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Real Estate Articles

Structuring Real Estate Joint Ventures & Syndicates

Real estate investors work together all the time. More and more, we see combinations of brokers, money investors, contractors and other folks flipping or developing properties. As members of a real estate venture, these folks need a formal structure to govern their relationships within the venture. In this presentation, I hope to give you a brief but condensed outline of the issues to think about when forming joint ventures for real estate investments. There are three key concepts in structuring your joint venture: control, splitting up the profits, and exit. First, you need to think about who will control the venture, including the votes needed to make decisions, and day-to-day operational control. Second, think about how you will split the profits of the venture, including how you compensate those members who contribute their time (for example, contractors). Third, think about your exit – before you enter any business relationship, you need to have your exit locked down. One last introductory thought: At a later stage in their evolution, to handle more projects and bigger projects, real estate investors and developers start looking for money, that is, for passive investors. Essentially they start to build real estate funds for the purpose of raising capital. This will be the topic of a later presentation – the building of real estate funds. LEGAL ENTITY You should always operate a joint venture through a legal entity, whether a corporation or an LLC. Without a legal entity, the members will be partners in a general partnership. A partnership is about the worst structure possible, because it makes all partners personally liable for the partnership’s debts. CONTROL The concept of control generally includes board / member voting, and veto rights. Voting Power Generally, you make decisions about projects and other matters based on a vote of members. In a corporation, this is done through the board of directors. It is very important that you think through who will be on the board and how the directors will get along and ultimately line up in voting coalitions. An LLC works about the same, except you count member votes instead of director votes. LLCs also can have managers, who are given varying degrees of operational control. Veto Rights For specified operating decisions, the parties can require a certain percentage (e.g. 75% or 100%) of the votes. These decisions can include purchasing or selling properties; budgets; hiring contractors; salaries & bonuses; affiliate transactions; bringing in new members; distributions; loans; etc. Veto rights generally help minority owners, because a minority can use a veto right to block company action. This can lead to deadlock. DISTRIBUTIONS A venture throws off money in various ways, including the sale of properties, lease rentals, interest payments to lenders, compensation to contractors, and compensation to the venture’s employees. You need to clearly provide for the splitting of profits among the members based on such factors as money invested, time and labor spent in fixing up properties, and time spent in management. Remember that managing owners can siphon off substantial salaries and perks, but absent mandatory distributions, passive owners might get no return on their investment. Consider how salaries and related party contracts will pull pre-distribution income out of the venture. EXIT Before you enter, always know how you will exit a business venture. You need a structure that permits an economic divorce among the members in a venture. Essentially, if the venture or the relationship among the members falls apart, all members should receive their fair share of the venture. No one should be able to short-change anyone else. Trigger Events The precondition for the economic divorce is some bad event. Examples of bad events are irreconcilable dispute among the members, the need to remove a member from the venture, or the death of a member. These bad events trigger the economic divorce. The economic divorce can either be a complete liquidation of the venture, or for individual members, the buy-back of the member’s shares. Liquidation of the Venture The value in most real estate ventures is the real estate itself. There is little goodwill value in the venture, in contrast to other types of business. Nor is there much sentimental value in the real estate – the venture holds the real estate on a short-term basis with an eye to flipping it for profit as soon as possible. With this in mind, if the members cannot get along, it is very easy to liquidate the venture’s assets, distribute the profits and let the members go their separate ways. This is the economic divorce. Buy-out of Individual Members Sometimes you only need to deal with one member and don’t want to liquidate the whole venture. For example, an individual member might get a better job and stop putting time into the venture. This member becomes a freeloader, and the other members might decide to remove the freeloader to prevent him from benefiting from their hard work in building up the venture. Or for example, a member might be such an irritating malcontent that the other members decide to be rid of him. Or a member might die, in which case the venture will want to distribute cash to the deceased member’s estate in a fair amount equivalent to the deceased member’s stake in the venture. Or a member might go bankrupt, and the other members will want to protect the venture from his creditors. In all these cases and other cases, the venture needs a structure for the orderly and fair removal of members. Note Regarding Disputes Sometimes two members just can’t get along. To deal with this situation, you can use “shotgun” procedures. This means that, between the two warring members, the first member offers to buy out the second member, and the second member has the choice, either accept being bought out, or turn around and buy out the first member on identical terms (i.e. I cut, you choose). Either way, a price is fixed for the buy-out, and one of the warring members leaves the venture. BUY-OUT PRICE The buy-out price is crucial. A high buy-out price gives the exiting member a windfall. A low buy-out price is unfair and leads to litigation. The trick is finding a procedure that ensures a fair price – for example, using a neutral appraisal process to fix a price. Further, deciding to buy out a member is the easy part – paying the purchase price is harder. You will need cash to pay off the member. There are many methods to handle these problems, and ultimately all methods derive from the specific structure of the venture. Here are some general concepts, however: Liquidation of the Venture A straight liquidation of the venture can be clean and simple, because the real estate will sell at its fair market value and thereby produce cash profits. The members will distribute the cash profits per their ownership percentages and dissolve the venture. That’s the end of it. Buy-out of Individual Members If you only want to buy out a single member without liquidating the venture, you will need a source of funds. From whence the money? One structure that I use is to make the buy-out price the net equity value of a member’s interest in the venture. The other members then finance this amount. As another example, for buy-outs upon death, the venture can put in place life insurance on the life of the deceased member, then use the proceeds to fund the buy-out. This is classic buy/sell work. In any case, your structure will have to handle these issues down to the last detail. PERSONAL GUARANTIES Be very careful regarding personal guaranties. These are the wild cards in an exit structure. An effective exit structure must fairly compensate and/or protect members for their guaranties. This presentation only gives a brief outline of some issues involved in a real estate joint venture. There are a lot more issues and details to worry about. I strongly urge you to get competent legal and tax counsel when you set up a venture.

