Fund the Deal How Real Estate Contracts Work

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person signing a real estate contract

Understanding real estate contracts can be tough for first-time investors.

For some newbies, reading a real estate agreement can seem like reading a foreign language. The contract is typically full of confusing legal jargon that doesn’t make sense. But navigating contracts in real estate transactions is crucial for becoming a successful investor. 

The term “real estate contract” refers to several types of agreements or contracts to “seal the deal.” So, whether you are buying, selling, transferring, or leasing property, a legally binding document is always part of the sales process. Therefore, it’s vitally important you understand how real estate contracts work and the common terms used in property agreements.

This article aims to provide a comprehensive overview of different types of real estate contracts. Additionally, you will learn common real estate investing terms to help you make informed investing decisions.

What Is a Real Estate Contract?

A real estate contract is a legally binding agreement typically involving two parties in a real estate transaction and outlining each party’s responsibilities and obligations. The contract is usually a written and signed document. Real estate agreements typically include terms such as contingencies, purchase price, earnest money deposit, closing costs, inclusions and exclusions, and closing date, among others.

Because a real estate contract is legally binding, it’s vital to understand its different aspects. Once you sign the contract, you are bound to the terms. Therefore, the terms of the contract will have a significant impact on your rights and obligations in the real estate deal.

In all cases, a contract in real estate transactions protects both parties. The only way to terminate the agreement is typically if contingencies are in place, such as a satisfactory inspection, financing, or sale of a previous property or if the contract expires. If one party breaks the terms of the contract, the other party can take legal action to recover losses, such as earnest money or damages.

How Real Estate Contracts Work

A real estate contract is usually the result of lengthy negotiations. Although you can find templates for sales contracts or lease agreements, both parties must agree on the finer details. The contract only becomes binding when both parties accept the offer by signing the agreement. 

What are the necessary steps for a real estate contract to work? Each contract must meet the following main requirements: 

  • Negotiation: First, both parties discuss acceptable terms of the transaction. These can include purchase price, rental amount, security deposit, contingencies, closing costs, and closing date.
  • Offer: The first party prepares the real estate agreement with the initial offer. They then sign it and give it to the second party.
  • Acceptance or counteroffer: The second party can now accept, counter, or reject the offer. A counteroffer could involve modifying or adding contingencies, renegotiating the purchase price, or including a deal sweetener. Making a counteroffer invalidates the initial offer. And if the offer is rejected, the contract is canceled.
  • Signing: When both parties agree on the contract—either accepting the initial offer or agreeing to the counteroffer—they both sign the agreement.
  • Consideration: The last step to legalize the deal is “consideration.” This term refers to something of value exchanged in the deal. Common forms of consideration are cash, a promise to perform, or property in exchange. No consideration means the contract is not enforceable.

In addition, there are several other criteria for a real estate contract to be legally enforceable. These are the following:

  • Signatories much be of legal age, not mentally impaired, forced or coerced to sign the contract.
  • The contract must have “legality of purpose.” In other words, it does not involve illegal activities.
  • The contract must identify all parties involved and the subject property.

Most Common Types of Real Estate Contracts

The four most common types of real estate contracts are a purchase agreement, lease agreement, real estate assignment, and power of attorney. However, depending on the type of deal, contracts could include more specific agreements for non-traditional properties, buying through a real estate agent, or directly from the seller.

Purchase agreement

Also called a sales contract, a purchase agreement outlines the terms when buying or selling property. This is a legally binding contract describing the obligations and responsibilities of the buyer and seller.

Here are the main components of a purchase agreement: 

  • Identities of all parties involved
  • The address of the property and description
  • Purchase price
  • Inclusions and exclusions
  • Earnest money deposit
  • All contingencies
  • The party responsible for closing costs
  • Possession date and terms
  • Closing date
  • Signature of all parties involved

There are three types of purchase agreements, depending on the type of real estate transaction.

  • State/association purchase agreement: This real estate contract is used when buying a property through a real estate agent. The contract is based on local realtor guidelines.
  • General purchase agreement: Like the state/association purchase agreement, this type of contract is used when buying a property directly from the seller.
  • Property-specific purchase agreement: Suppose you are buying a plot of land, mobile home, or other non-traditional type of property. In that case, you use a property-specific purchase agreement.

Ultimately, a purchase agreement protects the buyer and seller in a real estate transaction. Therefore, it’s necessary to take your time to read the contract and understand its terms before signing.

Lease agreement

A lease agreement is a real estate contract that outlines the terms and conditions of renting a property. The agreement is between the property owner (landlord) and the tenant.

