Back to Basics: Joining the dots

Contract structures is a broad topic, so here I look at how to structure various overlapping conditional contracts where there are multiple parties fulfilling different roles but ultimately where all interests are aligned. While it is a typical contractual structure deployed by many commercial real estate developers, it will ultimately benefit all participants if deployed in the right chronological order and on fair terms. Timescales In this scenario we are assuming that the relevant developer does not hold any land interest at the outset and will require third-party funding to finance construction costs. These types of deals are enjoyable as ultimately everybody wins, provided that the right advisers are in place and the expectations of all parties are appropriately managed.  While this sort of legal structure can take some years to come to fruition, the rewards will be there, provided that patience prevails. However, for those who are looking for a “quick turn”, this is absolutely not the legal structure to consider. Competing interests  Each party will naturally have a different commercial objective in mind. However, these objectives can be aligned through negotiation to secure the outcome that will benefit all, ie the completion of a new commercial real estate product. While the legal structure can be applied to all types of commercial real estate development, we are going to assume the intention here is to deliver a new logistics warehouse and loading depot with ancillary offices.  We then look at the role of each participant in more detail, the chronology and how the developer would need to engage with them. Step 1: land assembly and planning The first step for the developer will be to agree terms with the landowner to acquire the land. In the case of logistics development, the development site will usually be greenfield/brownfield land with access to a nearby motorway network and/or transport hub. Typically, the landowner won’t have the time, financial resources or skills to deliver the project. The appropriate contract here might either be a conditional purchase agreement (where the developer is committed to buy the land once the conditions have been satisfied) or a conditional option (where the developer has the choice to acquire the land subject to satisfaction of the conditions).  Land price The developer and landowner will agree a price for the land. This will usually be at open market value and so the price will assume the land is not developed. This gives the developer the headroom to create further land value in due course via development. Depending on the circumstances, a well-advised landowner may seek to impose future overage payments on the developer through the land contract. This may be appropriate where, for example, the proposed development could yield a very high value on completion and, therefore, the landowner might want to secure further payments depending on performance. Pre-conditions A well-advised developer would not want to fully commit to purchase the land unless and until it has managed the risk with other facets of the project. So usually the land contract will be conditional on the developer obtaining planning permission for the intended development. More often than not, this would be a positive legal obligation to secure planning so the developer is compelled to get on with the process and incur the relevant costs. The land contract may also be conditional on the developer securing a commitment for funding of the intended development. A contract may be structured with a further condition which gives the developer the ability to have a binding contractual commitment from an occupier in place before it is required to purchase the land (known as a prelet condition). The land contract should give the developer enough time plus some contingency to enable it to satisfy the conditions (planning in particular). Ability to transfer the land to a third-party funder  The developer should take care to ensure that the landowner can be required to transfer the land to a third-party funder at the direction of the developer. This is vital from the point of view of the developer as it potentially allows for a “forward-fund” transaction with the funder, which would deliver significant efficiencies in terms of stamp duty land tax. Cost exposure for the developer Each party would usually bear their own professional costs incurred during the process. At this point the exposure of the developer is limited to the costs it has incurred to get into contract plus the obvious contractual liability to progress a planning application. This may include payment of a deposit equivalent to 10% of the agreed land price at the outset. Required outcome/next steps Once the contract has been exchanged the developer now has a legal commitment from the landowner to transfer the land to it (or a nominated funder) within a fixed window of time. Therefore, the developer now has the requisite legal mandate to get a funding partner on board and secure a commitment from a prospective occupier. Step 2: securing a contractual commitment from the occupier If it has not already done so, the developer can now approach an occupier and secure a commitment to the project. In this example the developer would pursue a logistics operator. Usually, a developer would have a target occupier in mind and would already have had initial discussions before committing to the land contract.  The developer and occupier would need to agree on the outline design for the proposed development taking into account the operational requirements of the occupier. This would then inform the developer’s approach to the relevant planning application. Conditional agreement for lease The parties would then need to negotiate and agree terms for the lease of the completed development. This would require the occupier to enter into a lease of the completed development at a rent for a fixed term which is long enough to justify the initial investment. Typically, the term would need to be at least 10 to 15 years at a market rent. The general financial status or “covenant strength” of the occupier will be relevant here too. Clearly an occupier that is a household name with a strong trading history would make for an ideal tenant.  The parties would then negotiate the agreement for lease and lease, together with any ancillary documents. It would be prudent for the developer to impose a land condition in the AfL, which refers back to satisfaction of the conditions under the land contract. The developer is then protected in that it is only required to grant the lease to the occupier if and to the extent that the conditions under the land contract have been satisfied. Usually, the AfL will also require the developer to seek the approval of the occupier at various stages during the planning process. The logic being that the occupier has a real vested interest in ensuring that the planning consent that will be obtained caters for all of its operational requirements. Timescales The AfL essentially requires the occupier to commit to acquiring the lease for a significant period of time to allow for: obtaining planning consent – usually anything between 12 to 30 months; and implementing and completing construction of the development.  This will depend on the design of the logistics facility and to what extent (if any) additional infrastructure works are required. Typically, this would be a period of at least 18 months if not longer. The occupier would be expected to commit to the project for a period of at least three years before it would be expected to enter into the lease and commit to paying rent. In return, the developer gives a contractual commitment to the occupier to procure that the project is completed within agreed timescales once the conditions under the AfL and/or land contract have been satisfied. Retaining the ability for the occupier to take the lease from a funder The developer should ensure that the AfL gives the developer the ability to compel the occupier to acquire the lease from a funder who owns the land as opposed to the developer. This is a vital step to ensure that a forward funding structure can be achieved (more on that in part two).  The occupier would typically want to understand how the construction of the development is to be financed and whether the entity that will end up as the landlord has the means to comply with any landlord requirements in the lease. Cost exposure for the developer At this point the developer would have incurred further costs in agreeing commercial terms and negotiating the AfL. It is likely the developer would have incurred design fees too in mapping out the design detail of the project, having regard to the operational needs of the occupier. Usually, the expenditure incurred in getting the developer to this point would be treated as a development cost.  Required outcome/next steps Once the AfL has been entered into, the developer has the commitment from an occupier to pay rent as and when the land has been acquired and the development has been constructed. It now has a compelling proposition to put to any prospective funder.  Roy Barry is a partner at Brabners Next time in Back to Basics, Roy Barry concludes his mini series by discussing the funding structure Image © Pixabay