In last month's article, we discussed the process of finding land to develop as well as how to conduct the preliminary investigation and financial analysis. Part 3 in this series will discuss tying up the land, due diligence, and financing.
Tying Up Land Until It's Time to Make the Acquisition
Once you've identified a parcel of land and completed the preliminary investigation, you'll need to tie up the land until you are ready to acquire it. Tying up the land allows you to gain control of the property with minimal risk while you complete a formal due diligence. The method of tying up land prior to the actual purchase depends on the seller's requirements coupled with the developer's ability to pay. Often the seller wants cash. In other situations, the seller may prefer payments over time for tax planning purposes or to allow participation in the future profits of the developer.
There are many options that you can use to tie up land. The three most common methods are:
- Letters of intent
- Option agreements
- Purchase contracts
1] Letters of Intent
A letter of intent is a document used to describe your interest in a parcel of property and the terms and conditions under which you will purchase it from a seller. While typically not a binding contract, it can be used as an outline or framework from which a more binding contract could be drafted. At a minimum it usually contains a clause allowing price to be determined by mutual agreement in the future, a timeline for you to perform due diligence on the property, an acknowledgment that it is the seller's intent to sell the property to you and the seller's agreement not to market the property in the interim.
2] Option Agreements
An option agreement is a contract between you and the seller that allows you to have the right to purchase the property once certain contingencies have been met. As a buyer, an option contract gives you a secure agreement, subject to events or timing that neither seller nor you can control or predict. This is why it is imperative that the agreement specifies the conditions of the sale very clearly. In general, you purchase the option rights at a price, much like making a nonrefundable down payment on the property that may be deducted from the purchase price if you opt to complete the purchase.
Some examples of options that are widely used include:
The Straight Option. Using a straight option, you have the opportunity within a specified period of time to purchase a given piece of land for a certain price. For the privilege, you pay the seller a certain amount of money. If you ultimately proceed with the purchase, this money can be deducted from the purchase price at settlement. If instead you do not close on the property, then the seller keeps the option amount. The straight option is the most common form used by sellers and purchasers of property.
The Letter of Credit Option. Using this type of agreement, a letter of credit is issued from your bank to the seller in the amount of the option price. There is a charge for the letter of credit and the bank typically requires some type of security. If the option is exercised, in other words, if the purchase has proceeded to closing, the letter of credit is voided. If the option is not exercised, in other words the contemplated purchase does not close, then the seller collects the value of the letter of credit from your bank. This form of option eliminates money up front, however the additional required paperwork involving your lender makes it more complex.
The Interest Option. In this form of option agreement, you agree to pay the seller the amount of interest that he or she would have earned on the purchase price or appraised value of the parcel during the period of due diligence. If you do not exercise the option to purchase the property, then at least the seller has received compensation while the property was unavailable for sale. This form of option is more commonly used when the seller is only willingly to tie up their property if the buyer is willing to pay the true "loss of use" cost between the time of sale and time of closing.
The Rolling Option. The rolling option is used when you and the seller divide a larger parcel into smaller parcels and the selling price for each is predetermined from the onset of the option agreement. When you take the option on the entire parcel, you both agree to treat each smaller parcel as an individual contract within a larger contract. A predetermined event typically triggers closing on each smaller parcel. Developers use this option to gain control of a large piece of property as it is needed for development. This is ideal for the small developer who discovers the "perfect" parcel for a project, but it is too large for the immediate development plans.
3] Purchase and Sale Contract
A purchase and sale contract is a document that outlines the terms and condition under which you will purchase and a landowner will sell their property. It becomes the roadmap to the planned closing on a parcel of property. If drafted properly, it will also allow you some "outs" should the property fail to meet all of the requirements during the due diligence process. Only experienced developers should consider drafting the purchase and sale contract language. Competent legal advice prior to executing this contract is also advisable. Besides the obvious items of purchase price and closing date, several important issues should be addressed in any purchase contract, including the following:
Contingencies. The contract should specify any terms and conditions, called contingencies, set forth by you and/or seller that must be met prior to purchase. In a contract with contingencies, parties are not bound to the purchase until the specified terms and conditions set forth by you and/or the seller are met. Establish reasonable contingencies to protect yourself in the event that the property is unable to support planned development activities. Contingencies help you avoid entering into a purchase and sale contract to then learn that the property is unsuitable for your intended use.
