Real Estate Rundown

By Grayson Holmes:

Part I: An LLC’s Guide to Purchasing Real Estate Investment Property in Tennessee

This article presents general options for a hypothetical individual, attempting to operate under an LLC, starting in real estate investment in Tennessee and the relevant laws governing this type of venture. This individual is aware of the benefits of creating an LLC, such as privacy, limiting liability, and tax benefits.^[1] But, this individual now faces the daunting task of following through with their plans…

So, you’ve just formed your first LLC. You’ve filed your articles of incorporation with the secretary of state, received a certificate of recognition in response, and drafted up an operating agreement covering how your new real estate investment business will work. Furthermore, there’s an old run down home in the Fort Sanders neighborhood of Knoxville, Tennessee that you have your eye on. The home has good bones, and a few repairs would make it suitable for college students to live in. The listing price: $250,000. Sadly, your business bank account does not have $250,000 sitting in it. So, what do you do next?

First, you’ll need to look at what other potential assets could be accessed as sources to fund your new purchase. If no such asset exists, we will simply be looking at taking out a mortgage for the investment home. Here, we need to go to a bank to discuss what options we have. This will require setting up a meeting with the branch where our LLC has an account. We need to provide them with the history of our LLC’s actions, credit history, and what plans we are making.^[2] In this case, it is common to have to put around 20% to 30% down on the investment property.^[3] The exact down payment required will depend on the bank lender. In addition, most typical home residential loans will not be offered.^[4] Regardless, we want to at least have enough cash in the LLC’s account to fund expenses in addition to the mortgage payment. For example, in our hypothetical, enough cash must be left to make the repairs needed to get the home in safe living conditions and to pay the mortgage payments prior to having short-term tenants. In addition, while there may be a housing crisis, locking down a 12-month lease in a college town can be challenging during the middle of a school year when most students have already found housing. Thus, while a large down payment may reduce the length of our mortgage on the property, maintaining liquidity is important when first purchasing an investment property.

The major concern for the lender, the bank in this scenario, is ensuring that the borrower, the LLC, is going to be able to pay back their loan. If you are a newly formed LLC, how do you show this? Well, here comes your first hurdle, and it’s a big one. Banks are less likely to loan to LLCs for the exact reasons that it is advantageous for individuals to create an LLC.^[5] Banks want some tangible collateral that will secure the loan.^[6]

If you purchase a home with an LLC, Banks cannot go after your personal assets, without piercing the corporate veil, which usually requires a costly lawsuit.^[7] To avoid this, lenders simply will not offer most loans to LLCs. For instance, Rocket Mortgage does not loan to LLCs at all.^[8] In addition, potential income from renters from the investment property is usually not considered as tangible collateral.^[9] Thus, as an investor looking for their first investment property under their LLC’s namesake, you will need to be able to clearly show you can pay the 20–30% down payment and have extra funds in the LLC remaining for other expenses and loan repayment, or you will likely have to use personal assets as collateral.

So, now we must confront the question: do you want to make a career of real estate investing? If the answer is no, and this is just a one-off property investment, the pros of investing in your own name greatly outweigh investing through your LLC.^[10] Despite the fact that this opens you up to more personal liability, it may be practically impossible to invest through your LLC without having necessary assets in your LLC’s business bank account and the willingness to expose yourself to some personal liability to secure a bank loan. If, instead, you want to make several real estate investments, these initial hurdles can be worth overcoming.

On the other hand, suppose you already own a personal residence in your own name. If this is the case, things get a lot simpler, or more complicated, depending on one’s perspective. Here we would look to transfer the title of the property from your personal name to the name of your LLC. This can be performed relatively simply through a form recorded with the local register of deeds office.^[11] Prior to this transfer, you need to know how much equity you have in your personal home. If it’s owned free and clear of all creditor’s interests, that is ideal. If not, we need to consult the deed of trust. In this document, we need to see if there is a “due-on-sale” or “acceleration” clause.^[12] If these clauses are present, the remaining amount due on the mortgage may become immediately due upon transfer.^[13] If this is the case, you need to be prepared to pay these funds prior to any further transaction.

Now, suppose we have transferred the real property into the LLC’s name. We have three potential options: (1) a home equity loan, (2) a home equity line of credit, and (3) a cash-out refinance.

