Risk vs. Profit: How much is enough? (A Case Study)
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I was approached by a broker (“Broker Bob”) who had a client/owner of 12.65 acres of land who needed a land loan to pay off a first lien that had come due weeks earlier, with foreclosure procedures to commence within the next 10 days. Broker Bob was seeking a $300,000 loan for his client at 10% interest for 15 years, paid monthly. A balloon payment would be negotiable.
Now, most investors want the highest yield possible, correct? To me, a 10% yield was not very appealing. On the other hand, usury limits must be a consideration for every hard moneylender in the market. If I could legally earn a higher rate, I would be interested, so we proceeded to explore the proposal.
First, we reviewed the real estate and found that the property was well located across the street from a major mall, had level topography, and located as a key parcel in the center of several parcels that were being promoted as a 50-acre power center site. The owner claimed that he had received and had rejected (unfortunately) prior offers of over $1,000,000. He was very confident that in the next year or so, he could sell the property for more than $1,000,000. He needed $225,000 to payoff the loan that was now overdue.
The questions: Do we make the loan? How should we structure the loan? Or, do we just offer to buy this property? These are typical considerations that every investor faces.
We told Broker Bob that we would provide the $300,000, but not as a loan. We elected to make the deal a purchase at below market with an option for the seller to repurchase. We would provide the $300,000, but the Owner would deed us the property free and clear. After paying the $225,000 to the lender, the owner would net $75,000. As the new owners, we would pay the property taxes and any other costs that might be associated with the property during the 5-year contract period.
In return for selling us the property at below market value, we would create an option contract that would allow the former owner to buy back the property for a period of four years. The option price would be based on a price schedule that would increase each year. We would also grant the owner the right of first refusal to purchase the property during the fifth year. If the property were not repurchased by the end of the fifth year, the seller would have no further claim on the property. If the owner was correct about his evaluation of the property’s value and it’s marketability, then he could easily sell the property during the option period, pay us the scheduled option price and pocket the difference between the sales price and the option price. The option price would repay our $300,000 plus a return on our $300,000 that would be significantly higher than a typical land loan.
Structure:
While I was structuring the transaction, I planned to use the sale proceeds of a property that a partner and I had just sold. In addition, a previous partner came to me and had $150,000 to invest. My partner and I each placed $75,000 into the deal and the previous partner was included with his $150,000. The total of $300,000 was achieved, we closed on the purchase, and I then owned a 25% interest in the 12.65 Acres. The three of us formed a partnership with each of our interests being controlled by separate corporations.
During the 5-year contract period with the former owner, there were several offers made to the previous owner. Even though the price was acceptable to the option holder, none of the proposed transactions ever closed. I had promised Broker Bob that, if he could get the property sold during the option period, I would not participate in the commission. That of course made him happy.
At the end of five years, the property was still unsold. The option holder’s failure to close on a sale meant that at the end of the 5th year the property was ours with no further obligation to the former owner/option-holder. As a courtesy, we allowed Broker Bob to keep his sign on the property and we began to deal with potential purchasers. During that 5-year period, the mall across the freeway doubled in size, the retail market in the area went crazy, and the land values for property adjacent to ours soared to $15.00 per square foot, a ten-fold increase in land value in those five years.
A Second Transaction with Broker Bob
Early on, when the deal with the landowner started, I learned that Broker Bob was in another partnership with some other friends of mine. That partnership owned income-producing property. His partners were unhappy because of the demands being made by Broker Bob for commissions. During the first year of the option period, the partners approached me to buy Broker Bob out of their partnership. I said I would look into that possibility if they would provide me with the partnership information.
After some negotiations, I purchased Broker Bob’s 25% of the income producing partnership for $380,000.00. I did so by paying off a $100,000 note owed by Broker Bob to his bank and, for the remaining balance, Broker Bob agreed to take a personal unsecured note for $180,000.00. The note would have no payments. The interest would accrue and be due in 5 years. Since my buyout of Broker Bob, I have kept the property associated with the income producing partnership leased and I have received a minimum of $60,000 per year in pre-tax dollars.