The following terms are often contingencies within most purchase and sale contracts:
- A brief explanation of your development plan to include a condition that the purchase is only possible if the site is economically feasible
- An adequate timeframe set by you to obtain the necessary approvals, to determine the project's feasibility, and to complete the appeals period or any subsequent litigation
- A statement that you will be the sole determiner of the feasibility of the development project on the property specified for purchase
Timeframes. It is imperative that a purchase and sale contract provide ample time for you to perform reasonable due diligence on the property and to seek necessary approvals in order to develop the property. This timeframe varies by region and municipality. It may be necessary to include reasonable extension times in the contract to anticipate unforeseen delays during the due diligence period.
Right to Cure. The contract should include an automatic extension, or right to cure, on the feasibility period for approvals that are pending when the agreement expires. Similar to timeframe extensions pertaining to the activities during the due diligence period, this right ensures that you will not have to close or lose out on the property if your contingencies have not been satisfied due to lagging third party activities for which you have little or no control. Some developers attempt to negotiate extensions for the "free-look" period by offering to hand over all due diligence materials obtained, if the deal does not go through.
Assignment. A statement should be included in the contract which allows you to assign the ability to close on the purchase of the property to another individual or entity without amending the original terms and conditions of the contract.
The Due Diligence Phase
In the formal due diligence phase, you complete a more thorough investigation of the parcel. It builds on information gained during your preliminary investigation to clarify and address any issues or concerns that should be clarified and addressed. Your objective is to clearly define any land development issues and determine whether to proceed with the purchase of the land and construction of the development. If you have tied up the land in a formal agreement, it would likely have a provision for a period of formal due diligence in which you are allowed to perform these investigative activities. If the parcel gains a positive evaluation, then you would complete the land purchase transaction. However, if the due diligence raises costly land development issues, then the contract should allow you to walk away from the deal with no fines or penalties.
Formal due diligence often requires a financial investment to hire professionals and specialists who perform land evaluation services that provide the definitive information you need about land usability for the planned development. Civil engineers or land planners are essential in this process and can aid in determining a budget for the tests and studies that may need to be performed. In addition, they can provide an estimate or a contract for the services they may be required to perform. If they are not able to answer your questions, they can identify other experts who have expertise in specialized fields of study to add to the development team.
As in the preliminary investigation, formal due diligence requires exploration of the same land characteristics, except with more depth of consideration. You take additional steps and involve expert resources to arrive at a final conclusion or decision including the following:
Wetlands Study. Developing land that contains wetlands is highly regulated at federal, state and local levels and many municipalities have different rules that may apply to development within flood plain areas. Wetlands are "those areas that are inundated or saturated by surface or ground water at a frequency and duration sufficient to support, and that under normal circumstances do support, a prevalence of vegetation typically adapted for life in saturated soil conditions. Wetlands generally include swamps, marshes, bogs and similar areas." (EPA Guidelines, Section 404)
Tree Survey and Appraisal. Trees are valuable resources on parcels. Tree surveys locate and identify the number and type and provide valuable information to use in the concept creation.
Flood Plain Analysis. If the property has any areas along creeks or drainage ways, your civil engineer should survey the property to verify if it lies within the flood plain. The survey helps you avoid creating any lots within a flood plain. You'll also need this verification to assure most jurisdictions, insurance companies and title companies that your development does not lie within a flood plain—areas that have a high probability of flooding within a 100-year time period and thus are susceptible to property and home devastation. These entities will not always rely exclusively on the maps created by Federal Emergency Management Agency (FEMA) because they don't always accurately depict elevation.
Soil Testing. Your civil engineer can survey to determine if soil testing is necessary and direct you to a firm that performs the tests. In general, if anticipated road cuts in grading or trenches for utility lines are to be less than five feet in depth, then soil testing may not be necessary. The primary concern of testing lies with two soil types: rock formations and unstable or expansive soils. Either can be dealt with using cost effective alternatives but only if they are identified in advance.
Topography Mapping. For areas where improvements are to be made for roadways and other improvements, such as detention areas and underground utilities have your civil engineer create more accurate on-site topography maps. The USGS maps you referenced during the preliminary investigation only provide a general sense of the topography. New global positioning technologies make this task less costly than it has been in the past.
Utility Assessment. Confirm any preliminary findings with regard to availability and location of utilities. In addition, if using public utilities for water and wastewater, confirm any tap fees associated with the development. Using a conceptual drawing of the development, you can obtain accurate estimates for the installation of water and sewer lines. For all utilities, verify the cost of extending service and determine whether any easements are going to be required from adjoining properties.