A home equity loan, i.e. a second mortgage, allows the borrower to borrow against the equity of their existing home.^[14] The loan amount is the difference between the personal residence’s fair market value and the amount remaining on the first mortgage, i.e., the equity one has in their home.^[15] These loans have a fixed interest rate that must not be 4% higher than the prime rate set by the Federal Reserve.^[16] These loans provide a lump sum payment and are usually due to be paid back in full in five to fifteen years.^[17]

On the other hand, home equity lines of credit usually have a variable interest rate and several lines of credit, unlike a home equity loan.^[18] The money can be accessed when needed and operates more like a credit card.^[19] In our situation, we would prefer a home equity loan to fund the purchase of the new investment property.

There is also the potential of pursuing a cash out refinance. Here, you would refinance the mortgage on your home by taking out a bigger mortgage amount and, while using the home as collateral, taking out the difference in the original loan and the new loan in cash.^[20] Potential issues arise again regarding the amount of equity in the home, and actually receiving the cash can take a few months; thus, action needs to be taken soon if you want that Fort Sanders home. Since Tennessee operates a little different than the common perception of mortgages, if real property is used as collateral to secure a loan, a lender will need the deed of trust to secure said loan.^[21]

The crucial calculation we need to understand is as follows: is the principal and interest amount due on your monthly home equity loan going to be less than your current obligations? Critically, banks won’t be interested in how much you’ll potentially be charging tenants in your new investment property. Instead, current factors will be considered, such as the fair market value of your home, your current equity in the home, and your credit history.^[22] Thus, you will need to make sure you look like a reliable person on paper for a bank to lend to, regardless of your future plans. However, it is also important to determine the expected amount of income from this new property to make sure that it will cover (1) your existing home’s mortgage, (2) the refinancing plan of your existing home, and (3) the purchase and predicted upkeep of your investment property.

Finally, it is important to note that no Tennessee laws limit a borrower’s personal liability for debt secured by real property. Thus, we are heavily relying on our LLC’s formation to shield us from personal liability. Also, Tennessee law allows a guarantor who believes that the borrower is about to become insolvent or leave the state to send a written notice to the lender requiring the lender to file a suit against the borrower to enforce the debt.^[23] If the lender fails to commence an action enforcing the debt within 30 days from the notice, then the creditor forfeits the right to recover on the guarantee’s obligation.^[24] This provision is waivable by the guarantor in writing.^[25] Thus, when purchasing real estate for investment purposes, an individual’s tolerance for risk needs to be clearly understood as refinancing one’s own home can be a high-risk and high-reward venture.

Part II: An LLC’s Guide to Purchasing Commercial Real Estate in Tennessee

Well, you found the funds to purchase the Fort Sanders home, and your tenants have been more than happily living in it for the past year. You feel like it’s now time to expand your real estate empire, but this time into the commercial world. You’ve noticed a warehouse up for sale just north of downtown Knoxville. How can you go about putting down a competitive offer?

First, it may be a good idea to entertain the idea of retaining a mortgage broker or a commercial real estate agent to help with this purchase. A mortgage broker matches you with the best lender for your needs, and they can submit multiple loan applications, increasing your approval chances, and track down agreeable pricing.^[26] Either of these individuals are likely going to help the attorney and the purchaser so that the most viable offer can be put down.

Two new elements are at play in the world of commercial real estate acquisitions: (1) a letter of intent and (2) a purchase and sale agreement. There are more issues that may arise during this type of transaction, but the scope of this blog is limited to these two elements. The letter of intent in this scenario is an agreement between the buyer and seller, in a general and preliminary sense.^[27] This agreement is not a formal contract and is not binding.^[28] Instead, it is a mutual understanding of the key elements at play and how each party intends to proceed.^[29] Typically, the terms agreed upon in the letter of intent are considered non-negotiable in the subsequent purchase and sale agreement.^[30]

A letter of intent, as its namesake describes, shows the parties’ intention to enter into a formal contract.^[31] While it is not binding, the key with the letter of intent is for the two parties to have some general understanding of what the major points of the contract will be. For example, in our case, if you are looking to spend around the $500,000 range, but the buyer won’t sell for under $1 million, the letter of intent would be able to expose this discrepancy prior to the two parties entering formal contract discussions. Thus, when looking at this warehouse, you need to make sure that any non-negotiable terms you wish to have are included in the letter of intent. This will save lots of time and money down the road.

The second element, a purchase and sale agreement, is a formal binding document on the buyer and seller.^[32] Here, more specific terms are debated, such as the due diligence period, representations and warranties, covenants, and closing conditions.