Title Insurance in Real Estate Purchases

In this article I will briefly explain what title really means in a real estate purchase. I will discuss (1) how to review a preliminary title report, (2) how to handle title exceptions, (3) how title fits into the purchase agreement, and (4) what a title policy really gives you. Because buyers buy title insurance, I will mostly take the buyer’s perspective. #1 – REVIEW THE PRELIMINARY REPORT The preliminary report (the “prelim”) is usually the first step in understanding title. Legally, a prelim is an offer from the title company to give insurance. When you accept the prelim, a binding contract is created between you and the title company. Hence before accepting the prelim, review it, the documents listed as exceptions in Schedule B and the proposed policy itself. Now, how do you review a prelim? Focus on the following: *** Verify that the seller holds fee title to the property, and that your name, as the buyer, is exactly correct. *** Be sure that the legal description of the property is identical to the description shown on any survey. *** Review the exceptions in Schedule B for third party claims, including whether any encumbrances affect the desired use. *** Review the exceptions in Schedule B for any restrictions on ownership, e.g. check the covenants, conditions and restrictions (CC&Rs). *** Get copies of and read all documents referenced in Schedule B (since these will be excluded from coverage). #2 – HANDLE TITLE EXCEPTIONS After reviewing the title exceptions in the prelim, your next step is clearing some of them. First, in the purchase agreement you should require the seller to remove all monetary liens by payoff prior to closing, except: (i) financing that you will assume; (ii) current taxes constituting a lien not yet due and payable at the closing; and (iii) bonds or assessments to be allocated between the buyer and seller as of closing. Second, negotiate with the seller for the removal, if possible, of problematic non-monetary exceptions (e.g. easements). Consider also having the title company remove all boilerplate exceptions that have no basis in reality. A few minor title exceptions show up in all prelims. Ordinarily you don’t need to worry too much about these exceptions, namely: *** General and special city and/or county taxes which are liens not yet payable. *** Lien of supplemental taxes assessed pursuant to Division 1, Chapter 3.5 of the Revenue & Taxation Code. *** Utility easements, but depending on their location and whether you intend to build over the easements. *** CC&Rs, unless they affect or prevent your intended use of the property. Remember that buying insurance coverage for a defect in title does not fix the defect. Although insured for, the defect remains on your property. If the defect is serious, consider walking away from the purchase no matter whether you can get title insurance, because: *** Your policy limit is usually the purchase price for the property. The policy will not pay anything more – not the policy premium, closing costs, loan fees, repairs, improvements or anything else. *** The insurance company might deny your claim for coverage. *** Even if the title company gives coverage, still, if a defect ripens into an actual third party claim against the property, you will suffer delays and consequential economic loss during the litigation (which probably won’t be covered under the policy). *** The next buyer or a future lender might decline a deal with the property based on the defect. Conclusion: Remove all serious defects. If that is impossible, don’t buy the property no matter what coverage is available. #3 –TITLE ISSUES IN THE PURCHASE AGREEMENT Usually the seller promises marketable title in the purchase agreement, no more. From the seller’s perspective, representations and warranties about title are not necessary because the buyer should protect itself with a title policy. The seller should also beware of giving a broad representation that the property is “free and clear from all encumbrances” – as applied to land, an encumbrance is almost anything including unknown encroachments. Hence this representation is too broad. Although sellers avoid representations about title, title is usually a condition of closing. In this respect, the parties can attach the prelim title report to the purchase agreement, and show on the prelim what title exceptions the seller will remove as a condition to closing. #4 – THE TITLE POLICY My last topic is the nature of a title policy. What kind of protection are you buying? Do you even want a policy, given its cost? It seems a bit funny to talk about first things last. This discussion is very difficult, however, and I am afraid that if I started with it, no reader would survive to the end of this article. So if you’ve read this far, congratulations. I will discuss only the CLTA Standard Coverage Policy, because that is the policy that buyers commonly purchase. [see ft.1 regarding ALTA policies] CLTA title insurance insures title as shown in the public records. Off-record items generally are not covered. That is, CLTA insures that the liens and encumbrances listed in the prelim are the only ones of public record, as of the date of issuance of the policy. You, the insured, are buying peace of mind that the disclosed lien situation is correct, and there are no other liens of public record. Also, CLTA insures that that the seller actually owns the property – this covers problems related to fraud or forgery by the purported grantor. With a CLTA policy, you are uninsured for liens not on the public record. Therefore, you should inspect the property for encroachments, third-party possessory rights (e.g. tenants, adverse possession), boundary line problems and anything else of interest that would not appear on the record. Also, remember that you, as a bona fide purchaser, will take free of unrecorded liens. PARTS OF A CLTA POLICY The CLTA Policy is comprised of four parts: (1) Title page It is pre-printed and tells you the scope of your coverage and exclusions from your coverage; (2) Schedule A It tells you the amount of your insurance (invariably the purchase price), the premium, your name as the insured, the legal description, and any special coverage; (3) Schedule B It has two parts: Part I gives preprinted exceptions to coverage (including the big exception – no coverage for easements, liens and encumbrances not of public record). Part II lists the specific title exceptions from the prelim, all of which are of public record, plus a few extra exceptions that the title company tries to throw in (e.g. if the current owner acquired title as a single person but is now married, there may be an exception for any interest of the spouse). ****Here is the key to the CLTA policy – the policy covers only encumbrances of record, then the policy removes from coverage everything that the title company actually could find of record. You, the insured, are left with little except peace of mind that the disclosed lien situation is complete. You are insured that there is nothing else of record out there (that is, in the chain of title). Is the peace of mind worth the cost? I don’t know – all I know is that I buy title insurance and so do my clients. (4) Conditions and stipulations These are more preprinted terms. The most important term here is that the title company’s liability terminates upon conveyance of the estate held by the insured, except if the insured sells and receives back a purchase money deed of trust. CONCLUSION I hope this article has helped you understand title a little better. There is a lot more to a real estate deal, however, than what I discuss here. As always, get competent legal counsel for your real estate transactions. [ft. 1] ALTA gives more coverage than CLTA because ALTA insures recorded and unrecorded defects. For this reason, ALTA costs more than CLTA. The insurance company in an ALTA policy takes the risk of inspection of the property, including encroachments, unrecorded rights of way, unrecorded leases, and the boundaries of the property based on a current survey (unless the policy has a survey exception). Lenders use ALTA to insure the priority of their liens, because lenders (unlike buyers) don’t inspect the collateral. Should you consider an ALTA policy? Maybe, if after you inspect the property, you find that there might exist an off-record claim to use the property, e.g. a driveway is being used by neighboring landowners, structures appear to encroach between boundary lines, or boundary lines are unclear.

