The real estate market is always changing with new and innovative ideas. However, in the race to be the first to introduce a new idea, we sometimes come across strategies that are not well thought out or ill advised.
It has come to our attention some real estate gurus are pushing out novation agreements. What is a novation? Put very simply, a novation is change to a contract. You are canceling your original agreement and creating a new agreement. When I prepare an investor for closing, the contract may be in their personal name and we decide to take title in a newly formed LLC. I contact seller’s attorney and they agree to change the buyer name to the LLC. We’ve just completed a novation.
It’s a very simple concept. As I’ve discovered in my many years in real estate, the simplest of concepts in the wrong hands can be disastrous. The agreements being circulated attempt to take an assignment of contract and label it as a novation agreement. The investor exercises their rights to enter into a contract to replace their name with the buyer. If the sale doesn’t go through, the property reverts back to their contract.
Let’s look at Illinois case law: “In order for there to be a novation, four elements are required: (1) a previous, valid obligation; (2) a subsequent agreement of all the parties to the new contract; (3) the extinguishment of the old contract; and (4) the validity of the new contract. Roth v. Dillavou, 359 Ill.App.3d 1023 1032, 296 Ill.Dec. 391, 835 N.E.2d 425 (2005).”
For one, the property cannot revert back to the previous contract. In order for there to be a valid novation, the previous contract on the property must be terminated. If the end buyer does not buy the property, the middle man no longer has any enforceable contract rights to the property. The middle man also cannot enter into the novation on behalf of the seller. The end buyer and seller must be brought together to enter into a new contract.
For any wholesalers considering this strategy, please keep this in mind. If you do a novation, the previous contract must be cancelled. The new contract must be entered into by all parties. When the new contract is created, what is your relation to the contract? The answer is, you are not a party to the contract. The allure of wholesaling was the cloud on title that ensured payment at closing. By entering into a novation, any rights you had to payment are extinguished with the old contract. You will need to negotiate your fee in the new contract between the buyer and seller.
To be clear, novation is a valuable tool. Over the summer, I had a client place a building under contract. He found an investor interested in the building, but he wanted to use an FHA loan. What was our solution? We went to the seller and renegotiated the contract for a higher price between the seller and end buyer and came to an agreement for my clients fee to be paid at closing. It was a novation of the contract. Of course, there was no need to call it a novation. We were entering into a new contract. The need to use the term novation is akin to stating the payee shall provide an order for their drawee to pay the Bearer of the Note the amount stated herein. You could also just call it a check. The use of a rarely used legal term (I’ll admit I had to look it up) is likely meant to create an implication of sophistication. Unfortunately, they are misinterpreting the definition and putting investors at risk.
Before entering into a ‘novation agreement,’ ask yourself, is this an assignment of contract that has been labeled a novation? Are you abiding by the definition of novation as stated by Illinois case law? If the previous contract has to be cancelled, what’s the point of a novation agreement?