Typical terms of a rental agreement include the following:

  • Monthly rental amount
  • Security deposit
  • The party responsible for utility payments
  • House rules, like the maximum number of occupants, pets, and smoking
  • The landlord or property manager and the tenant’s original signatures
  • Provisions related to lease renewal, termination, and default.
  • Conditions of the property and any repair or maintenance responsibilities.

Lease agreements are used for residential and commercial properties. 

Power of attorney

A power of attorney (POA) is a legal document used in real estate transactions to authorize one person to act on behalf of someone else. A POA is necessary when one party cannot physically or electronically sign the real estate contract. 

Reasons to use a power of attorney document are usually due to the following circumstances:

  • Physical or mental incapabilities or age prevent the person from signing.
  • The person is hospitalized or has another illness preventing them from signing the document.
  • The property owner manages investment properties through a company or third party.

Real estate assignment contract

A real estate assignment contract is a legal agreement used in wholesale transactions where a wholesaler assigns the rights and obligations of a purchase agreement to an end buyer in exchange for an assignment fee. The wholesaler enters into a contract with a seller to purchase a property at a certain price and then assigns that contract to an end buyer for a higher price, keeping the difference as profit.

Contract assignment in real estate is common when a homeowner wants to sell without a realtor (FSBO) or sell their property to a cash-only buyer. The wholesaler acts as the middle person between the homeowner and the buyer.

There are a few important things to note regarding assigning a real estate contract:

  • The investor doesn’t obtain title to the property.
  • Assignment contracts don’t involve selling or transferring the property directly.
  • The assignment of the contract doesn’t show up in the title chain. 

What Are The Essential Elements Of a Real Estate Contract?

A real estate contract is only legally binding if it meets specific criteria. One of the basic elements of a legal contract is that all the terms and clauses must be clear, unambiguous, and specific. Contracts can lose their legal validity if terms are too vague or uncertain. 

For a real estate contract to be legally binding, it must contain the following seven elements:

  1. Intent to create a legal purpose: All contract terms must adhere to existing laws.
  2. Authority and legal capacity: Parties signing the contract must be at least 18 years old and legally competent.
  3. Offer: This must be a definite offer for the other party to accept.
  4. Acceptance: Any rejection or counteroffer renders the contract invalid. Acceptance occurs when both parties sign the contract.
  5. Consideration: Money, goods, or services must change hands for the contract to be legally binding.
  6. Certainty: The contract must contain unambiguous terms. These relate to the purchase price, contingencies, property address, and closing date.
  7. Payment terms: The manner of payment, financing terms, earnest money deposit, property taxes, closing costs, and interest payments (in the case of deferred payments) must be clearly stated in the real estate contract.

It’s good to note that a verbal agreement in real estate can also be binding if it contains the key elements of a valid contract.

Who Creates a Real Estate Contract?

The buyer’s or seller’s real estate agent or a real estate attorney typically draws up lease or purchase agreements. You can also create your real estate contract using an online form or template. 

However, because of the complexities and legal obligations involved, it makes sense to have a real estate professional licensed to practice law draft a contract.

Common Terms You Should Know

Getting started in real estate investing typically involves learning a new language—legalese. But the good news is that the meaning of terminology and phrases related to real estate transactions are not difficult to master.

Here is a list of common terms real estate contracts use:

  • Parties: The individuals or groups involved in a real estate contract.
  • Sale price: The individuals or groups involved in a real estate contract.
  • Financing: The method used to finance the real estate transaction. This could include cash or a home loan.
  • Legal description: The legal description of the property should include the address, lot, block, and subdivision. It’s also helpful to provide detailed written descriptions of the property.
  • Earnest money: A payment made to the seller to show serious intent to buy the property when signing the real estate purchase agreement. Depending on the purchase agreement terms, the deposit may or may not be refundable.
  • Survey: As part of due diligence, the survey confirms the property boundary lines and any current or previous issues, title ownership, and other relevant details of the property lines.
  • Addendum: This term refers to additional documents in the real estate contract. Addendums could include lead-based paint disclosure, seller disclosure, or property condition. However, addendums can also include modifications to the original contract.
  • Special provisions: This part of the real estate contract allows parties to include clauses or other information not covered in the purchase or lease agreement.
  • Mortgage note: A document outlining the mortgage loan terms and is signed during the closing period.
  • Contingency clauses: Requirements that must be met before closing. Common contingencies may include home appraisals or inspections, the buyer selling their current home, or financing approval.
  • Closing costs: The seller incurs additional fees and expenses when completing a real estate transaction. The costs can include origination, processing, escrow, appraisal, title searches, surveys, and recording fees. 

Understanding how real estate contracts work is key to being a successful real estate investor. At first, terms used in real estate agreements can seem intimidating. However, this guide should help you to become comfortable working with real estate contracts.

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