Five Land Banking Lessons Learned During the 2008 Great Recession
April 29, 2020
By Bart J. Page and Anthony Eulano
Land banking was one of the hardest hit industries during the 2008 Great Recession. As the housing and financial markets declined drastically, many homebuilders terminated their option agreements with the land bankers and walked away from entire projects. As a result, many land bankers were left with a large inventory of finished lots and very little cash, and some of those land bankers ultimately lost their lots and projects to their lenders.
Over the past several years, land banking has made a comeback and has become an increasingly popular method for homebuilders to develop residential communities. However, as the fallout of the COVID-19 pandemic progresses, some analysts are drawing several analogies to the economic impacts of the Great Recession. Consequently, the current financial impact to land bankers may mirror that of the 2008 financial crisis, in which case some of the common land banking issues from years past may resurface.
Homebuilders may want to consider involving legal counsel in the earliest stages of contract drafting and negotiation in an effort to avoid the land banking pitfalls encountered during the Great Recession. The following land banking lessons may help homebuilders navigate the impact of another economic downturn on the land banking industry.
Lesson One: Monitoring Construction Reimbursements
It is often advantageous for a homebuilder to complete the infrastructure construction of a project in advance of the deadlines set forth in the construction schedule. However, in times of economic uncertainty, homebuilders may want to be careful that their construction does not get too far ahead of the reimbursements by the land banker under the construction agreement. The homebuilder may want to consider making sure that the land banker is timely funding each monthly draw under the construction agreement. Failure of the land banker to timely fund draw requests may signal that the lender is having issues with its lender or other capital source. Homebuilders may want to consider carefully monitoring their projects to make sure that it does not complete millions of dollars’ worth of construction before discovering that the land banker or its lender is unable or unwilling to fund the remaining improvements.
In an effort to mitigate the foregoing risks, a homebuilder may want to pay close attention to the payment of draw requests under the construction agreement. If the homebuilder discovers that there are delays in the payment of draw requests, the homebuilder may want to consider stopping further construction until those issues are resolved with the land banker. If the homebuilder encounters problems, the homebuilder may want to consider requiring the land banker to deposit cash or other security into escrow to ensure the timely payment of the balance of the improvements. In addition, the homebuilder may also want to consider reviewing any offset rights or other remedies it may have under the land bank documents in the event of the land banker’s default. These precautions may help the homebuilder limit the impacts of a land banker default and make an informed decision in electing and exercising its rights and remedies in the event of a land banker default under the construction agreement.
Lesson Two: Obtaining Lender Approvals
When amending the option agreement and/or construction documents (even if requesting a simple extension) under a land bank transaction, it may be important for homebuilders to ensure that the land banker’s lender has approved all such modifications. An extension in the construction or takedown schedule or another modification of the land bank documents may trigger defaults by the land banker under the loan documents, which can result in the lender’s refusal to fund further construction and/or the exercise of other rights and remedies by the land banker’s lender.
In an effort to avoid unintended defaults, the homebuilder may want to consider obtaining from the land banker evidence of the lender’s approval of all modifications to any land bank documents. A transparent negotiation may help all parties minimize unforeseen complications in the transaction.
Lesson Three: Liabilities Upon Termination
A change in economic circumstances may force a homebuilder to terminate its option agreement and, subsequently, its right to acquire any remaining lots. Although the homebuilder’s termination of the option before it has acquired all the lots does not generally constitute a default under the Option Agreement, it may trigger a number of consequences that the homebuilder may want to carefully consider. For example, the homebuilder may forfeit all or a portion of the option consideration paid by the homebuilder under the option agreement. There may also be a number of continuing liabilities, indemnities and obligations under the land bank documents that will follow the homebuilder. Generally, the homebuilder has an obligation to continue to perform and complete the infrastructure development of the property in accordance with the construction agreement, and if the homebuilder fails to timely complete the construction, the land banker may have the right to replace the homebuilder with another contractor, in which case the homebuilder may be responsible for any cost overruns or other amounts incurred by the land banker in excess of the price set forth in the construction agreement. The homebuilder may also continue to be liable to the land banker for any environmental issues or other conditions relating to the property. The homebuilder may continue to be liable under any bonds or other security provided by the homebuilder to governmental authorities or other third parties in connection with the construction. There may also be infrastructure or utility reimbursements that the homebuilder may not be able to recover in the event that the option is terminated before all of the lots have been acquired.
Therefore, it may be critical that the homebuilder carefully review the land bank documents with its attorney and evaluate these continuing liabilities before electing to terminate the option before all the lots have been acquired.
Lesson Four: Lien Releases
As homebuilders proceed with all construction projects (including, without limitation, all land bank projects) during uncertain times, it may be important for homebuilders to closely monitor lien notices and obtain lien releases. Any mechanic’s or materialmen’s liens may create unnecessary encumbrances on the property and cause delays with disbursements. In an effort to avoid such problems, the homebuilder may want to consider carefully reviewing its current subcontractor payment and lien release practices to ensure that it is obtaining appropriate lien releases from all contractors, subcontractors and suppliers that have filed preliminary lien notices or otherwise have the right to lien the project. The failure of the homebuilder’s contractors and subcontractors to timely pay for equipment, materials or labor provided by others to the project can cause big problems for the homebuilder and its project.
Lesson Five: Offset Rights Bolster an SNDA
Lastly, in any land bank transaction where the land banker has a lender, the homebuilder may want to consider whether it has negotiated and secured a strong Subordination, Nondisturbance and Attornment Agreement (SNDA) with the land banker’s lenders. Specifically, it may be critical for the homebuilder to obtain the lender’s obligation to recognize and adhere to the homebuilder’s rights and benefits under the land bank documents (including, without limitation, all credits in favor of the homebuilder for option consideration, deposits and other amounts paid by the homebuilder and any offset rights that the homebuilder has under the land bank documents). The homebuilder may also want to consider obtaining the lender’s unconditional agreement to release lots from the lender’s lien upon the homebuilder’s payment of the lot purchase price under the land bank documents.
A carefully negotiated SNDA may protect the homebuilder from potential disaster in the event that the land banker defaults under its loan and the land banker’s lender forecloses on the property. It may also provide the homebuilder with the leverage to restructure the transaction with the land banker’s lender after a foreclosure has occurred.
Lessons Learned: Proactive Precautions
It is unclear how COVID-19 will ultimately impact the housing market in the long term. However, homebuilders can take proactive precautions now in an effort to prevent or minimize some of the hard land bank lessons learned during the Great Recession.
In addition to the foregoing pitfalls and issues of which homebuilders may need to be especially cognizant during this time, it is important to note that an economic downturn (and the potential option terminations arising therefrom) may provide homebuilders and real estate investors with opportunities to acquire large numbers of finished lots in broken land bank projects. Often these lots may be acquired at discounts from the land bankers or their lenders. These opportunistic homebuilders and investors may want to consider involving their legal counsel in the early stages of the acquisition to navigate the various issues and potential liabilities that may be involved in these broken projects.
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