What Is Novation In Real Estate? Definition & ExamplesMay 21, 2023
According to Redfin, approximately 64,000 home-purchase agreements fell out of contract as recently as August of last year. The failed agreements accounted for 15.2% of all the homes that went under contract in the United States that month. As shocking as those numbers may appear, the state of today’s housing market may have inflated them even further if it wasn’t for the use of novation real estate practices.
Real estate novation has the potential to salvage unsavory or old contract agreements, but most people don’t even know what it is. Therefore, instead of ignoring this powerful tool, we developed a guide to help everyone understand it.
What follows from here was designed to teach anyone everything they need to know about novation real estate, including:
- What Is Novation In Real Estate?
- Types Of Novation
- Novation vs Assignment
- Novation In Commercial And Residential Real Estate
- Pro Tips For Novation Agreements In Real Estate
- Final Thoughts
What Is Novation In Real Estate?
Novation in real estate is a legal tool used to modify existing contracts at any point of an agreement. That’s not to say anyone can resort to dismantling the terms of an old agreement they don’t like, but rather that this process grants each party the ability to replace existing obligations with new ones — provided everyone involved accepts the new terms of the contract. In other words, changes may only take place when everyone is on the same page.
When called upon, novation may be as blunt as altering an entire document or as precise as replacing specific obligations with new terms. Either way, even the slightest amendments render the original document moot and replace it with an entirely new contract. The newly created agreement supersedes the original legal obligation and binds each party to the newest contractual obligations.
While legal documents may be changed in any industry, it is becoming more and more common in the real estate sector. In particular, the complexity of real estate agreements, and the abundance of unseasoned buyers and sellers, ultimately create the need for more audibles. As a result, novation real estate practices are not only common but also facilitate more deals that may have otherwise never happened.
Types Of Novation
Every novation agreement has something to do with making changes to an existing contract. That said, there are different types of novation based on what or who is being replaced. Depending on what obligations are being changed, the parties on each side of an agreement have access to the following types of novation:
- Standard: The most common way to alter an agreement, standard novation is the act of replacing existing terms with new obligations. Unlike the other types on this list, standard novation is a mutual agreement between two parties (and no more).
- Expromissio: True to its Latin origins, expromissio literally refers to the act of binding oneself to another's debt and thereby releasing the transferor from obligation. This type is used when the obligation being replaced is the debtor themself. Consequently, expromissio novation will transfer the rights of the original debtor to someone else, who will then assume responsibility for the contractual obligations. Again, this may only occur if everyone agrees — including the assignor or lender.
- Delegation: Delegation novation is only called upon when a third party enters the picture. However, instead of the debtor being replaced, delegation novation is an instrument used to replace the assignee (usually the lender). When the lender is replaced, the original debtor is released from the existing contract and subject to the new lender’s agreement.
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How Are Novations Used In Real Estate?
The definition of novation calls for altering the terms of a real estate contract in a way that pleases each party. It is worth noting, however, that the average agreement is comprised of several unique obligations. Therefore, novating a documented agreement may include, but is not limited to:
- Increasing or decreasing monthly rent obligations
- Deciding a fair earnest money deposit
- Changing the date tenants and owners can move in (or out)
- Adjusting the terms that may disqualify someone from receiving their deposit back
- Replacing or removing the deposit altogether
- Negotiating lease terms
- Moving the closing date
- Delegating the closing costs
- Transferring leases to a new property
- Adjusting the sales price of a single-family home following an inspections
- Novation real estate practices can negotiate almost anything, as long as each party is on board
Novation Vs. Assignment
As previously discussed, novation real estate may involve replacing the debtor or the counterparty. Regardless of who is being replaced, each change transfers the interest in a contract from the original party to a new party. If the debtor is being replaced, they are transferring the debt obligation to a new debtor. If the counterparty is being replaced, the new counterparty will introduce new terms to their benefit. Combined, each type is capable of transferring both benefits and burdens.
An assignment of contract, on the other hand, is a subsequent tool used to transfer one party’s interest in an original agreement to another. Not unlike the most common novation real estate practices, assignment inherently changes who is responsible for the contractual obligations, but with at least one major exception: A contract assignment only transfers the original benefit of a contract (not the burden).
