Invitation To A Minefield
A new construction purchase offers an exciting opportunity for buyers: the prospect of acquiring a brand new customized or semi-customized residence. The flip side, however, is that new construction contracts are often lengthy, detailed bespoke agreements that tend to be heavily one-sided in favor of seller-developers. They require a thorough review and analysis of contract terms. Having said this, it is not the goal of this article to paint developers in a bad light or to dissuade people from entering into such contracts. There are many practical and/or reasonable motivations that account for the way these transactions are structured from a developer's point of view. Rather, the goal of this article is to help illuminate some of the particular vulnerabilities buyers may face in entering into such agreements, which they may or may not be able to modify during attorney review, so that buyers can make fully informed decisions on how they may proceed. While every contract is unique and should be reviewed closely on its own terms, based on my experience, below are a few general considerations to keep in mind when contemplating entering into a new construction contract.
1. Little Or No Opportunity For Attorney Review.
In more typical transactions involving existing residences, attorney review generally allows a buyer to suggest modifications to a contract. Under certain circumstances, it even enables a buyer to outright terminate the transaction. In contrast, developer contracts often only allow severely limited attorney review and, on occasion, no attorney review at all. Both buyers and their realtors need to be mindful of the potential for little or no attorney review before making an offer. If a buyer enters into a contract that does not provide for attorney review, it means that there should be no expectation that some of the other, more challenging provisions discussed below will not be modifiable or, even worse, that a buyer may not have an option to terminate the contract. When in doubt, an attorney should review a contemplated new construction contract prior to any offer to determine if the agreement provides for robust attorney review. If not, a rider or addendum allowing such review should be drafted and tendered as part of contract negotiations.
2. Non-Existent Or Vague Financing Contingencies.
The peril of not knowing what you do not know or, in the words of Donald Rumsfield, the risk of the "unknown unknowns."
Again, in more typical transactions involving existing residences, a mortgage contingency is a very powerful buyer protection. Indeed, I consider it to be the "mother of all contractual provisions." In theory, a mortgage contingency enables a buyer to set the parameters for and timeline to obtain acceptable financing terms. Those parameters include the type of financing, down payment amount, loan term length, ceiling interest rate, and whether an interest rate will be fixed or adjustable during the life of the loan. If a buyer cannot in good faith obtain the desired financing, a mortgage contingency allows the buyer to completely back out of a transaction.
In contrast, developer contracts tend to provide vague parameters for buyer financing, often to the point of offering no real substantive buyer protection in the event that acceptable financing is not attainable by the buyer. For example, instead of specifying some or all of the loan parameters discussed above, developer contracts will often state that the transaction is contingent upon the buyer obtaining financing pursuant to terms "currently offered in the marketplace" or "at prevailing rates." The types of financing arrangements that can be read into such vague phrases are endless, regardless of whether a buyer would want or could be able to purchase a residence under such conditions. This language is deliberate, as it provides little or no wiggle room to a buyer to exit a contract due to unfavorable lending terms. On rare occasion, I have even seen contracts without any type of mortgage contingency. With little or no protection from a mortgage contingency, a buyer's failure to close may lead to the loss of earnest money and may require a buyer to cover a seller's carrying costs for the property until the seller is able to close with another buyer, as well as cover any difference in purchase price if the seller has to sell the property for a lower price to a subsequent purchaser.
3. Insufficient Time To Complete The Financing Process.
Related to the challenging financing terms discussed above, developer contracts often provide an unrealistic timeline in which the buyer has to complete the financing process (i.e., obtain final underwriter approval to close the transaction). While a typical timeline of 30 - 60 days is generally attainable in an existing residence transaction, new construction deals tend to operate on a completely different timeline, yet they tend to provide the same 30 - 60-day time period to complete buyer financing. Often, the residence has not been built at the time of contract execution and, generally speaking, the financing process cannot be finalized until the structure has been completed. Construction timelines can range from 3 to 18 months (or more). Understandably, sellers do not want a deal to be vulnerable to a financing contingency for such an extended period of time.
There are other financing considerations that can be impacted by the length of time a new construction transaction takes to close. For example, when and for how long should a buyer lock into an interest rate, especially if interest rates are rising? Locking in too early means a buyer may have to pay for costly rate lock extensions until the deal closes or may not be able to maintain a lock for the time period required for the residence to be completed. Likewise, buyer circumstances such as employment, health, and financial position have a greater chance of changing during an extended time period and may affect a buyer's ability to close a transaction. A buyer financially qualified to purchase a home on day 1 may not be so qualified on day 180. These are all factors to be considered when evaluating the buyer protections afforded by a developer contract.
4. The Developer Has Wide Latitude To Set The Closing Date.
Developer transactions are often located at the corner of "My Way or The Highway." In my experience, sellers frequently decline accepting proposed buyer modifications to challenging contract provisions.
One of the most important deadlines in a real estate deal is the closing date. Typically, a mutually acceptable date certain for closing is selected as part of contract negotiations. A firm closing date allows a buyer to plan accordingly, including when to terminate a lease or when to close on the sale of a currently owned residence. Moving, storage, and/or housing arrangements can all be scheduled in advance and with a reasonable degree of certainty.
While a date certain for closing is standard in a regular real estate transaction, a new construction contract poses a unique difficulty in that a developer will rarely (if ever) set a date certain to close. This is because the residence is often still being built while the parties are under contract and construction projects are vulnerable to delays outside a developer's control, such as supply chain or labor issues, poor weather conditions, and the timing of any required municipal processing and/or approvals. No one, including developers, can predict the future. As a result, developers will qualify any contractual closing date as being "tentative" or "targeted" and allow themselves the relatively unfettered ability to push back the date, as may be required to complete construction. This means that buyers need to be prepared to be flexible in terms of a closing date and to understand that they may have to expend extra costs on storage or temporary housing and/or otherwise be greatly inconvenienced due to these delays.
5. Little Or No Recourse To Compel Completion Of Post-Closing Punchlist Items.
Construction projects are rarely finished prior to closing. Regardless, once a residence is deemed to be "substantially completed" - as solely determined by either the seller or the seller's architect - a buyer must close the transaction. While a buyer is allowed to inspect the residence prior to closing, creating a written checklist of all items that remain uncompleted and/or in need of repair or replacement (i.e., the "punch list"), the buyer often lacks the realistic ability to incentivize the seller to complete these items in a timely manner, either before or after the transaction has closed. Sellers usually will not agree to postpone the closing, nor will they agree to hold any of their sales proceeds until the punch list items are completed. Instead, buyers are left to rely entirely on seller's contractual promise to complete the punch list items in a reasonably timely manner post-closing. If the seller fails to perform, the buyer must make the decision to take legal action, often without the possibility of recouping any of their legal fees or costs in taking such action. And if the cost of the work to be completed is less than the cost of legal action to compel the seller to complete it, a buyer will be forced to contemplate "throwing good money after bad" in order to secure seller's compliance with its punch list obligations.
It takes teamwork to navigate a transaction!
The above considerations are just some of the many provisions that buyers and their realtors should be mindful of when navigating a new construction contract. It really just scratches the surface on this topic. Ultimately, buyers (and their realtors and lenders) need to carefully navigate this environment, understanding both the risks and rewards, so that buyers are able to make informed decisions about next steps or whether to even move forward with a transaction. Best practice has the buyer, the realtor, the lender, and the attorney all working together to achieve this goal.
What challenging provisions or aspects of new construction contracts would you add to the above list?
