Land contracts, structures and strategies - Part 1
Now that we have covered proforma analysis, we can move to the next stage of a project, getting the land tied up, or under contract. Sometime people describe this process as putting the land or deal “into escrow”.
To start a few basic definitions and explanations:
Here, we will describe regional organization and structures and definitions from a California point of view.
Escrow: Escrow or escrow services are services provided by a company that acts as a neutral, third party, for handling documents and money that are required to be traded or transacted for the land to shift ownership or change hands from one party to another. Normally, escrow companies are licensed by a regional or state political body, like the state of California. Escrow fees are normally split equally or 50/50, but any split or no split can be negotiated as part of the purchase and sale agreement.
Title: Title companies provide insurance that protects against legal or other technical issues related to land ownership when you buy it. These types of issues might be encroachments, easements, legal or political covenants that affect land ownership. Normally, a seller will purchase or pay for the title insurance as part of the delivery of the land in the transaction. This point is negotiable. Generally, there are two levels of title insurance. First, what we call a “CLTA policy” or California Land Title Association. The other is called an “ALTA policy”, or American Land Title Association. The main difference is the criteria for putting the coverage in place, and the ATLA policy normally requires a survey. This survey, called an ALTA Survey, survey the properties for encroachments and other title issues. This survey will normally delineate the title exceptions show in Preliminary Title Report (PTR), and these need to match the actual title policy. They work together.
The PTR is normally received during the due diligence period, and once the transaction closes, you will receive the actual title policy, which is your insurance related to the land transaction. We’ll talk more about title review in the post on the due diligence process.
Letter of Intent (LOI): This is a deal memorandum or letter form that delineates the deal points for a potential offer. Most times, these are described as "non-binding", meaning that although the parties may negotiated an LOI, and sign it, the terms of the LOI are not legally binding unless and until a proper or complete purchase and sale agreement is drafted, signed, and submitted to escrow in order to open escrow.
We always use an LOI when possible, as it is a low cost way to negotiate terms of a potential sale. As well, we'll use it when the contract terms may be extra complicated. We almost always have an LOI when dealing with a professional seller, someone in the business of real estate or development. They typically understand the necessity of keeping the attorneys out of the negotiations until they're need to draft the PSA. We rarely get an LOI when dealing with less sophisticated sellers or real estate agents. They are not used to it, and normally see it as a hinderance, not a help. In that case, we'll use the CAR Vacant Land form or equal.
Purchase and sale agreement (PSA):
This can take a couple of different forms.
- a promulgated, or standardized form can be used. This might come from you local state realtor association, for example in California, it’s the California Association of Realtors form (or CAR form). These can be for many different types of transactions, but we use the CAR Vacant Land contract typically. We do tend to make significant additions, alterations, or adjustments to the CAR contract form in the Addendum Section. This allows us to tailor the contract to our needs typically related to timing of due diligence and close of escrow related to governmental approvals or entitlements for our project.
- The other way to provide a PSA is to have your attorney draft it, or you draft a form PSA prepared originally by an attorney. This would be used when dealing with a professional in the business, as they'll want the terms to be customized well beyond what a promulgated form can provide. As well, anyone in the business that deals with attorney drafted contracts, will know to anticipate what we call a "one-sided" PSA. This means that whomever drafted it, the seller or seller's' attorney, will try to make the contract favorable to their side. In our case, in our LOI, we use language in the LOI that indicates that WE will draft the contract, i.e. "such purchase and sale agreement shall be drafted on Buyer's form of contract" or something similar. I will say this, we are not typically comfortable making this move overtly. While there a thousands of small details in a complex PSA document, we don't like to make it so one-sided as to be egregious. Some folks do, we don't go to that level in that way we handle the drafting.
Side note: Regarding working with legal counsel. Many new or less sophisticated developers and real estate folks, don’t or aren’t able to keep their attorney's under control. What I mean by this is, that you as the developer, should always be observing your legal counsel to make sure they are both protecting your interest AND helping you to move the deal forward. Of course, we all know of attorneys under the old adage “deal killers”, but notwithstanding this common interpretation, for you to be effective, it becomes your job, if you want to close deals to manage the attorney so they don’t kill the deal. If they can’t do that, get a new attorney.
I have worked with both types over my career, and you will know the difference after working with a few different people and firms. The best case is a good balance between deal making and legal protection. There are certainly many ways to kill a deal over small and insignificant details. Part of my assessment of folks on other side of transactions is to assess their legal counsel and how well the other party manages their attorney. I have NO interest in fighting tooth and nail over non-critical legal details, we will just quit the deal and move to another. This is also the reason why you always want to keep a deep inventory of opportunities on the land side, so that when you do run into these types or any type of issue that causes you to spend inordinate amounts of time, energy, money, and lost opportunity, you can quit the deal. Same goes for when you sell your projects to new owners, make effective assessments of the other parties legal counsel.
Finally, sometimes you do get stuck with a difficult attorney on the other side, it does happen sometimes that you can’t avoid it. My best advice if to have a conversation with a principal on the other side of the transaction to see if they will manage their counsel. If they won’t, do your best to interact with that deal killer attorney as little as possible, and maximize the interaction with the principal without counsel.
There are different philosophies regarding getting a parcel of land into escrow.
- Get the land tied up first, based on a very rough order of magnitude analysis of the deal, then get into the details of underwriting, due diligence, and early market analysis while your are negotiating the contract or during due diligence. In some cases, if you know what a typical deal can pay for land, then you can use that. Example: On past deals, you have run numbers on a duplex, and these deals have been able to pay 50k per door for land, and you make your offer based on this standard land value. In a highly competitive land market, you may need to do this to compete effectively.
- Do the basic analysis, run the proforma, with some assumptions regarding rents, operating expense, build costs - all based on recent working knowledge of other similar deals, then make an offer based on that basic analysis.
- Do all the research, pull rent comparable, sale comparables, prepare an initial site plan, speak with general contractors, and any other research that you might think is warranted to do at this point.
For us, we generally use #2 above, do a basic analysis using existing data. Where we orient, it to run numbers very quickly, as a litmus test on what we want to offer, then base our offer on that.
Next, Land Contracts - Part 2, where we'll discuss more contract details, escrow timing, etc. As well, we'll delineate alternative land transaction structures.
