Land contracts, structures and strategies - Part 2
Land Contract Structures
There are infinite ways to structure your land contracts, and particularly, we are always working on timing of those contracts. We seek to obtain the maximum amount of time possible in which to complete our due diligence, capital raise, project design and planning approvals. One thing we never do, is close the land transaction prior to completing the discretionary land approval or entitlement process. We are just not in the business of taking entitlement risk. Having said that, there are many ways to work around this, including our favorite, buying sites that are zoned “by-right” (see previous chapter on Zoning for explanation). This allows us to move quickly in our process of making ready to build and lease up, removes any doubt that our project will be approved. Our main job then in this example is to produce a ready and stable source of by right sites.
Here are a few typical structures for your land contracts:
Regular Escrow - These deals are typically 30-60 days for the due diligence period, plus 30 days more to close escrow. This is a fairly standard time period for many projects. One reason for this is that it is very difficult to complete a professional level due diligence process in under 30 days, there are just too many pieces of info to collect, analyze, and make decisions from to finish any sooner. Due Diligence (DD) is a process of review and investigation of the real estate, market, and zoning characteristics of the site to make sure you can do the deal. The DD process includes, but is not limited to, having a soils engineer prepare a soils analysis, an environmental engineer prepare a Phase 1 environmental report, market studies, title review, legal review, and zoning review. You get the point, there’s lots to cover and research and you don’t want to have insufficient time to complete the reports and allow time for your decision making process.
Long Term Escrow - very long escrow periods, sometime measured in years. We typically see these longer escrow periods when dealing with sites that require entitlements. We generally put language in the contract that says we will be obligated to close escrow once the city we are working in grants final unappealable project approvals. We then negotiate either an open ended contract timing, or set the outside date months or years in the future. These differ from long term options contracts in that we have actually enter the contract (signed or executed it), passed hard money through to the seller, but only require contract conditions to be met then we close. We don't’ normally make multiple payments into to escrow, but it can be structured this way similar to options. Option contracts are described below.
Short DD, Long Close of Escrow (COE) - This would be where you have a 5, 10, 15, 30 day due diligence period, then a longer term close of escrow. This would market and market cycle specific, and specific to your situation and capabilities. You would use this structure to help you compete, by clearing the due diligence contingencies more quickly, and getting the seller the escrow deposit more quickly (also called “passing monies hard”, or “hard money passthrough”). This means the escrow deposit is released from escrow to seller and cannot be returned (unless seller commits fraud). This hard money pass through can be a big incentive, as sellers see this as a true commitment to the deal. Obviously, because it’s your money you want to be sure you are OK with accepting of “clearing” the due diligence items - title reivew, soils engineering analysis, Phase I environmental report, zoning clearance, etc. You can still walk from the deal after you pass money through, but you won’t get your money back.
Long DD, Short COE - same as above, but allows more time for due diligence. Sometimes you can use this timing to test the equity and debt markets for your specific deal, if you don’t have capital relationships that are already in place. You might use this in new markets, where you existing capital relationships are not comfortable yet, or you need to develop these relationships from scratch. Also, allows for timing of zoning and planning conversations. If you think you may have a controversial planning process, such as neighbors against your project, you may want to use this structure to meet and try and resolve controversial project and plans.
Option Contracts - more often used in very long term land purchase structures. In this case, you may be working on a land deal over a number of years. Here the option contracts is where regular payments are made to the sellers to purchase the land. Sometimes people use this term interchangeably with a long term escrow, but an option contract is different. An option contract is a contract to enter a future purchase contract, with the options contract creating a specific right to enter into the future contract by the option parties, the seller and buyer (developer or builder). Options payments might be made monthly, quarterly, or yearly. This is totally and fully negotiable. Options are many times paired with the land entitlement process to gain approval for the land parcel under contract. There can also be a phased take down process, sometime called “rolling options” that give the developer or home builder the option to take down parts of the land in phases to suit their entitlement or build schedule. These are more often used by homebuilding companies, that only want to purchase the lots they need to build and sell homes.
Alternative Land Offer Structures
Entitle and sell
This is where a developers enters into a purchase contract with the intent to complete the entitlement approval process, then sell the land and the approvals as a package at the end of the entitlement period. Sometimes these are sold in a double escrow, where the buyer (developer) and seller are in one contract, and the developer sells to another buyer in another contract. Each of these has a separate contract and usually a separate title and escrow process. In some cases, the two contract can be tied together, i.e. of one does not close escrow, the other does not also. They don’t have to be tied together, but can be if needed or wanted.
We have sold a number of land opportunities, where we put the land into escrow, completed the entitlements, design, and subdivision mapping process, then sold to another "builder" who took on the risk of the actual financing, construction, marketing, and sale of the project. By doing this, we skipped the entire build process and avoided the market entirely, plus we went FAST. In the real estate development business, I say "slow kills". These type of land sale projects have been some of the most profitable projects in our company's history.
Project or Land Joint Venture (JV)
This is a structure where the developer asks the land seller to "invest" or transfer their land and land value into a new single asset entity like a limited liability company or LLC. The LLC is then co-owned by the developer and landowner, and is the vehicle to complete the development project including project approvals, design, debt financing, construction, lease up, and sale. Normally, we see the landowner and developers agree to a land value for the invested land before the transfer, which is sometimes supported by an appraisal. This land value can then be utilized as equity as related to the debt financing, and in an amount the lender approves based on the appraised value. At the completion of the deal, the project is sold, the land owner receives their agreed upon land value, and depending on how the land value equated to the needed equity, they would then get an equity investment return the same as if they invested cash in the deal. In many transactions, you might see the land value be close to or equal to the equity which would remove the necessity to find outside or 3rd party equity investors. If a landowner has sufficient experience, savvy, and knowledge, this is a great way to generate additional returns beyond a straight land sale. This also provides a delay in the tax liability from a land sale. It doesn't remove it, just moves it into the future. Normally, the transfer of land into a new LLC by the owner, for which the landowner is also an owner, is not a taxable event. These LLC interests can also be exchanged in a 1031 exchange structure (We are not accountants or CPA's, so please check with your CPA for your specific tax situation). For the developer, this is a great way to raise a different form of equity, usually from a landowner that already knows the specific geographic market in which the land is located, and can be a win for both parties.