In regard to due diligence, you should have in mind, to some degree, what the ultimate goal of the property is. For example, there may be plans to keep this warehouse as is, renovate it, or turn it into a single-user retail space. A due diligence period allows you, the buyer, to look for any issues with the property that may lead to a withdrawal of our letter of intent.^[33] While the length of the due diligence period is usually determined by the letter of intent, the specific areas under investigation are determined in the purchase and sale agreement.^[34] Common areas include searching the title history to identify any liens, encumbrances, or opposing interests.^[35] More elements and requirements can be made by the purchaser for the seller to satisfy; however, this can induce the seller to make less representations.

Warranties and representations are the facts that the buyer and seller rely upon while entering the contract.^[36] Here, you as the purchaser are trying to get as much information about the property as possible. This would include promises such as the land being free and clear of any other interests or structural integrity of the property. On the other hand, the seller wants to try to limit these promises made and protect itself from liability. What warranties and representations are finalized should be emphasized at closing for clarity, along with the implications of any misrepresentations and the monetary cap and basket amounts for any breach of contract.

While warranties and representations reference specific factual parts of a contract, covenants often represent general obligations through the contract.^[37] For instance, if the seller was to maintain an interest in the property, they may covenant to maintain and repair the property until and/or after closing, while the purchaser, on the other hand, could potentially have limits on what contracts they are able to enter while the seller has an interest in the land.

Finally, as the purchaser, we need to pay particular attention to the closing conditions.^[38] Generally, the seller will try to limit their closing obligations and do what is most likely to allow the sale to go through.^[39] However, we want to make sure that the seller follows through with their obligations prescribed in the contract through closing. Thus, we should make closing contingent upon as many warranties, representations, and covenants as possible. This ensures that the property we purchase will be transferred in the manor and condition upon which it was agreed upon. In addition to these conditions, we want to ensure that the closing ensures the complete execution and delivery of the commercial property after the completion of all seller obligations are fulfilled, unless an obligation specifically states otherwise.^[40]

The purchase and sale agreement is incredibly important when purchasing commercial real estate and can often determine if the entire venture is successful. Entering into this type of agreement should not be taken lightly and contract negotiations should involve the input from all members who are on the purchasing side.

^[1] See, e.g., Melissa Brock, A Guide to Buying a House with an LLC, Rocket Mortgage (Aug. 28, 2022), https://www.rocketmortgage.com/learn/buying-a-house-with-an-llc.

^[2] Mandy Sleight, Can You Buy a House with an LLC? Should You?, BankRate (Aug. 4, 2022),https://www.bankrate.com/real-estate/buying-a-house-with-an-llc/.

^[3] Id.

^[4] Michele Lerner, Can an LLC Buy a House? What to Know about Buying a House under an LLC, Realtor, (Aug. 11, 2022), https://www.realtor.com/advice/buy/benefits-buying-home-with-llc/ (stating LLC’s likely won’t be eligible for most types of residential loans, including FHA or conventional loans sold to Fannie Mae or Freddie Mac).

^[5] Id.

^[6] Brock, supra note 1.

^[7] Sandra Feldman, Piercing the Corporate Veil: LLC & Corporation Risks, Wolters Kluwer (Aug. 5, 2020), https://www.wolterskluwer.com/en/expert-insights/piercing-the-veil-of-small-business-what-the-owners-of-llcs-and-corporations-need-to-know#:~:text=or%20veil%20piercing.

^[8] Brock, supra note 1.

^[9] Michael Steward & Rachel Edwards, Real Estate Finance: Tennessee, Westlaw Edge(May 3, 2020), https://1.next.westlaw.com/Document/If528c3c7102311e9a5b3e3d9e23d7429/View/FullText.html?transitionType=Default&contextData=(sc.Default)&firstPage=true&oWSessionId=8dc40ade8d5441a99f39fc1f3e3d4f11&isplcus=true&fromAnonymous=true&bhcp=1.

^[10] See generally Jeff Rohde, The Pros and Cons of Buying Property through an LLC in 2022, Roofstock (Jun. 6, 2022) https://learn.roofstock.com/blog/buying-property-through-llc.

^[11] Tennessee Real Estate Deed Information, Deeds, https://www.deeds.com/forms/tennessee/#:~:text=In%20order%20to%20convey%20any,of%20a%20variety%20of%20deeds (last visited Dec. 17, 2022).

^[12] Lance Denha, Due On Sale Clause Effect on Transferring Title, Denha & Associates, https://denhalaw.com/due-on-sale-clause-effect-on-transferring-title/ (last visited Dec. 17, 2022).

^[13] Id.

