Forming an entity to purchase, develop and operate real estate is generally a good idea for many reasons. There are tax considerations and liability implications that should always be at the forefront of any discussion when investing in real estate.  These are primary questions whether there are multiple partners or only a single investor involved in the deal.  But, when there will be more than 1 partner in a project, some sort of entity will need to be formed, whether a corporation, general or limited partnership, or a limited liability company or similar limited liability entity.  The “partners” (I am using this term generically to cover all  possible entities) should enter into an agreement carefully to set forth the rights and obligations of each partner so that there are not any questions about what happens in the future if/when certain problems arise.

Every relationship starts out with the best of intentions. Friends and family members, even acquaintances, generally trust each other to do the right thing.  But when money is involved or deals turn side ways, all bets are off.  Here are 6 provisions that should be considered in every shareholders, partnership or operating agreement, particularly when real estate is involved:

  1. Management Authority and Major Decisions – going into a real estate deal, 1 or 2 people might be the sponsors, or, 1 partner might have certain expertise and another might have a different expertise. Very likely, 1 partner might be the real estate guy and the other or others might be providing the capital.  It is important to determine who will make the day to day decisions and what decisions constitute “major decisions” requiring a vote of the partners.  Will  major decisions require a majority vote or a super majority?  Perhaps even a unanimous vote?

 

  1. Admission of New Partners – it is important to determine whether there will be spelled out criteria for admission of new partners and whether a vote of the partners is required to admit new partner or if the managing partner may admit new partners on his/her own. More importantly, will the admission of new partners dilute the voting interest or equity interest of the existing partners?

 

  1. Transfer of Ownership Interests – there are 2 concerns here, voluntary transfers and involuntary transfers. A voluntary transfer is the ability of a partner to freely transfer or sell his/her interest to 3rd parties.  Should this be permitted?  Or, should voluntary transfers be tightly controlled or absolutely restricted?  Involuntary transfers include transfers due to bankruptcy, divorce and death or a partner.  These are of concern to the partners because often, the non-transferring partners don’t want to be partners with the ex-spouse or surviving spouse, or be forced to deal with the bankruptcy trustee.  Therefore, it is important to provide mechanism for dealing with involuntary transfers.

 

  1. Capital Calls – the partners must determine the procedures for dealing with the need for additional capital and what happens when a partner does not fund.

 

  1. Buy/Sell Provisions – often, partners want to add provisions allowing for a partner to buy out the other partners. Sometimes, these mechanisms allow for “put and call”, requiring a potentially purchasing partner to sell his interest instead so that the financially stronger partner can’t force out the weaker partner any time he/she desires.  These provisions also can include rights of first refusal.

 

  1. Exit Strategy and Other Obligations – what is the partnership’s overall exit strategy? Have the partners agreed to sell the property at a fixed benchmark such as the exercise of a purchase option by a major tenant? What about other obligations like loan guaranties?  Are any of the partners obligated to provide guaranties for financing for the project?  These kind of provisions must be included in the partnership agreement.

 

These 6 provisions might only scratch the surface of issues relative to real estate deals. Every partnership and real estate transaction is unique.  If there are deal specific provisions, they should be added to the partnership agreement so that no questions or expectations are left unanswered.

Selecting the right property to buy or lease can be tricky. Every one knows the old adage “location, location, location”.  Clearly, location is crucial to every one involved in a real estate project from brokerage to development to construction; from lending to investment; from management to leasing, location will be a crucial factor in everyone’s return on the investment in real estate.  However, a corollary to location is zoning, zoning, zoning.  A property that does not have the proper zoning and land use designation for the proposed use, and one that can not be appropriately re-zoned, or variances obtained, will have no value to a buyer, developer, tenant or investor and location will add no value.

This rule applies to properties that are being purchased or that are being leased. A retail location might be the best spot in town for your client’s hot new night club.  But zoning might not allow any business which serves alcohol to be located in that location because a church is located within 1000 feet.  Or, noise regulations prohibit music after 10:00 because of the hospital across the street.   These are some of the things that should be considered even before entering into a contract or a lease.  They can save time and money.

When purchasing a property, it is a good idea to have preliminary, exploratory conversations with city planning and zoning staff to discuss the site. This is a good way to learn what the city would be comfortable with.  The meeting will help the buyer understand what approvals will be necessary for the project and will assist in formulating a timeline for obtaining approvals.

Upon preparing the contract, the buyer should make the obligation to close contingent upon obtaining the necessary approvals. The approvals can be specific, but I like to keep them as generic as possible.  For example, I define “Approvals” as all approvals necessary to enable buyer to obtain building permits to construct the Intended Improvements.  When pushed, I will list approvals to include, without limitation, zoning, land use, platting, site plan, and I will expand as necessary.

Many times, going into the contract, the parties know precisely what zoning is going to be required, or the seller has already begun the process of re-zoning in anticipation of a sale for such a use. This should not affect buyer’s contingency as the use drives the value of the property and must be in place prior to closing.

Zoning diligence before contract can make negotiations smoother and faster. It can also help buyers and sellers set a realistic price for a property, particularly because with proper approval contingencies, buyers won’t have to close if the zoning is not sufficient for the intended use.  But patient sellers will be more likely to get their desired price.

I have been negotiating and closing real estate development deals for a long time. In nearly every case, my developer clients have come to me prior to executing a contract to discuss the due diligence that they have already done on the property and what will need to be done going forward.  We discuss the proposed use of the property, the current zoning and land use, the necessary land use to construct the proposed improvements, what other approvals will be required and the seller’s willingness to allow us to obtain all these approvals prior to closing.  The client has generally assembled all or most of his team and has a pretty good idea of what he wants to accomplish and what he will be capable of getting approved, subject to further research and subject to the give and take of the zoning and land use process.