When wholesaling real estate, for example, investors will enter into a new agreement with the owner of a subject property. While there’s more to it, the average wholesale contract explicitly gives the wholesaler the right to buy the home. To be clear, the deal doesn’t state that the wholesaler is a home buyer. Instead, the contract gives the wholesaler the sole right to buy the home.
Once under contract, the real estate investing professional may proceed to sell their right to buy the property. Otherwise known as an assignment contract, the transfer of interest in the contract is only accompanied by the benefit to buy the house — there are no burdens involved. The homeowner benefits from the sale of the property without hiring a real estate agent or Realtor, and the investor collects a fee for their services.
Novation In Commercial & Residential Real Estate
Changes can be made to both residential and commercial real estate deals. Perhaps even more importantly, novation real estate principles do not change, regardless of the type of property in question. Nonetheless, changes are as simple or as complex as the underlying agreement makes them.
Residential underwriting, for example, is typically a lot simpler. More often than not, standard novation is all that’s needed to make changes to an existing contract. While there are exceptions, most residential agreements only involve two parties: the lender and the borrower. Due to the number of parties involved — or lack thereof — the process is relatively easy and straightforward.
When it comes to commercial real estate contracts, however, implementing changes may grow exponentially more complicated. If for nothing else, the sheer cost of dealing in commercial property is so immense that it usually requires multiple parties to finance real estate transactions. As a result, commercial assets have become synonymous with more contracts than their residential counterparts.
Consequently, each of those contracts will need to be novated in the appropriate order to bring about new contractual obligations. Again, the same novation real estate principles still apply — just on a more complex level than in the residential market.
Novation Real Estate Example
Novation real estate examples can be used to describe any number of changes to existing contracts. Still, it may be helpful to contextualize the act of making changes to a contract with a real example of novation.
Let’s say, for example, a tenant is currently in the fifth year of a 10-year rental agreement. In the five years since signing the lease, rental asking prices have drastically increased. Not surprisingly, the tenant is enjoying a great rate, but the landlord is missing out on necessary cash flow. At the same time, the tenant is entertaining a job offer halfway across the country which would force them to move and break the lease.
At this point, both parties would likely benefit from the same thing: a shorter lease. Instead of penalizing anyone for breaking the original contract (or the law), a novation agreement can replace the existing lease terms with something more acceptable to everyone involved, like a month-to-month option. That way, the landlord can increase the rent at the first opportunity they get and the tenant can begin a new career without being penalized for breaking the original lease agreement.
Pro Tips For Novation Agreements In Real Estate
On the surface, changing the terms of a contract is another form of renegotiating. As a result, most of the advice that applies to negotiating a contract can be applied to using novation in real estate agreements. That said, there’s one piece of advice that’s more valuable than all the others combined: communicate.
Anyone who wants to change a contract needs to learn how to communicate properly. After all, how will either side know changes need to be made if nobody speaks up? Let your intentions be known. Explicitly inform the creditor, lender, or counterparty what it is you would like to replace in an existing agreement.
Remember, this isn’t a command; it’s a negotiation. In return for your request, be willing to offer something in return. Find out the motivation for why the counterparty offered the contract in the first place and see if there’s anything you can do to make it more appealing. More often than not, the counterparty is motivated by money, but there are always exceptions. Nonetheless, if you can pinpoint their motivation, you may increase your odds of changing something in your favor.
Legal agreements are meant to set things in stone. After all, signing on the dotted line contractually binds each party in a respective agreement — that is until it doesn’t. If for nothing else, changes may become necessary for any number of reasons.
Fortunately, there are several ways to amend contracts, not the least of which is the act of novation. Using novation real estate practices will ultimately reflect each party’s best interests, but not unless everyone is fully informed on the subject.
Understanding novation and its implications in the real estate arena is key to its effective use. It's a nuanced subject that requires a comprehensive understanding to navigate successfully. This is where the experts at Real Estate Skills step in, offering the knowledge and guidance necessary to fully comprehend and adeptly handle real estate novation.
At Real Estate Skills, we aim to empower you with the tools and insights needed to make informed decisions in your real estate ventures, including the effective use of novation. Our in-depth resources and expert advice on a wide range of real estate topics can help you navigate the complex world of contracts, amendments, and agreements with confidence.