Who’s in charge?
Near the end of the sixth year, Broker Bob came back to me and asked if we would sell the property for a price lower than option price. I said no, and he reminded me that I had partners and threatened to go talk to the partners. I was naturally offended by the threat, but I said he was welcome to talk to the partners, but until he wore my shoes, they would not listen to him. As predicted, he did, they didn’t.
Use the Land to Your benefit!
As the end of the sixth year approached, the entire principal of the $180,000 note plus five years of accrued interest was coming due. Thinking that I would be under heavy pressure to pay off his note, Broker Bob’s next strategy was to approach me and state that he had an interest in buying the 12.65 acres, but, again, at a significantly reduced value. He said he was even willing to purchase my interest in the land by forgiving a portion of the note and accrued interest that I owed him.
I later learned that Broker Bob’s keen interest in our land was because he was working with a developer who had spent close to $100,000 in fees for inspections and they believed that they could develop a major retail development by assembling the 50 acres mentioned above. Broker Bob was attempting to obtain control of the multiple parcels that comprised the proposed shopping center site. Our parcel was in the middle of the site and absolutely essential to any meaningful development. Broker Bob wanted to own or be under contract to control the various parcels so that he could be the sponsor for the overall transaction. Even though he was looking at a potentially huge pay day if he could assemble the key parcels, he was still trying to use the upcoming due date on my note as a tactic to pressure me on the price.
He told me that the owners of the remaining parcels that were required for the assemblage were determined to sell their properties and would sell for less than market value and wanted me to do the same.
I really don’t like someone trying to bully me, and I especially didn’t like Broker Bob’s heavy-handed approach. We negotiated for the next full month and Broker Bob finally agreed to surrender 100% of principal of my note and waive 100% of the accrued interest in exchange for my 25% interest in the 12.65 acres. That was a great deal for me and had the effect of providing a fantastic return on my investment. In addition, I had enjoyed $60,000 per year during those five years, (and still continue to receive each year) from the partnership interest purchased with the $180,000 note and the $100,000 in cash.
Of course, prior to agreeing to the sale of my 25% ownership share in the land, my other partners were informed of my thoughts and they fully approved the deal. They realized that nothing would change for them with the acceptance of a new partner. Under the terms of the partnership agreement, the two of them still held full control of the partnership with their 75% ownership. The two of them would be able to out vote Broker Bob. Oops, I guess Broker Bob forgot to look at the big picture.
Summary
My reluctance to accept a 10% yield led me to a more creative way to structure the transaction. The result of that structure was that the former owner avoided eminent foreclosure, pocketed $75,000, and had five years to repurchase the property and make a nice profit. When he failed to do so, we owned the property without the burden of having to foreclose on a loan.
Early on, Broker Bob’s inability to work closely with his partners in an income producing partnership led to a second transaction with him. Then going full circle, Broker Bob became a minority owner in the land partnership by acquiring my interest with the note that I owed to Broker Bob. Based on my cash investments in the two transactions, my yield has been in excess of 35% per annum, a far cry from the 10% that was offered.
As I fully expected, Broker Bob’s plan for the mega-retail transaction has fallen by the wayside and the big pay for him has not materialized. I can’t help but wonder if he tried his bully tactics on the other owners too.
The 12.65 acres is now for sale. Guess who is the listing broker? Yes, That right. With their 75% ownership, despite Broker Bob’s objection, the former partners have voted to have my firm market the property.
Editor’s Note: Mark Johnson, S.E.C. and Phil Corso, S.E.C. together teach a two-day education program entitled “Broker Estate Building.” The program is based upon the original class created and taught by Colby Sandlian, S.E.C. and Cliff Weaver, S.E.C. in the 1970’s and ’80’s. Totally rewritten to reflect the realities of the real estate business today, the program is offered nationwide. For additional information, contact either Phil or Mark or visit the S.E.C. Education Foundation web site: www.secedfoundation.com.