            Perhaps at this point a Letter of Intent has been discussed or even executed; the basic financial terms agreed to.  However, my job is about to begin – prepare a contract.  It will be most important to hash out the contingencies, specifically the contingency for approvals.  Although the seller is prepared for this, we both might have strong opinions about the required time frame to obtain the approvals.  Some of this will be based on the amount of time the buyer needs to prepare plans.  Some this might depend on seller’s desire to approve plans, particularly if the property is part of a larger development.  Sellers want to make sure buyers don’t miss rigid deadlines.  Buyers, on the other hand, need leeway for governmental delays, slow engineers and architects and even slow response times from sellers.  There is give and take between the parties.

            Extensions of time periods may be built into the contract or subsequently negotiated.  Additional deposits or extension fees are part of this discussion.  Are they applicable to the purchase price?  Are they refundable or non-refundable?

            I write about this because I am working with a client who recently came to me with a fully executed contract for property on which he wants to build a high density (for the neighborhood) multi-family, multi-story apartment building.  the property is only about 1.25 acres and currently has a single family house with an ancillary garage or some other building on it.  The property is zoned for residential/agriculture.  The contract has a 120 day due diligence period followed by an immediate closing.  The purchase price reflects the desired use of the property, but not the current market value or as is use.  The client had not assembled any team or professionals and, other than a brief meeting with city planning and zoning staff, had done no investigations to determine whether we could build what he wanted to build.

            We have since met with the city and determined that the city is in the process of initiating a re-zoning of the property to a favorable designation.  However, the density will not provide the desired number of units, leaving the client roughly 15 units short.  This city does not allow variances for density and there is no possibility of re-zoning to another classification.  The economics of the deal would not work without these units.  The zoning classification will allow mixed use, meaning that the client can put office/retail on the ground floor.  With about 10,000 square feet of office/retail in addition to the apartments, the client believes the economics are very favorable. Tthe client has not yet assembled his team and the due diligence deadline is rapidly approaching.  We have a team that has submitted proposals that are awaiting the client’s approval.

            But, that brings us back to the seller.  The seller’s expectation is to close immediately following the 120 day due diligence period.  This is the problem with executing a contract before understanding what is permitted and what will be necessary in order to build your project.  The seller, unfortunately, has medical issues and needs cash.  Fortunately, non-refundable extension fees solve the seller’s cash needs and we will be able to extend the contract for the 10 months necessary to obtain the approvals.

            The work is just beginning. The project needs to be designed in order to be approved.  We need to now work with the engineer to prepare a site plan in accordance with the proposed zoning ordinance.  The client needs to describe his vision to the architect to design a building that the city will also like.  Working with a good land planner who will act as the quarterback to keep everyone on task, including surveyors, civil engineers, landscape engineers and me, we can get this project approved within the 10 month time frame and the contract closed.

Contract Agreement on the Office Desk

Every buyer of real property wants representations and warranties from its seller in the purchase contract. Every seller knows that the buyer is going to request that the seller make representations and warranties as to everything under the sun and the seller will do its best to eliminate as many of the requested reps and warranties as possible. Then, the seller will do whatever is possible to water down the remaining reps and warranties so that they have as little meaning as possible and the exposure to the seller is as minimal as possible.

In a recent contract negotiation, my client was assembling two parcels of property for development. The first parcel seller was actually going to flip the property to my buyer client. Having just acquired the property from the local government, the seller was very unwilling to provide any meaningful representations or warranties. What reps and warranties the seller was willing to provide, seller strictly qualified to “the best of Seller’s knowledge”. My client, understanding how the seller acquired the property and that the seller did not every operate a business on the property or have any plans to develop the property, was willing to rely on its own due diligence with respect to this parcel.

The second parcel, owned by a different seller, was owned by the seller for a number of years. There was not a lot of discussion concerning the warranties and we were able to get nearly all of the reps and warranties we requested, without much qualification and without much discussion. Together with the due diligence my client would do on this property and given the fact that the parcels were adjacent, my client had a great deal of comfort that there would be no issues with either parcel.

The trouble, however, began in negotiating the second contract on a similar issue as to representations from my client, the buyer. As part of the consideration for the acquisition for the second parcel, upon the closing, my client agreed to convey, or cause the first seller to convey, a 75 foot by 300 foot piece of the first parcel to the second seller. This strip (the “Conveyance Parcel”) would allow the second seller to “square off” property he was retaining adjacent to the total parcel my client was purchasing and would provide a better access point for his property. The second seller asked my client to provide all of the same reps and warranties for the Conveyance Parcel that seller was providing to the buyer for the main parcel. The second seller was adamant and would not listen to our logic that because we did not own the Conveyance Parcel, we could not make any reps or warranties about the Conveyance Parcel. And, in fact, because the first seller would be conveying directly to the second seller, we would never actually own the Conveyance Parcel.

Notwithstanding, the second seller insisted. We went so far as to show the second seller the provisions in the first contract that were the toothless representations and warranties from first seller, again explaining that we could not provide the same reps. A compromise was reached. My client was willing to provide the exact same reps and warranties that he received from the first contract seller, but these reps and warranties would be “to the best of Buyer’s knowledge” which was further diluted to mean solely as to the seller’s knowledge as set forth in the underlying contract. In essence, we were getting two layers of insulation in providing these reps. But the comfort factor meant enough to second seller to proceed with the transaction and that alone, provided enough teeth necessary to make the reps and warranties worthwhile. Sometimes, toothless representations and warranties are better than no representations and warranties at all.

 

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