Generally, a novation is a legal instrument used to replace one obligation or party with another in a contract. All parties in the original contract must agree to the changes to execute a novation. Once all parties accept it, the novation nullifies and replaces the previous agreement.
Legal obligations or terms appear in a real estate purchase agreement, rental agreements, and other contracts. A novation might be used to negotiate, renegotiate, or clarify the terms that were either missing from the original contract or require adjustment to satisfy all the parties and keep the transaction on track.
Typical contract terms that are renegotiated with a novation include:
Novations are more common in commercial real estate deals, but residential contracts may implement novations as well. A novation is usually more straightforward in a residential transaction because they are more likely to involve fewer parties (usually only the buyer and the seller). A few ways that novations are used in real estate include:
In each scenario, the new contract will replace the existing one with a novation. In the first two scenarios, transferring the burdens and benefits of the current contract to a new party is often better for a business’s reputation and credit than attempting to cancel the contract or default on a loan. When walking away from a deal results in undesirable consequences, attempting to renegotiate the terms or supplant one party may be the best strategy.
In a residential purchase agreement, an inspection contingency often gives buyers more leverage to walk away without a financial repercussion, like giving up the earnest money deposit to the seller. However, depending on market conditions, both buyer and seller might prefer moving the current deal forward with a novation rather than canceling it altogether.
If a novation involves transferring a mortgage or other financial obligation to a new party, the lender will likely require a thorough background and financial check on the buyer.
While a straightforward concept, novations can be difficult to implement because they require agreement of three parties: the transferee, the transferor, and the counterparty. The counterparty, like the lender in the second scenario, may be unwilling to take the risk of a new party (the transferee) who may not meet the terms of the original contract.
When a novation isn’t possible, many professionals use an assignment instead. Assignment contracts are common when wholesaling real estate. In an assignment, only one party transfers the benefits of the original contract to another party and the original contract remains intact. For example, if there is a contract for Bob to sell two lemons to Mary, and Mary assigns her interest in that contract to Carl. Carl is only entitled to the two lemons, per the contract. Bob cannot give Carl only one lemon, and Carl cannot demand three. However, if this was a novation, Bob, Mary, and Carl could renegotiate the terms of the original contract, and Carl could then ask for three lemons.
Another way a novation is different from an assignment is that the assignor in an assignment remains legally responsible for the terms of the contract. Using the example above to illustrate, Bob and Mary enter a contract for the sale of two lemons, and Mary then assigns her interest in the contract to Carl. If Carl backs out of the assignment, Mary is still on the hook to perform under her contract with Bob. If they used a novation rather than an assignment, Mary would be out of the picture completely, and Bob and Carl would be the only parties to the contract, per the novation.
A novation is a great tool for renegotiating the terms of a contract, but it may not always be the best tool. Before attempting to use a novation, consider if another tool like an assignment, amendment, or other is better to accomplish your intended goal.
If a novation is the best solution for your circumstances, work with each party to find a suitable outcome for each. Making communication a priority will help resolve issues quickly. It’s advisable to consult an attorney when navigating options around contractual responsibilities. Getting a real estate deal to the finish line will often require staying in touch with each party regardless of whether a novation is used.
The information provided in Peak Title Professionals, does not, and is not intended to, constitute legal advice. All content is for general informational purposes only and is not intended to provide a complete description of the subject matter. Specific processes will vary based on applicable law. The title and closing process will be handled by a third-party attorney to the extent required by law. Product offerings vary by jurisdiction and are not available or solicited in any state where we are not licensed.