Endangered Species Study. The types of creatures on the endangered species list are diverse, from warm or cold-blooded to furry or feathered. It may also include plant life. Many activist groups are trying to stop development at all costs to protect them. Your task is to identify if any of them exist on your parcel. If the possibility exists for a habitat of an endangered species on the property, it is better to discover this prior to completing the land purchase instead of spending 10 years in court to fight activists opposed to your development.
Archeological or Historical Study. Finding archeological ruins or burial grounds while constructing a road are two common reasons for identifying the historical significance of the land under consideration. Many times, family burial grounds have little to no markings or the archeological or historical significance of a structure is not self-apparent.
Environmental Analysis. Preliminary investigations sometimes uncover potential environmental concerns. In these situations, most lenders require further investigation during the due diligence period. Certified engineers conduct a formal environmental analysis, called a Phase I audit. The audit provides definitive answers regarding those concerns — good information for both you and the lender. The formal environmental analysis may involve as many as three phases.
The Phase I environmental audit usually addresses the most concerns with the exception of hazardous materials. Engineers certified to do the audit perform it. Depending on the availability of those certified in your area, it might take three to four weeks to have this completed.
The Phase II environmental audit is completed if Phase I produces negative results. The Phase II goes further with actual tests performed in the area where any environmental hazards are suspected. It includes recommendations for clean up.
The Phase III environmental audit focuses on the actual clean-up and legal disposal of contaminated material.
Costs for the audits increase with each phase. Typical costs for a Phase I for a 20 acre site might range between $1,500 to $3,000 with Phase II and III costs varying with the nature of the issues involved.
Political Analysis. During due diligence, formalize your involvement in the government approval process. This means gaining a very complete understanding of the process, achieving a common understanding with municipal staff, and establishing a timeline. If you have not already done so, obtain a checklist from the governing municipality.
Community Relations. At this point, coordinate meetings with the concerned citizen groups identified in your preliminary investigation, as well as any regulatory groups affected by the development. This can include school, fire, and special utility districts. The purpose of the meetings is to give information, allow time for feedback, and ultimately secure support for your project.
Financial Analysis. In the preliminary investigation, you prepared a thumbnail estimate to make an initial determination of financial feasibility. Once due diligence is completed, you can update your lot analysis based on the additional and more thorough information you have gained. Add in the option cost, if applicable, and the costs for completing the due diligence. These costs can range from $25,000 to $70,000 and you should count on spending it. Most important, regardless of this investment in the property, you have to be able to walk away from the deal if your due diligence determines development is not feasible for any reason. Other important financial factors should be considered at this point, including slow profits, the timing of tax liability and the impact of velocity on financial feasibility.
Land Development Financing
Financing your land development projects is a key component of running a business. In recent years this task has become one of the more challenging and complex aspects of land acquisition and development. Traditionally, your first source of funds to purchase land is personal equity invested in the company and retained earnings. Much of the day-to-day operations of the building or development are funded by your personal equity investments and the short-term credit of the vendors. However, when embarking on a land development project, the construction of developments requires more money than your own resources.
Land acquisition and development financing typically comes from any of the following three sources:
- Debt financing
- Private financing
- Public financing
With more than 15,000 institutions in the United States, commercial banks handle a significant portion of real estate lending. They buy a wide variety of assets, ranging from short-term government securities, to long-term business loans and home mortgages.
Depending on its business focus, a bank may offer debt financing to support any or all of the land acquisition and development process. There are three financing phases in the process, each financed separately. They are:
- Land acquisition debt financing used to secure the purchase of raw land
- Land development debt financing used to build the subdivision improvements, earthwork, sewer, water, streets, etc.
- Construction debt financing used for construction of models and homes for sale
Despite the fact that financial institutions have become more specialized, major lenders often finance more than one phase of complex projects and one lender can finance all three phases of development. Land acquisition and development financing are often combined. Regardless, each phase presents unique challenges and risks.
Land Acquisition Debt Financing. The land development business is risky because it tends to generate little cash. Raw land may also be difficult to resell if a project fails because it may reduce its value as collateral. As a result, there are few major lending institutions that are involved in land acquisition financing and most of it comprises a combination of bank financing and developer equity. The institutions that finance raw land purchases typically rely heavily on your credit worthiness for assurance of payment. They often approve them only for their strongest customers or for those who have entitlements to develop the land and alternative sources, other than sale or development of the land, to repay the loan. The proportion of their real estate loan portfolio that can be used for land acquisition is restricted. They also provide no more than a 50 to 60 percent loan-to-value ratio funding.
