What to Do in a Boom to Prepare for a Bust
LOS ANGELES—Now that the Great Recession is fading into the past, and 2015 seems to be shaping up as a boom year in real estate, there is a temptation for real estate developers and investors—eternal optimists—to extrapolate from a few good years into an ever rosier future.
Which is exactly the time to remind ourselves that ours remains a cyclical industry, in many sectors well along the curve, and that we should not be lulled into forgetting the hard-earned lessons from the darker days of the recession:
1. Pick your partners well. When the going gets tough again, having partners, tenants, landlords and lenders who are financially strong, reasonable people, with interests largely aligned with yours, makes a huge difference. Do your due diligence: how did these people actually behave in the recent unpleasantness?
2. Think carefully about securitized loans. Yes, you can often save a handful of points, but when the economy dips and you need a reasonable accommodation, do you really want to spend months trying to get a beleaguered special servicer to think about listening to your problem? And are you comfortable that you’ve really included in the loan documents the right, with or without consent, to do everything you want to do with the property over the next ten years?
3. Pay attention to the negative stuff. In the fast-paced excitement of snagging a great deal in a rising economy, do you really want to be worrying about partnership exit provisions and dispute resolution mechanisms? Well, yes, you do. If your hastily-drafted buy/sell doesn’t really work, or you’ve inadvertently consigned yourself to the terrifying gamble of a jury trial, you’re going to be in a world of unnecessary hurt when—not if—the real estate market cools.
4. Don’t skimp on due diligence. While in a rising economy little problems won’t hurt much, in a falling economy they can make the difference between afloat and underwater. Always get the Phase I environmental report, because the problems it can disclose are not little problems.
5. Be stingy with guarantees. A lender asking for a payment guarantee almost seems to be calling your bluff: “Well, do you believe in your project or not??” Of course you do, but real estate lenders get paid to take the risk of the project’s success, and successful real estate developers and investors are successful because they’ve learned not to unnecessarily put their personal assets at risk. And if you do have to give a guarantee, remember that these things can be negotiated—ask for a cap, for exhaustion of remedies against the collateral first, for a burnoff as your pro-forma is achieved.
6. Listen to your lawyers. Yes, even though it is our profession—not economists’—that is the dismal profession, paying us to think of and try to head off all the things that can go wrong, when things do in fact go wrong it will make a big difference if you’ve done what can be done to protect yourself.
Tom Muller is Co-Chair of the Land Use and Real Estate Practice at Manatt, Phelps & Phillips LLP. This article is for educational purposes only. It is not legal or tax advice or advice to take any action. The information in this article cannot be used to avoid penalties that may be imposed under the Internal Revenue Code or state or local tax laws.
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