Strategies for Negotiating a Construction Contract

Real estate owners and construction contractors sue each other all the time. The reason is simple – construction rarely goes as planned. Given this reality, you as a real estate owner (whether a homeowner or a commercial property owner) need to get smart at the front-end of the construction, or else you might pay for litigation at the back-end. Here are five basic strategies for negotiating a construction contract. DETAIL YOUR SCOPE OF WORK The single most important provision in a construction contract is the scope of work. The owner should give a large amount of detail about the work to be done, including what the finished product should look like and what it should do, and anything else the owner believes is important. As an owner, you should sit down and list your most important objectives and concerns and then include these in the scope of work. Just giving the contractor a set of plans is not enough. Owners must be careful in their plan review with the architect and the contractor to make sure they understand the work. Owners then must communicate the spirit of the plans to the contractor. As an owner, communicate your intent in simple English, detailing the goals you want achieved. For example, for an office building, “the HVAC shall be sufficient to allow all offices on the west (sunny) side of the building to be cooled to a temperature of 72 degrees even during the hottest days of the year at the hottest times of the day.” UNDERSTAND YOUR PRICING OPTIONS You frequently can choose from several pricing options. The three most common are cost plus, stipulated sum, and a hybrid of cost plus with a guaranteed maximum (G-Max). Cost plus is the most favorable to the contractor, because it allows the contractor to be compensated for time and materials plus a percentage for overhead and profit. Stipulated sum is arguably the most even-handed, because it reflects what both parties believe is a reasonable price for the agreed scope at the time of contract. The most advantageous for the owner, however, is the hybrid. The hybrid gives the owner the benefit if a cost-efficient contractor completes the job for less than the G-Max, yet has the G-Max to give protection from cost overruns. GET A RETENTION Contractors juggle multiple jobs. There is a real risk that as the owner’s job draws to a close, the contractor will focus on its new projects and their promise of new money. Here the contractor never gets around to your final, punch-list items. To keep the contractor’s attention at the end of your job, hold back some portion (usually 10%) from the contractor’s compensation. In this way, even on a relatively small $500,000 job, the owner is still holding $50,000 at the end. This keeps the contractor motivated to finish the job. INCLUDE AN ATTORNEY'S FEES CLAUSE If you sue your contractor and win, you want to recover your attorney’s fees and costs (which can be significant). So add an attorney’s fees clause to the contract. Note that the most commonly used form construction contract is the American Institute of Architects form, but this form does not contain an attorney’s fees clause. KNOW YOUR LENDER'S REQUIREMENTS If a construction lender is involved, ask the lender to recommend two or three contractors. By using a lender-recommended contractor, owners can leverage that relationship to get a contractor’s most honest and responsible performance. Also, ask the lender up front for its required inclusions in the construction contract. This saves time when negotiating the contract, and even lets you use the good cop / bad cop negotiating strategy when negotiating with the contractor. As always, these strategies are only the tip of the iceberg. You should hire an attorney for all important projects.

