The Basics of a Novation Agreement in Real Estate

An Overview of a Novation Agreement

What is a novation agreement? It’s typically used in real estate contracts to transfer the responsibility of ownership of the property and make the other parties responsible for it in a way that if the first party doesn’t perform, the second will.
The legal concept is that when the Original Party Covenantor fails to perform, the Second Party Covenantor automatically falls into the shoes of the Original Party Covenantor and assumes responsibility . The consideration in the contract is obviously that the purchase price is going to be paid and possession taken in exchange for the deed, so the obligations of all parties are clear.
It should be noted that the attorney who drafts the novation agreement has an easier time writing it than does one who merely reviews it after having had nothing to do with the negotiation or drafting.

How a Novation Varies from an Assignment

The difference between novation and assignment is found in their legal outcomes for the parties involved. At its most basic, assignment transfers the rights, duties and benefits of a contract from one party to another; whereas novation replaces an old obligation with a new one, extinguishing the original obligation. In a real estate context, an assignment might be used for a lease, giving a tenant the ability to transfer its rights and obligations under a lease to a new party, while novation might be used in an asset purchase or a new loan transaction to transfer the obligation to repay an existing debt to a new party without a release of the original obligation.
Novation may protect the other party against potential liability if the assignee does not perform and the supervisor of the transaction is not released from its obligations under the contract by the non-assigning party. Even though the original party is not released from its obligations under the contract, the ability to collect from the assignee through novation may be more likely to be paid as the new other party may have a closer relationship with the new obligor than the other to the contract.

The Positive Aspects of a Novation

Novation is often the preferred method for assigning and discharging contractual obligations in a real estate context. Its benefits include:
Enabling all parties to preserve the benefit of specific terms negotiated in the original contract, such as favourable provisions requiring specific financing, state-of-the-art technology, or highly skilled labour.
Preserving vendor protections and rights of redress in regard to non-performance by the successor to the original purchaser under the novation agreement.
Allowing negotiating parties to address any adverse tax consequences that could arise from back-to-back capital gain realizations in the context of a straight assignment.
Preserving the goodwill of the vendor in effecting the sale of its business to an appropriate purchaser.
Ensuring a passport through anti-trust hurdles that may arise with respect to certain types of real estate transactions.

How You Can Carry a Novation into Effect

Generally, there are three steps involved in executing a novation agreement. In the first step, the parties negotiate and execute a contract in which the purchaser acquires property with the stipulation that the lender’s, lessee’s or property owner’s (as the case may be) interest under a mortgage, lease or deed of trust will be or is assigned to the purchaser. In the second step, the lender, lessee or property owner must give its consent or approval to the transfer. In the third step, the existing lender, lessee or property owner assigns its interest to the purchaser.
Assuming the existing lender, lessee or property owner is an individual, no additional paperwork is required. If, however, the existing lender, lessee or property owner is a business entity, such as a corporation, limited liability company, general partnership or limited partnership, additional steps may be required. Under the modified uniform commercial code, for example , existing partners of a general partnership must adopt a new partnership agreement identifying any new partner joining the partnership and confirming the dissolution of the old partnership. In addition, if the existing lender, lessee or property owner is a limited liability company or other business entity, a "resolution" may be required to be adopted in the transfer agreement, confirming that the transferee organization has all authority available to it to assume the rights and obligations of the transferor and to perform all duties under the contract.
There may also be additional requirements under state law associated with transferring ownership of a residential unit in a condominium or cooperative association; see articles on requirements for transferring a condominium and requirements for transferring a cooperative apartment. To the extent additional procedural steps are required by law, by agreement between the parties or by the governing documents of the property in question, it is best to undertake these steps at the outset to avoid what may turn out to be a nullification of the transaction after the fact.