Additionally, because your ability to repay a development loan is dependent on the successful sale of the lots, a lender must be satisfied that you will be able to sell enough lots fast enough to pay off the loan. Toward this point, appraisals can have a critical impact to securing financing. The federal government stipulates standards that appraisers must use. These standards require discounting the appraised value to adjust it to a present value. The discount, usually around 15 to 25 percent, results in a land value equivalent to a "bulk sale" purchase. A bulk sale is a price a single purchaser would pay to purchase the land for cash. This price allows for your overhead and profit earned by selling the lots at a retail price. After discounting the land and factoring a time value and velocity for a sale, the appraisal may be discounted up to 75 to 80 percent of the retail value. If the lender only lends 70 to 80 percent of that discounted appraised value, the amount the lender can actually lend in a transaction is severely restricted.
Addressing this issue early avoids undesirable project financing surprises. It is important that the appraiser understands the market, velocities, and appropriate discount rates for the local market that is being appraised. While federal regulations require banks to order the appraisal, you can ask the lender who it uses and work to educate the selected appraiser. Supply the most accurate and favorable information about your project in your loan package, including market information, costs, projections, comparable sales, and your retail house product pricing. You don't want the appraiser to have to work any harder than necessary to find this information and fairly appraise your project.
Land Development Debt Financing. Once land has been acquired for a project, you obtain land development financing. This financing covers the following activities:
- Site preparation
- Installation of infrastructure
- Engineering and consultants
- Architect fees
- Other soft costs
Most land development loans are a first lien on the property and are short-term. Rates are generally one to two points above prime rate. Check around and try to get the lowest rate. Again, lenders take high risks when financing raw land development. If the project falls through, the forecasted increase in land value will not be realized. Therefore, the lender carefully scrutinizes the credit worthiness and project potential and takes specific steps to minimize risk. Lending by parcel, developer backing, and repayment procedures are three common risk management examples in lender land development financing.
Parcel Lending. If you subdivide the raw land, lenders may approve loans for each subparcel separately. This is true because land loans are riskier than construction loans since repayment of the development loan is contingent on the sale of the building sites.
Developer Backing. Construction loans are generally backed by a commitment from the developer to assume the loan if the product does not sell. Often this is in the form of a personal guaranty of performance provided by the principals of the developer's company.
Repayment Procedure. Repayment of land development loans is conducted via a "release price" procedure. Lenders specify a loan payoff amount required before the land can be cleared of mortgage liens, a prerequisite for you to sell the lot free and clear. The release price per lot is calculated based on the proportion of the project's total financing cost, represented by the lot price plus 10 to 20 percent. The use of 110 to 120 percent of the proportional share is required by lenders to minimize the risk associated with the development. It allows the lender to recapture the bulk of the loan before project closeout, which provides the lender with further assurance. In turn, you receive profit from the sale of the lots at the end of the development period.
Construction Debt Financing. A construction loan is used to finance improvements to the property, primarily the grading, drainage, streets and utilities. Generally this type of loan requires collateral, usually the land itself assuming that you have sufficient equity value in the land. The lender will disburse funds according to completion of the improvements as the project is developed. Commercial banks make the preponderance of construction loans, leaving life insurance companies, syndicators and mortgage banks to pick up the rest. While land development financing is sometimes considered risky, construction financing is popular among lenders because of its characteristics. The appealing characteristics can include:
High Interest Rates. Risk and ongoing administrative burden generate the high interest rates and substantial loan commitment fees of construction loans.
High Loan-to-Value Ratio. Construction loans generally equal 100 percent of the total construction cost if you can provide adequate security.
Short Term. These loans cover the expected period of construction, usually from six months to three years. Payment in full is expected at the end of the construction period.
Timed Funds Disbursal. Funding is released as construction progresses, in a predetermined sequence. You pay interest on the funds disbursed and the lender's risk is reduced since the outstanding loan is matched closely to the value of the construction.
Repayment at Maturity. During the construction period there is no cash flow and no amortization on the loan. Repayment is made possible from the proceeds of long-term financing or from the sale of the residential units.