Understanding Commercial Leases

In this article I explain the basics of commercial leases. Given that most form commercial leases are extremely long, I can only explain a few basic concepts here. Tenants and Guarantors. Begin your analysis of a lease with the tenants and guarantors. The tenant is initially responsible to pay rent. If the tenant is poorly capitalized (for example, a startup corporation) the landlord likely will require a guarantor for the lease. The landlord pursues the guarantor if the tenant goes broke and can’t pay the rent. Most guarantors rue the day they sign on the dotted line. Although Frank Sinatra can sing, “regrets, I’ve had a few, but then again, too few to mention,” he probably never was a guarantor stuck with the long-term lease of a bad tenant. Tenant Improvements. The landlord might offer some tenant improvements to entice a tenant to sign the lease. A landlord will only do so if the market is soft and tenants are hard to find for the premises. The landlord then increases the base rent through the first few years of the lease to get repayment of its up-front costs for the tenant improvements. Nothing is free in this world. Taking Possession of the Premises. When the tenant takes possession of the premises, both sides need to be very clear about the condition of the premises. Most leases have the tenant take possession of the premises in “as-is” condition, so the tenant must be doubly satisfied with their condition. From the landlord’s perspective, you don’t want your tenant to feel cheated, angry and vindictive from day one, so make sure your tenant receives the premises as promised. Option Terms. When evaluating an option for extending a lease term, make sure you understand how rent is calculated. Most options require a fair market rental at the time of the option term, which is fair enough (but the devil is in the details). Tenants: Calendar the time window within which you must notify the landlord of your exercise of an option term! Miss your window and you lose your option. Gross or Triple-Net? There are two basic flavors of commercial lease – gross leases and triple-net leases. In a gross lease, the landlord charges a flat rent that covers all of the landlord’s costs associated with the premises. In contrast, with a triple-net lease the landlord charges a base rent, then passes through to the tenant an additional amount to cover the tenant’s share of the building’s property taxes, insurance premiums and costs of common area maintenance. Neither type of lease is cheaper than the other. Since nothing is free in this world, the rental for a gross lease just incorporates the costs that would be passed through in a triple-net lease. Note: it’s hard to find a true gross lease anymore. This is because most so-called gross leases contain “stops,” that is, they are modified triple-net leases in that the tenant pays its share of increases in expenses after lease year 1. Call if you want me to explain more. Rent. You can understand base monthly rent, so I won’t belabor the point. Triple-net pass-through charges are more interesting. Nearly every tenant in a triple-net lease will complain of sudden and drastic increases in triple-net costs, for example, costs for major work on the building, miscalculated back utility costs, or higher property taxes. A surprising triple-net bill can tap out a tenant’s cash flow and put the tenant in default under the lease. To reduce this risk, tenants bargain for caps and exclusions on triple-net costs. Landlords despise caps and exclusions, however, not least because they make the calculation of rents very difficult. Lastly, note that in a shopping mall, tenants pay an additional amount called percentage rent, which is a piece of their gross profits. Maintenance. Usually a tenant is responsible for maintaining the inside of the premises (including electricity, plumbing, floor slab, windows, front glass and door) while the landlord is responsible for exterior walls and roof. Keep your eyes on HVAC – leases differ on how they treat the costs of maintenance and replacement of heating, ventilation and air conditioning systems. I hope this article is useful to you. As always, I only glossed over the outlines of the subject. A lease is a major financial commitment so please talk with a lawyer before signing one. Good luck.

Common Area Maintenance (CAM) in a Lease

