An Investor’s Guide to Novation in Real Estate

Key Takeaways


Most real estate transactions are complex affairs, and several factors on a contract can change before the deal is closed. For example, either party can ask for different terms or change their demands between the first negotiation session and the closing date. Since buying a home is one of the most significant and expensive purchases you can make, you should ensure all your paperwork’s information is recorded correctly and ready to go. More importantly, any contract you sign has to be up to date and accurate. If a transaction’s contract has a problem, it could delay or derail the transaction process. To ensure this doesn’t happen to you, you need to understand novation in real estate.

What is Novation?

In a nutshell, novation means an existing legal contract or obligation is replaced with a new contract of either equal or close to equal (proximate) value. Through novation, an original contract is nullified and eventually replaced with a new contract. All of the benefits, terms, and burdens originally discussed are transferred to the new contract.

Novation is necessary because a new contract must always be redrawn and signed by all involved parties whenever a deal term or element is renegotiated, especially with something as complex and valuable as a real estate transaction. Verbal agreements just won’t cut it, nor will modifying an existing legal contract by scratching out certain words or phrases. Novation sets a new real estate contract as valid and legally binding. It ensures that everyone gets access to the new contract whenever a term renegotiation occurs (which can be frequent for real estate). For example, parties may disagree on the selling price, the mortgage term, the burdens or debt obligations, and so on.

Aside from real estate, novation can also be used in finance contracts, business contracts, and anything where legal terminology is crucially important. Novation’s primary benefit is arguably the nullification of earlier contract versions. Without novation, earlier versions of real estate or other contracts may be used in court to argue ownership, price disagreements, and more. Novation protects real estate investors by nullifying earlier contracts and rendering them legally invalid.


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novation in real estate

The 3 Types of Real Estate Novation

Novation is performed in three ways:

  1. Standard novation occurs when both parties in a given transaction agree to a new contract and add new terms to the document. The new contract is then signed by both parties.

  2. Expromissio novation is necessary if three parties are involved in the transfer of certain rights. The parties are the transferor, the transferee, and the counterparty. Each party in the transaction has to agree to new novation contract terms if they want to move forward with the transaction.

  3. Delegation novation is needed if a new creditor takes on the benefits and contractual responsibilities for an old creditor. In doing so, the original debtor is discharged from their financial obligations to the first creditor. The delegation novation contract then legally binds the new creditor to the obligations of the debtor. In simpler terms, the debtor stops owing money to the first creditor and then owes the same amount to the new creditor.

Assignment vs. Novation in Real Estate

Novation in real estate is very similar to assignment in real estate, as both processes can be used to bring at least one new party into an existing contract or real estate transaction. For example, novation makes a new agreement and transfers contractual obligations or rights from an existing party to a new party.

On the other hand, assignment only transfers the benefits and rights of the original contract to the new party or “assignee.” But any burdens, such as debt obligations, stay with the original party per the contract’s terms. In this way, with an assignment in real estate, the assignor or the person transferring property is still legally responsible for any contract terms or burdens.

Because of this major difference, novation and assignment are used for different purposes or objectives. Typically, assignments are used in real estate if someone needs to sublease a rental property to a new party while remaining on the same lease. This contract adjustment can be useful since real estate assignments don’t require a third party’s approval. Novation in real estate does.

Novation in Commercial and Residential Real Estate

Novation can play a key role in residential and commercial real estate transactions, although it also significantly draws out these transactions or negotiations. In residential real estate transactions, the process is a little simpler. Most residential real estate transactions are, after all, conducted between only two parties: the real estate buyer and seller. Things become much more complicated if novation is used in commercial real estate transactions, which may involve three parties or more much more often. If anything is changed in the contract, which happens very frequently in all real estate transactions, especially commercial real estate transactions, novation is used to produce a new contract ready for signatures from all involved parties.

Example of Real Estate Novation

To make sure you fully grasp novation in real estate, let’s break down an in-depth example of a typical residential real estate transaction.

Say that a real estate buyer makes an offer on a house. However, according to an in-depth inspection, it seems that the property’s yard line or borders don’t meet regulations. Even worse, they infringe on the property lines of another adjacent home. In this case, the owner and/or buyer have several options. For example, the owner could pay for the adjustments to the yard line out-of-pocket. Alternatively, the owner and seller could renegotiate the contract between themselves for a lower price. The buyer would pay a lower price since they would need to redo the yard line instead, covering the cost of that modification after closing. In this instance, the burden or responsibility to adjust the yard line must be placed on at least one party. It all depends on what the buyer and seller decide.

Say that the buyer and seller for the real estate property agree that the buyer will be responsible for modifying the home in exchange for a lower purchase price. Therefore, they draw up a new purchase agreement that includes the revised price using novation. The old agreement is henceforth voided and is no longer valid. The real estate transaction then moves forward to a close using the new contract.

As you can see, one of the most important aspects of real estate novation is the voiding factor. It makes an existing contract invalid and stops it from being used in any legal context. The new document is the only true document that matters unless novation is used to redraw the agreement once more.

Summary

Ultimately, real estate investors need to know how and when to use novation in real estate transactions. If you buy or sell any property, odds are you’ll use notation at least a couple of times as contract terms shift and as party expectations are adjusted based on things like price negotiations, inspection reports, and so on. Thanks to novation, real estate transactions can be modified relatively quickly, new contracts can be drawn up, and all parties can rest assured that earlier versions of real estate contracts won’t come back to cause them legal trouble later down the road.


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