How to Avoid Getting Taken Advantage of in a Real Estate DealJul 19, 2018
I have been around for an awfully long time now. Close to 35 years since I started my real estate career in 1984 – after a year in litigation. And, just for amusement, this issue is going out on my sixtieth birthday.
I have seen a lot of things happen, including the laws of unintended consequences upend some really smart real estate players. Here are some things I have seen (very smart) people do that have turned out quite badly for them in the end, always to their surprise:
In a joint venture, the bigger guy has the advantage in a buy/sell right? Wrong! Often the big guy has to pay a lot more to buy out the little guy and the big guy might be a fund or other vehicle where in the future there is just zero cash around to fund the buyout. The predator becomes the prey! Yikes!
Same thing happens with capital calls as the bigger guy insists – sometimes vehemently – on terrible and horrible punishments to the little guy if the little guy doesn’t fund its capital call. This despite the fact that the bigger guy is putting in 90% or even 95% of a capital call. But then years later it turns out that the bigger guy has to put in close to 20 times what the little guy has to fund and the bigger guy doesn’t want to fund or can’t fund. Oops – again – the predator becomes the prey!
You are conservative on your debt with, say, 50% loan to value, but the term of the debt isn’t that long and the term of the loan runs out at the worst possible moment. Ironically, the conservatism on the LTV turns out to be a lot less important than the length of the term of the debt. Surprise!
You are the borrower and you let the lender get a pledge as well as a first mortgage, thinking, they can only kill me once – what’s the difference if I die by pledge or foreclosure. Boy are you wrong in a state – like New York -- where foreclosure takes three years and a pledge ninety days. You just gave up your swords, plowshares, and other weapons and are now defenseless. Egad! [Note – this is not settled law and no one knows whether the short-term pledge would be enforceable, but if you are going to be in this position it would be nice to understand it ahead of time]
You are in a joint venture with a money fund and time creeps up so that you get to the end of the fund’s life and the party running the fund just wants to dump the asset. This can be an opportunity for the joint venture partner or a real problem. Hmmmm!
What if a key man/woman leaves a fund or other major organization where the investors are there “because” of the key man/woman? On a related note what if third parties – such as lenders, financial partners, etc. -- have rights triggered by this? A very awkward situation to say the least and especially so if not planned for ahead of time!
What if you are the seller with a hot asset and just “strutting your stuff.” The buyers are begging you – and your broker – for just a moment of your time. You are on top of the world. You pick a buyer and the buyer flakes out for whatever reason. All of the sudden you are a wounded fish aren’t you? This is because the next-in-line buyer knows he has you over a barrel as you can hardly go to your third choice can you? And it happened so quickly you were the king to the pauper. Now what!
You and your partner were buddies when you started on the deal – on the business – on the venture. But now you hate each other. It is (almost) at the point of litigation, or maybe it is at the point of litigation. Is your reputation going to be destroyed if a fight brews up – are you effectively out of business until (four years) of protracted litigation is resolved – is the value of your investment going to be trashed before things are over. Despite good documents are you over a barrel anyway? Did you think ahead of time about the “practical” implications of a litigation that effectively puts you out of business for an extended period of time, or did you just assume that if the documents protect you then you will be fine? Not good!
Did you sign a contract to sell a piece of property worth, say, $100M to someone who is known to be a “sleaze-ball.” Did the “sleaze-ball” put down, say, $5M as a deposit and are you feeling pretty good knowing that if he defaults you get his money? Well, your good feeling is illusory since you just tied up a $100M asset and the “sleaze-ball” just tied up $5M. Who would you rather be for the next three years of litigation where you can’t sell or even finance your property. Yuk!
Are you a mezzanine lender feeling pretty good that you are clipping the coupon at 10% plus and have “points in” and “points out”. And maybe you even leveraged your position. Your returns are in the high teens – pretty sweet. But then the deal gets in trouble and the first lender is calmly moving forward with a foreclosure. Do you have the money to buy out the first – to cause a refinancing – to take control of the borrower – to put in a substitute guarantor – and all those other rights? If not, as the highest yield debt, you are not sitting pretty at all. Instead, you may look more like a fatted calf ready for slaughter. Many mezz lenders, preferred equity providers and high-yield debt players learned this the very hard way during the financial crisis and some are still learning it today. You need a source of capital to protect yourself or you find yourself with few – if any – friends during a workout. Alas!
More intricately, these same issues applied in more depth in so-called “tranche-warfare” among parties to CMBS capital stacks that didn’t really review the domino-like nature of the documentation. Typically the party with a lot of cash to protect itself came away the winner and the parties that didn’t have cash at their disposal were victimized and even wiped out completely. Ugh!
Are you the kind of guy who is pugnacious and kind of a [fill in nasty word]? No one and I mean no one messes with you! If so, did you wonder why no one is calling you with deals day and night and why others seem to get the plum deals? It’s like that country song, “if the phone ain’t ringing, it’s me.” Bottom line is that people who act like [nasty word] find themselves gradually going out of business over time, but they never know why. Sigh!
Did you agree to act in “good faith?” Did you agree to be “reasonable?” That always sounds so, well, good faith and reasonable doesn’t it? But when the sh_t hits the fan those are the words that the litigators seize on to create all sorts of trouble. Bummer!
Did you sign a guaranty and your partner didn’t? Did you and your partner sign a guaranty but you are the wealthy one and your partner has close to nothing? If you did, you blew it and this could be a very hard lesson to learn. Ick!
Did you assume that the single purpose provisions in the CMBS financing documents that made all bad acts guarantors personally recourse for the entire loan didn’t mean what they said. Well the Michigan Supreme Court came out different in the famous “Cherryland” case and said basically that “a contract is a contract.” If you didn’t get nailed for this it is just because everyone got lucky. Whew!
Real Estate Philosopher Prediction for Amazon HQ2
Everyone told me I shouldn’t do this. So far everything I have predicted has thankfully been accurate – and why ruin that track record? But here goes anyway: I am predicting that Amazon HQ2 will be in Newark, NJ.
To be clear I have zero inside information.
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