As the housing market slows, buyers & sellers are increasingly at odds.
It's no secret that the housing market has slowed in recent months. According to the National Association of Realtors, new home sales in 2006 were estimated at 1.06 million, the fourth highest annual total on record. In contrast, experts predict that new home sales will decline to 961,000 in 2007 and then rise only slightly to 971,000 in 2008.
This downturn in the housing cycle is not just making things difficult for sellers. It’s also creating an environment of increased adversity between buyers and sellers of residential development projects and spawning a flurry of litigation.
In recent years, when the housing market was on a consistent upswing, residential home developers were clamoring to snatch up property to add to their inventory. When residential developers entered into contracts to purchase land for development, they were willing to conduct the required due diligence in as few as 30 to 90 days. And even if issues turned up that could increase the development costs, purchasers then had more flexibility in their anticipated profit margins to overlook the problems.
They were willing to take these risks on the assumption that the accelerating sale prices of the homes to be built on the property would be more than enough to absorb any unexpected increases in development costs. Residential developers were also willing to expedite their land acquisitions by waiving conditions to closing so as not to delay the time line for construction of the new homes that were then so highly in demand. Trying to hold on to their real-estate contracts, purchasers were quick to file suit to force the sale if they heard of any attempts by a seller to break a deal and sell instead to a competing bidder.
NOT SO FAST
However, since the housing market entered its cyclical downturn, the buyers of residential development projects are no longer analyzing deals under fast and furious trajectories of increased new home prices. Profit margins have tightened, and developers’ flexibility to take on the risk of increased development costs has correspondingly declined.
In this environment, residential developers can no longer assume that issues affecting their development costs will not financially strain a project. They now expect sellers, who are typically sophisticated parties in these types of transactions, to share more in the financial risks. Many residential home developers have also found themselves holding excess inventory—and their interests have shifted from acquiring property to depleting the supply that they hold. Sellers, on the other hand, no longer have a line of back-up bidders knocking at their doors and have lost much of the leverage they previously held over their buyers.
In short, as the housing market has slowed, tensions between purchasers and sellers with diverging interests have mounted, and a new wave of litigation is spinning off from residential land development deals gone sour. So what is all the fighting about?
The crucial fact is that the typical land acquisition deal for the construction of new homes involves a due-diligence period during which the purchaser studies the feasibility of the project. At the conclusion of the due-diligence period, the buyer typically decides if it wants to go forward with the contract or to exercise an option to walk away from the deal. Once the purchaser (the developer) commits to the project, the seller is usually obligated to complete the process of subdividing the land into buildable lots, with all required governmental approvals, before the purchaser has an obligation to close. These two periods—due diligence and the subdivision development process—are breeding grounds for disputes.
In today’s market, disagreements between buyers and sellers are arising as early as the due-diligence period. Developers are now taking more time with their due diligence than they did when new home sales were burgeoning and are more closely scrutinizing the economics of a project before committing to it.
The discovery of issues that can affect the costs, complexity,and time line for the intended development is causing developers with narrower profit margins to proceed with caution. For example, if a developer discovers the presence of a hazardous material that requires remediation on the site, it may seek an extension of the due-diligence period to see whether the hazardous material might lead to increased costs or delay. A developer may try to renegotiate the deal for a reduced purchase price reflecting the increased risk or may demand that the seller share the risk by bearing some or all of the remediation costs. Such demands to rewrite a deal or share costs tend not to sit well with sellers, who are anxious to close their deals as quickly as possible to convert their asset to cash.
Other tensions related to due diligence arise out of the sellers’ obligations to disclose information known to them about the property. While buyers expect sellers to fully disclose information about conditions on the property that might affect its development, sellers also have a disincentive to come forward with information that may have an adverse impact on the buyers’ willingness to purchase the property. In fact, sellers may delay making their disclosures until late in the study period to diminish the amount of time the buyer has to consider the information. But that can lead to further problems: Once the buyer is committed to the contract but may still want to get out of the deal, the buyer may look to the seller’s nondisclosure of any important information as a means for declaring the seller in default.
THE GREAT DIVIDE
The subdivision process is the next phase in the development process place where disputes are on the rise. The contracts typically require the seller to apply for and obtain approval of the planned development from the required governmental authorities. This process often means the seller must submit plans for the new residential development to the locality’s land-use or planning commission. It may also mean that the seller must apply to rezone the property to maximize the allowable density of lots, thereby increasing the number of lots the seller can sell and the number of new homes the purchaser can build.
The sellers are also typically responsible for coordinating the provision of water, sewer, utilities, and roadway access to the site, responding to the locality’s comments and conditions to approval for the project, working with transportation departments on roadway approvals, and working with environmental, wetlands, engineering, or archaeological consultants to analyze and address factors that can affect the development of the land.
These activities can give rise to countless obstacles. It’s these obstacles that are giving rise to disputes. For example, the presence of wetlands or environmentally protected areas may limit exactly where residential lots will be permitted on the property. And with a reduced area of usable land, the number of buildable lots the property will yield might be cut to an amount less than the minimum number of lots required by the contract. In circumstances like this, if buyers cannot negotiate a sharing of the risk or resolution of the issue, they often seek to get out of the deal. Sellers, on the other hand, may attempt to avoid this obstacle and simply allow time to pass in hopes that the purchaser will become more willing to rework the project once the market bounces back. As the economics of a project start to fail, the developers are not hesitating to immediately hold sellers in default and terminate deals. Sellers resist, and litigation is under way.
ONE MORE STEP
The final place where disputes are arising is the closing phase of the deals. In the closing phase, a series of conditions usually must be satisfied before the buyer is obligated to tender the purchase price on the property. For example, contracts tend to require the seller to be able to deliver a clear and marketable title free of any liens at closing. But if the seller has run short on cash and failed to pay the contractors it hired to construct the roadways and if the contractors have filed for a lien against the property, a buyer is now more likely to delay closing and demand that the seller resolve the issue on its own, rather than waive the condition or assist the seller in satisfying the obligation. Buyers who used to be willing to tie up these kinds of loose ends are now, instead, holding the sellers strictly to their obligations.
Residential developers’ increased scrutiny of the conditions to closing and decreased flexibility to take on extra economic risk are also leading to disagreements over the quality of a seller’s satisfaction of conditions. For example, the buyer who learns that a seller failed to disclose certain information about the property that will increase development costs is now more willing to declare the seller in default and refuse to close on the deal. Then, what often happens is that the seller contests knowledge of the condition, argues that the purchaser knew of the condition all along, and demands that the purchaser close. When buyers terminate or refuse to close, which they are increasingly willing to do, litigation over the deposit, at a minimum, is almost certain to follow.
We expect disputes and litigation between purchasers and sellers of land for new home development to continue until the housing market for new homes picks up again. In the meantime, residential real estate developers will probably spend a little more time with their litigation counsel than they did in past years.
http://www.wcsr.com/default.asp?id=114&objId=230
