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Avoid pitfalls in buying distressed property in bankruptcy
Bankruptcy sale! Pay only cents on the dollar!
Buying real estate out of bankruptcy has real benefits: an opportunity to buy distressed property for a rock-bottom price; avoiding claims of the seller's creditors; cleansing title of liens and other defects through the bankruptcy process. But you must avoid the pitfalls.
"As is”? You better believe it! The bankrupt seller will not make meaningful representations and warranties concerning title, condition or use of the property. Even if it did, you wouldn't have a solvent seller to sue for breach of those representations and warranties. Consequently, as a buyer, your job is to do the most in-depth due diligence you can to discover the defects in the property. Title insurance is essential. A survey, environmental inspection, zoning review and building inspections are even more important than usual. Often pertinent documents and information concerning the property are incomplete or nonexistent, because the bankrupt seller's knowledgeable employees have left or a trustee unfamiliar with the property is now in charge. It all falls on you, the buyer, to find out everything you possibly can about the property, so you can assess whether a bargain price will compensate you for the risk you assume in buying a property out of bankruptcy.
Contingencies? Bankruptcy deals typically include fewer contingencies than in a traditional real estate purchase. The seller-debtor and its lenders are reluctant to spend the attorney time and money to proceed with the bankruptcy court approval process, if the buyer can easily terminate the deal and be returned its deposit. Consequently, much due diligence tends to be done before the purchase agreement is signed. Due-diligence periods often are timed to end prior to the date scheduled for a bankruptcy court hearing on the purchase or objections to the purchase. This means you as a buyer might only have 20 or 30 days to inspect the property, review title, do a survey or perform other due diligence, after the date seller and buyer sign the purchase agreement. The seller-debtor and its creditors will negotiate hard for a purchase agreement without a financing contingency. A rezoning contingency is virtually unknown. And not only are contingencies few and far between; the required earnest money deposit is typical
ly higher than in a non-bankruptcy deal. Your risk of losing a large deposit is bigger.
Competitive bidding? In a bankruptcy deal, a signed real estate purchase agreement is not the "binding deal" it would be outside of bankruptcy. Any purchase agreement will be expressly contingent upon bankruptcy court approval. It may expressly say that your offer will be exposed to competing bids. Even if it doesn't, the fact is that if another potential buyer steps forward and offers a better deal, the seller and its creditors will seriously consider the competing offer. The bankruptcy judge has broad discretion and might very well throw out your offer in favor of the better one. After all, the bankruptcy process is geared to getting the highest return possible for the creditors. It is NOT concerned with how much time, money and energy you spent performing your due diligence and negotiating your deal. There are ways to discourage competitive bidders and protect yourself from an overbid, like being the first or "stalking-horse" bidder who gets to define the scope of the bid to the real estate you want. A bid
for substantially all the assets often is preferred by a seller-debtor and its creditors over a bid for one parcel, even though at a better individual price. As the stalking-horse bidder, you often have the opportunity to do more due diligence than possible competing bidders. You may have more opportunity to line up financing because you got a head start. And in some large deals, you can get the bankruptcy judge to approve a "break-up" fee that reimburses some or all of your transaction costs if you are the stalking horse bidder, but out-bid.
Just like any other real estate deal? Buying real estate in bankruptcy is not the same as a traditional real estate purchase. In addition to all the typical issues a buyer faces, the bankruptcy process adds a host of additional issues: having to negotiate the deal not only with the seller-debtor, but also with principal lenders and creditors; navigating the bankruptcy court's process of providing sufficient notice of the purchase to all affected creditors and interested parties, and hearings and orders approving the purchase; dealing with unexpected objections by creditors.
These additional aspects tend to draw the transaction out, so it may take longer to reach closing. You need to work closely with the title company to make sure it is on board with the bankruptcy process and really will be willing to insure your title at closing. These additional tasks require an attorney experienced in doing real estate transactions in bankruptcy, one familiar with the judge and his or her way of doing things and who probably knows and has dealt with the attorney representing the seller-debtor or trustee. Without experienced help, you as a buyer are at the mercy of a seller-debtor and its creditors, whose sole interest is to unload distressed assets in return for your cash. You are at a significant disadvantage.
Greater transaction costs? The purchase price may be cheap, but the cost of getting to closing isn't. The more intensive due-diligence process and the need to hire experienced bankruptcy counsel who must not only do the deal, but must participate in bankruptcy court proceedings, result in higher to costs to you as buyer — both out-of-pocket costs and in the commitment of your time and energy needed to make the deal happen.
In this economy, you do have an excellent opportunity to pick up real estate in bankruptcy, at a good price. Don't be foolish and turn a great deal into a nightmare by ignoring the pitfalls in a bankruptcy purchase.
Bill Hall has more than 25 years experience as a commercial real estate attorney helping sellers, buyers and lenders deal in real estate in bankruptcy. Most recently, he and his firm, Warner Norcross & Judd LLP, represented the trustee in bankruptcy in the successful sale of the 1,000-acre Double JJ Resort Ranch, in Rothbury, Mich.