Construction lending and land development lending share a unique set of risks associated with the real estate market. First, loans must be based on estimates, projections, and judgments rather than facts. Lenders must assess the project's marketability, the accuracy of construction cost estimates, and the developer's competence — none of which is a known fact when making the loan decision. In addition, construction projects are subject to many external factors that can dramatically affect their success: These can include:
- Weather delays
- Unavailability of scheduled land
- Material shortages
- Environmental and regulatory barriers
- Changes in market demand
- Changes in interest rates
Lenders attempt to minimize these inherent risks in various ways, such as the nature and value of collateral, the method of funding of loan proceeds, and the method of repayment. Once the loan is made, the lender and developer must follow a very strict loan disbursement process. Funds are made available as work progresses. In addition, payouts are frequently authorized by the general contractor, but go directly to the subcontractor to assure receipt of funds.
Pension Funds. Pension funds are another viable source of debt financing for established developers. Pension funds have expressed an interest in real estate investments and they are becoming an increasingly popular option for large projects.
Small Business Administration. The Small Business Administration is a governmental agency that insures a percentage of the loan that is made by a local lender. These loans can be made on a real property for business use. These loans have many restrictions and usually take a long time to process. The interest rate is often lower than the current market because the government is guaranteeing a portion of the loan. You can find a description of the programs available and their requirements on the SBA website.
Private financing falls into the following categories:
Seller Financing. Within the seller financing category, there are several options available for land acquisition. The most common purchase arrangement is 20–25 percent down payment with the balance financed through a land loan. The seller-financed loans most commonly include: subordinated mortgages, installment contracts, option agreements and the partnering seller.
Subordinated Mortgage or Purchase Money Mortgage. With a purchaser money mortgage, also called a purchase money trust deed, you purchase all or a part of the land by giving the seller a mortgage at transaction closing for a portion of the purchase price. The Seller becomes the lender in the transaction. Typically you make a down payment of 10 to 20 percent of the purchase price to the seller. At closing you sign a note, secured by a mortgage lien, on the purchased property, for the balance of the purchase price. The mortgage term is generally short. Terms include balloon payments that are often used when monthly payments are set on a 20–30 year schedule.
Subordination is a key feature with this type of financing. Sometimes, the seller agrees to subordinate the first mortgage on the land to a subsequent construction financing lender and the lender typically demands a first lien. In subordination agreements, the Seller's interest in the unpaid balance of the purchase, whether as a contract balance or mortgage position, becomes a second interest behind a lender who takes a first position. If the lender in not paid and chooses to foreclose on the property, the Seller must pay off the first position of the lender or risk losing the unpaid balance of the purchase price. Other times, a seller will not agree to subordinate his interest to a construction mortgage because the seller's position is high risk and his or her interest becomes the equivalent of risk equity. However, in circumstances where there is a high degree of trust and credibility between you and the Seller, it can be an effective method of financing.
Essentially, the purchase money mortgage offers financing with no amortization or with the amortization delayed. It provides immediate financing and an investment for the seller secured by his or her property. This seller's position is high risk and his or her interest becomes equivalent to risk equity. In return for the financing opportunity, the seller receives a higher return from the buyer. However, it is in your best interest to prepay the purchase money mortgage as soon as conventional financing is available. This lowers the interest rate thus creating a greater leveraged return.
Installment Contracts. In a land installment contract, also known as a land contract, the owner retains title (and possibly possession and use) of the land until the purchase price is fully paid; however, you gain immediate possession of the property. You can also use these contracts to arrange a phased release of land portions, with 20 percent of the land held by the seller until full payment of a three or four-year contract. If the seller retains possession, other present uses may continue. This gives the seller security and enables you to obtain release of at least a majority of the land.
In the installment sale, you make periodic payments to the seller with interest on the unpaid portion of the purchase price. This continues until you pay the entire purchase price and obtain the deed. This is a non-recourse contract meaning that, in the case of default, the seller normally cannot force you to buy the remainder of the land. If problems with local municipalities and utility officials arise, these contracts usually offer an abatement of periodic payments on the land contract as an option. Also common, you can retain the right to pay off the outstanding balance at any time to facilitate land development plans.
According to the IRS regulations under a qualified installment sale, the seller can realize a tax benefit by spreading out the tax consequences of a sale over a period of time. The seller is taxed only on sales proceeds in the year they are received. The purchase price must be paid over two or more tax years.
Seller as Partner. You can also become a partner with the landowner to finance the land purchase. For example, the landowner can put up the land, while you put up the skill of platting the site and obtaining all the necessary approvals. After the plat has been approved and all appeal periods have expired, then the exchange of money can occur. The price for the land can be fixed or adjusted up or down for such provisions as the length of the closing date, the number of lots achieved or the actual costs of development.
Read the other parts in this series: