Sometimes the promise of big profits in a land development partnership are not worth the risk!
They wanted me to review and opine on this very simple two page proposal. On the surface the offer appeared to provide them with an amazing opportunity to make a large sum of money for an unutilized 10 acre parcel that was located on the fringe of their 150 + acre crop farm.
The good news was that the parcel was zoned residential and public utilities were available to be accessed, suggesting that gaining approval for a small housing development of property would be fairly simple.
The buyer was a small developer who specialized in seeking out small tracts of developable real estate that is well-located, already zoned and fully entitled (having utilities and rights to develop close at hand).
He was a classic small developer who focused on gaining the necessary government approvals (zoning, site plan, entitlements and land improvements) and then performing the work to be in a position to sell the finished lots to a residential builder.
In an ideal world such a developer seeks to add value to the property by using other people’s money (O.P.M. as it is known in the trade).
Now you, as many farmers and other owners of small tracts who are not active in the development business, may wonder how does someone make a buck on real estate development without investing significant sums of their own money into a deal like that?
That’s where “Other People” come into the picture!
Simply stated, as in the case of this proposal, the developer offered my clients an opportunity to make a very lucrative return on the value of their land, if they would enter into a partnership agreement (a.k.a. Joint Venture).
Typically a partnership of two or more parties requires that they each pool an equal amount of resourses into the arrangement. They would then identify the roles each would play in achieving the goal of the venture.
In its basic form, joint ventures require that each party invest an equal amount of cash into the deal. But in this case the developer offered his expertise (development experience and skill) as his share of equity, and he asked that the property owners put their 10 acre parcel into the deal – and to deed the property over to the to be formed venture entity.
The plan was for the developer to do the work to get the property approved and improved into 25 building lots and then sell them to a builder. The entire process should take about 24 months. Once completed the partners would split the profits 50/50!
But, so far no one has put any cash into the deal … and it will require a significant amount of that to make this venture work. So where will it come from?
With a bit of magic, the developer would be able to come up with all the cash necessary get the deal done, while the property owner just sits back, relaxes and waits. So how did this developer plan to create all the funds out of thin air?
The answer: LEVERAGE.
As part of the proposal the developer recommended that he have the right to use the 10 acre parcel as collateral for a development loan that he would obtain from his friendly banker.
In addition, he already had identified a builder who stated he would be interested in buying the finished lots the developer would deliver. For that “exclusive opportunity” the builder would provide the developer with a substantial financial deposit that could be used in making the site improvements. This deposit would be credited against the eventual purchase price the builder would pay for the finished lots.
In addition, the crafty developer added to the proposal that he would also be able to charge the partnership a fee for the services he would provide to make this deal work out.
Despite all those “details,” my clients, who were only paying attention to the potential big profits shown on paper, and were so excited about the simplicity of the proposal, that they confessed that they hesitated seeking my counsel.
“It just seems like a slam dunk,” the husband said. But it was his better half who felt like the proposal may be too good to be true.
I was happy that they called me, because after reviewing the proposal in detail, all I had to do was ask them one question:
“What if things don’t work out … then what?”
I painted a picture of several “What if’s” that could happen after a formal joint venture agreement was signed:
- What if the builder backed out and the developer does not have use of the deposit money?
- What if the developer borrows against the land and then takes that money, goes bankrupt and/or walks away from the deal?
- What if the building lot values drop and/or the development expenses far exceed expectations?
At the end of the day, it is possible that by deeding their 10 acre parcel into this joint venture, the owners could end up with nothing, or, even worse getting the land back, but having to assume the debts of the joint venture along with legal fees and possible lawsuits.
The proposal did not include any of the essential safeguards that should be incorporated in a traditional joint venture agreement.
In a future post we will provide our readers with a list of those essentials … so stay tuned to the MacRo Report Blog!
Oh, and by the way, as a means of minimizing the risk for my clients, we were able to find a buyer for the lot at a very fair price!
Rocky Mackintosh is President of MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland. He has been an active member of the Frederick, Maryland community for over four decades. He has served as chairman of the board of Frederick Memorial Hospital and as a member of the Frederick County Charter Board from 2010 to 2012. He currently serves as chairman of the board of Frederick Mutual Insurance Company. Established in 1843, it is one of the longest enduring businesses in Frederick County.