In this article I discuss common area maintenance (CAM) expenses in a real property lease. Also read these articles: Understanding Commercial Leases and Commercial Lease Terms – Advanced. In a triple net lease, the tenant pays a share of the building or shopping center’s expenses, including common area maintenance expenses. CAM usually is the longest and densest section of a lease, and landlords and tenants negotiate CAM harder than anything else. Bargaining strength wins, meaning the party with more leverage gets to pass off more CAM expenses on the other. Definition of Common Areas. Common areas are hallways, sidewalks, parking lots and other areas not held out to be leased, but rather are available for common use by all tenants. Tenant’s Proportionate Share. A tenant pays its percentage share of total CAM for the building or shopping center. Tenant’s share is based on the ratio of tenant’s premises to the total area of the building or shopping center. Expressed as a fraction, this is: Tenant’s total sq. feet // divided by // Total sq. feet in the center (sq. feet leasable or actually leased) Tenant wants a smaller share, and landlord wants tenant to pay a bigger share. In terms of the equation above, tenant wants a small numerator and a big denominator, and landlord wants the opposite. For this reason, tenant wants the denominator to be all leasable sq. feet existing in the center, not sq. feet actually leased (since the center might have empty units). A middle ground for the denominator is “leased sq. feet, but not less than 90% of leasable.” In a high-end mall, the landlord might pull anchor tenants completely out of the equation (because anchor tenants have the bargaining strength to get special deals), or landlord might use cost pools for certain types of tenants (e.g. restaurants). But that goes beyond the scope of this little article. Inclusions and Exclusions. Once the parties have settled on the tenant’s share, it’s time to argue about what’s in CAM. CAM covers a laundry list of expenses. In the interests of brevity, I’ll focus on administrative and management fees, and capital improvements. *** Most leases give the landlord an administrative fee of, say, 15% of total CAM costs, plus third-party management fees of, say, 3% of gross center revenues. Tenants who are still awake at this point in the lease object that the landlord is double-dipping and demand that landlord choose one or the other. *** Capital improvements are changes to the common areas that go beyond repair and maintenance. A capital improvement creates new value in the real property, which benefits everyone in the here-and-now, but which might continue to benefit the landlord long after the tenant has left the center. Capital improvements also can be sudden and expensive, and if passed through can cause unexpected cash flow problems. In the battle over capital expenditures, the middle ground is to amortize the tenant’s share over the life of the improvement (usually 15 years). In this way the tenant pays its share of the capital expenditure each month, in installments, but doesn’t pay for the improvement beyond the lease term. Cap. A tenant can demand a cap on CAM if it doesn’t want to pick through the lease’s CAM sections. With a cap, the tenant only pays annual increases in CAM under, say, 5% of the prior year’s CAM. This cuts off dramatic increases in CAM costs and makes negotiation of the details of CAM a bit easier. Landlords hate caps for obvious reasons, and also because random caps among tenants make the landlord’s accounting more difficult. Landlords might exclude from the CAM cap those costs that it can’t control, such as utilities. Alterations to Common Areas. A landlord must preserve its right to make changes in the common areas, for example, to construct a new building in the parking lot. A tenant might object because the new construction will hurt its business, for example, by impeding access, visibility sight lines or parking space. This is a tricky negotiation that is sometimes solved by permitting landlord’s development in certain pre-identified common areas (but not others), while prohibiting material impediments to tenant’s access, exposure and parking. I hope this article is useful to you. As always, I only glossed over the outlines of the subject. A lease is a major financial commitment so please talk with a lawyer before signing one. Good luck.

