses. That would be critical to the deal. So it's not the same. It's not like selling a stick-built home where I can go and look in the attic. I can try and turn the lights on. I can run the faucet. You can't turn the lights out and run the faucet on the actual financial performance based on the statements. So it's much, much more important that the seller warranty the things in the contract that they're true and accurate. Because if they don't do that, clearly you have reason to suspect that it's not correct.
Now, what would I not want to have in a contract? I wouldn't have the reverse of seller specific performance. It's an item called buyer specific performance. I don't want buyer specific performance. It's not fair, nor is it right. I'm putting up earnest money. So if I, for whatever reason, don't buy that storage property, the seller gets to keep my earnest money as liquidated damages. That's spelled out in the contract, but he can not have the right to force me to buy it when I don't want to buy it. Let me explain how that works.
Let's assume you have a heart attack during the deal. So you start the deal up, you've got your due diligence provision. You have a heart attack. You're in the hospital. You're not focused on business and you let the expiration of due diligence slide. You didn't terminate in time. And then you go into your financing mode. But once again, you're still in the hospital and you let that slide. And then when you get out of the hospital, you get notified by an attorney. Hey, you got to close on the deal because you've got buyer specific performance. It's an instrument that forces you to close simply by signing the contract, regardless of whether you want to close or not.
Now, it's only triggered if you don't terminate during that diligence or financing period typically, but it's very important you do not have that in the contract. Many people don't like to use an attorney. They say, "Well, I'll do my own contract." If you start seeing buyer specific performance in that contract, you definitely need to get an attorney involved. You can not get yourself in a position where you have to buy something that you don't want. That just doesn't make any logical sense to anybody.
Also, you've got to make sure, I can not emphasize this enough. There can be no encumbrance to you in your termination under due diligence or under financing. You just can't do it because you don't want the seller to second guess or try and block you from your ability to drop out. If you give them that right, and they say, "Well, that wasn't a good enough reason to drop my deal." They will then seize your earnest money. That's not fair.
They know everything when you go into the property, they know the truth about the revenue and the expenses and the permits and the property condition. You know none of these items. So if you allow them to negate your ability to drop for any reason you want, what you've done is you put yourself in a terrible trap and they may well be able to extract your earnest money by simply say "No, that didn't give you the right to drop out." You've got to make sure when you put your earnest money in, that there's no way that the seller can block you from getting it back as long as you cancel during diligence or financing. So those are the keys. No buyer specific performance and nothing that will stop you in any way for whatever reason you want from dropping that deal under either due diligence or under the financing contingency.
Let's also talk for a minute about the length of the contract. Sometimes mom and pop, typically is a seller who are less sophisticated, they'll say to you, "You know what? I don't like big old contracts. I just want to do this under a handshake." Well that isn't going to work. A handshake is not binding. There must be a written contract, but it is possible to put everything in that written contract just on one sheet of paper. If you must do that, if that's important to you to get the deal done, because mom and pop will not work with you in any form or fashion as long as it does not fit on one 8.5 by 11 sheet of paper front and back then again, the key provisions you must have in there. You must have the price. You must have the amount of earnest money who pays the broker, the due diligence provision, the financing contingency, seller specific performance. And it would be nice if you could throw some form of warranties, at least as far as the financial information. It must not contain buyer specific performance or any encumbrance to release of your earnest money.
And yes, you can fit probably all those things in to one sheet of paper, front and back with fairly small sized font. The important part in purchase contracts is you have those key items, most of the rest of the stuff in most contracts is mostly boiler plate. Often there are contracts out there that may have one or two solid pages of different warranties. Again, you can strike things. As you strike things, though, it increases your risk. The most important thing of any contract you do, you must read and understand every part of the contract. It's bad business to sign agreements that you have not read or have parts in it you do not understand. If you can read the contract and understand it in the absence of legal advice, then fine. If you cannot, it's essential, even though I know none of us like to pay it, you need to get legal counsel on that agreement. Never sign something that you do not understand.
This is Frank Rolfe for the Self Storage University podcast. Hope you enjoyed this. Talk to you again soon.