Risks Inherent in a Novation

The most common pitfall with novation agreements is that the subject matter, or future conveyance, of the original contract is no longer available to be assigned. For example, if a property subject to a contract to purchase and sell has been fully improved or built out prior to the closing of the same, it is not an option to novate the contract into a new sale agreement because the property is not in the same form that it was when the contract was executed. An award of the novated contract may be entered into under an adverse possession or unjust enrichment theory but this may be time-consuming and costly.
Another risk arises in instances where the novation is for the benefit of one specific party that is also benefitting from a disclaimer of the other party. For example, a condominium association may seek to guarantee a leasehold interest for its developer. If the developer seeks to have the unit purchased as part of the new contract, they may require the condominium association to consent to a waiver of all rights by the purchaser. If such a clause is included in the new contract and the purchaser is disclaimed, the purchaser will then only have recourse for damages (if any) on the original contract it executed with the developer. The agreement to grant the leasehold interest to the developer in the new contract may not be permitted based on the language used to disclaim all rights to the purchaser. This is an example of the type of issue that we advise developers and property owners of with respect to novation agreements.
Other risks include the inability of the developer/vendor to perform its obligations under the new contract. If time is of the essence, such a default may be costly to the owner.

Novation Examples

In the world of real estate transactions, few concepts are as crucial—and yet as often overlooked—as that of novation. Through a few real-life examples, we can examine just how effective a properly executed novation agreement can be.
The Commercial Property Purchase and Sale Agreement
With sky high prices sought in today’s commercial property market, it comes as no surprise that even the most basic of closing details can fall through the cracks. Such is the case in one complex commercial land transfer in which an LLC sought to purchase and renovate an office building in a densely populated urban area. The deal was soon approved, and even the odd issues of financing and payment terms seemed to be resolved—except for one detail that had apparently fallen by the wayside. Specifically, the purchase and sale agreement between the LLC and the seller (a large national bank) made no mention of what would happen in the event of an assignment of the contract. To make matters worse, when the LLC began to grant equity shares among each of its members, those members began to form their own LLCs. When the project went two years past schedule, it became apparent that new LLCs would either need to approve or disapprove of the initial agreement. As it turned out, neither party was satisfied with the original estimated cost—each contended that it should be significantly lower. The would-be deal between the bank and the LLC soon devolved into a situation of competing offers among multiple LLCs. (Some were willing to pay considerably more than the original deal, while others could pay considerably less.) Still, the bank was rightly concerned that larger LLCs could easily be used as proxies while their executives looked to negotiate small interests in backroom deals. Fortunately, the bank required that any potential buyer undergo extensive background checks by a third-party due diligence vendor. Essentially , the goal of such a precaution is to protect both the bank and the taxpayers who will be hefting much of the burden for future write-offs. But while all of this is happening, counsels for the LLC had already begun to move forward with the initial effort—to assign the right to assume the contract to the LLC’s "similarly situated members." None of them took the bank’s concerns to heart, nor did any of them bother to seek out the bank’s permission. Such failure would go on to cost many of them their claim with the initial LLC, when a much larger LLC won possession and moved forward with the deal without requiring the bank’s approval.
The Lessons Learned
In this case, the corner cutting by some parties led them to enter into a circumstance that brought them into serious conflict with multiple parties. Proper novation agreements could have gone a long way toward avoiding that conflict, even if the initial buyer had needed to explore multiple options for a sale and purchase.
Another Case Made in Heaven
A commercial corporation based in the Midwest was interested in turning a large tract of land into somewhat small-scale steel manufacturing. As is so often the case, the price of the property ended up being higher than expected, and when the time came to fund the deal, the deal’s owner did not take the step of obtaining approval from the bank of the property’s neighbors, who were largely responsible for the upkeep of the property’s vital community infrastructure. When the LLC came to put its plan into action, the remaining stakeholders (the neighbors) objected and sought out steps meant to block the LLC from control over the land itself. In this case, the LLC’s immaturity kept it from exploring its options and seeking out a proper novation agreement. The result was increased premiums for the LLC and a shortage of parties willing to be a part of the deal. The key to a successful novation is to ensure that proper communication is made among all impacted parties.