Commercial Lease Terms - Advanced

Some tenants need special lease provisions, for example, medical practices and businesses in the computer industries. In this article, I discuss special, advanced lease provisions that tenants frequently need. For a basic explanation of commercial leases, read my article Understanding Commercial Leases. See also Common Area Maintenance (CAM) in a Commercial Lease. Without further adieu, consider these additional lease provisions: Tenant Improvements. For your tenant improvements, negotiate a basic construction plan with the landlord before you sign the lease. Also be clear what the lease requires at the end of the term regarding your removal of the tenant improvements and restoration of the premises to their original condition. At the end of a lease, a landlord is more likely to demolish specialized tenant improvements (e.g. those of a medical office) than the more classic office or retail tenant finish. You might want to negotiate the cost of restoration in the lease. Hours of Operation. In many leases, the landlord does not provide basic services on the weekend, holidays or after hours. If you work on the weekend, after-hours or on holidays, be sure that the lease reflects this and that the landlord provides basic services during off-hours. Heating and air-conditioning are the most obvious needs – when these services are not provided, office space (especially space with big windows) can be freezing in the winter and roasting in the summer. Also, note that some leases require specific hours for which you must be open for business, so be sure that you will be open at these times (or change the lease to reflect your business hours). Option on Premises Next Door. If your business might expand rapidly, consider getting an option on premises next door in the complex, so that when the premises become vacant, you have the first right to lease them. Assignment / Sublet. You might want to sublet space in your premises to strategic partners, affiliates or related service providers. Make sure your assignment / sublet provision permits this. Also, it helps to have a provision that permits you to assign the lease to a buyer of your business who meets certain financial standards — this helps with your exit from the business. Use of Premises. You might want to increase the scope of your business beyond your limited scope when signing the lease. In this respect, be careful that your use clause isn’t too narrow. Forced Move to Substitute Premises. Many leases have provisions requiring the tenant to consent to a substitute premises if the landlord wants to move the tenant. Delete these provisions from the lease if your tenant improvements are significant, or if your clients will only access your original premises. Utilities. Some tenants need extra electricity, water or other utilities, for example, some hi-tech companies use extraordinary amounts of electricity (and air-conditioning for their server rooms), and some health care providers or food-service industries use a lot of water. If this is the case, before signing the lease, be sure that the building can handle your load on utilities. Also be very clear how the landlord will allocate charges for utilities to your premises. Co-Tenancy Termination. To get new clients or customers, your business might depend on another company that is located next door or in the same building or complex. If this is the case, consider negotiating for the right to terminate your lease if this other company were to leave. And lastly, Death / Disability Termination. For solo practitioners, consider negotiating for an automatic termination of the lease if you were to die or become disabled. This gives peace of mind to you and your family, because they won’t be stuck with your lease liability after you lose the ability to work. A lease is a major financial commitment so please talk with a lawyer before signing one.

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