^[14] Julia Kagan, How a Home Equity Loan Works, Rates, Requirements & Calculator, Investopedia (Jul. 25, 2022), https://www.investopedia.com/terms/h/homeequityloan.asp.

^[15] Id.

^[16] Tenn. Code Ann. §§ 47-14-102(7) and 47-14-103(2).

^[17] Id.

^[18] Rae Beck, Home Equity Line of Credit (HELOC), Investopedia (May 22, 2022), https://www.investopedia.com/home-equity-line-of-credit-heloc-definition-5217473.

^[19] Id.

^[20] James Chen, Cash-Out Refinancing Explained: How it Works and When to Do it, Investopedia (May 26, 2022), https://www.investopedia.com/terms/c/cashout_refinance.asp.

^[21] Stewart, supra note 9.

^[22] Chen, supra note 20.

^[23] Stewart, supra note 9.

^[24] Tenn. Code Ann. § 47-12-101.

^[25] Id.

^[26] Ashley Kilroy, Buying Commercial Property for Beginners: How to Start, Rocket Mortgage (Nov. 16, 2022), https://www.rocketmortgage.com/learn/buy-commercial-property.

^[27] What is an LOI? What does Letter of Intent Mean?, CARR, https://carr.us/real-estate-resources/glossary/what-is-an-loi-what-does-letter-of-intent-mean/#:~:text=In%20commercial%20real%20estate%2C%20a,deal%20points%20with%20proposed%20terms (last visited Dec. 17, 2022).

^[28] Id.

^[29] Negotiating Commercial Real Estate Purchase and Sale Agreements, Thomson Reuters, https://legal.thomsonreuters.com/en/insights/articles/negotiating-commercial-real-estate-purchase-sale-agreements (last visited Dec. 17, 2022).

^[30] Id.

^[31] Id.

^[32] See, e.g., Purchase and Sale Agreement for Commercial Real Estate, https://images1.loopnet.com/d2/WZ5aIHOqjk9RZMNqphhFoN9X6h3GaqBBj7LhCjfK4No/document.pdf.

^[33] How Long is the Due Diligence Period in Commercial Real Estate, Si Vales Valeo Real Estate (Feb. 18, 2022), https://svvre.com/how-long-due-diligence-period-commercial-real-estate/#:~:text=Usually%2C%20the%20due%20diligence%20period,property%20is%20a%20good%20choice.

^[34] Id.

^[35] Jason Rittie, Caveat Emptor: “Let the Buyer Beware” – Due Diligence in Commercial Real Estate Purchases, Einhorn Barbarito (Feb. 25, 2020), https://www.einhornlawyers.com/blog/real-estate/caveat-emptor-let-buyer-beware-due-diligence-commercial-real-estate-purchases/.

^[36] FAQs: What kinds of Representations and Warranties Do I Need From the Seller if I am Purchasing Commercial Real Estate Property?, Lawrences Lawyers, https://www.lawrences.com/resources/faq/lists/faqs/what-kinds-of-representations-and-warranties-do-i-need-from-the-seller-if-i-am-purchasing-a-commercial-real-estate-property- (last visited Dec. 17, 2022).

^[37] Representations, Warranties, and Covenants, Whitman Legal Solutions, LLC (Jun. 10, 2019), https://www.jdsupra.com/legalnews/representations-warranties-and-covenants-99335/#:~:text=Unlike%20both%20representations%20and%20warranties,covenants%20are%20combined%20with%20representations.

^[38] Closing the Purchase and Sale of Commercial Real Estate, Thomson Reuters Practical Law, https://1.next.westlaw.com/Document/I3b43b4cfebfa11e398db8b09b4f043e0/View/FullText.html?navigationPath=Search%2Fv1%2Fresults%2Fnavigation%2Fi0ad7401300000184e2e7f428159f4ac2%3Fppcid%3De455758276474385a957a779c3f861b8%26Nav%3DKNOWHOW%26fragmentIdentifier%3DI3b43b4cfebfa11e398db8b09b4f043e0%26parentRank%3D0%26startIndex%3D1%26contextData%3D%2528sc.Search%2529%26transitionType%3DSearchItem&listSource=Search&listPageSource=65fa632010151489a22aaea139c75589&list=KNOWHOW&rank=1&sessionScopeId=323e47b09a1eb8576bbac7af5e29023db2126776715cf1a9ce52200fd869a600&ppcid=e455758276474385a957a779c3f861b8&originationContext=Search%20Result&transitionType=SearchItem&contextData=%28sc.Search%29 (last visited Dec. 17, 2022).