by Peter McCarthy
Many years ago I wrote a paper extolling the virtues of partnership developments, and since then partnerships and joint ventures have become slightly more popular: nevertheless they still represent a small percentage of total land transactions. Several public and other major landowners for whom the method offers the greatest attraction rarely, if ever, dispose of land by this method, and even when they do it is often a cautious “toe in the water” approach.
Before proceeding to a consideration of partnership schemes, it is perhaps relevant to consider briefly the bases upon which land is normally sold.
The principle behind a conventional sale is to achieve the highest price obtainable at the time either by auction, private treaty negotiation or competitive tender.
Auction
An auction sale is invariably well advertised and open to all. No inquiries are made as to the purchaser’s financial ability to complete the purchase or carry out the subsequent development of the site. The purchaser is not required to produce a scheme and, if he is reckless enough, he can buy with the minimum of time spent on assessing the development possibilities of the site. Provided the reserve price is realised, the highest bidder secures the site, and once a bid is accepted a contract exists.
Private treaty
Private treaty sales may also be widely advertised, and a bargain is struck, often after negotiations with several parties. These negotiations sometimes become protracted and can even degenerate into “Dutch auctions” or informal tenders, when several potential buyers offer the asking price and are subsequently asked to submit “best offers”.
Tender
The tender method has become the most popular means of selling large and valuable sites. Tenders are sometimes called for on a contractual basis, particularly where much preparation for sale has already been undertaken by the vendor, who might even have obtained a planning permission. Tenders can be open — frequently the case with sales by public bodies — or restricted.
Very often the prospective purchaser is required to make a presentation. In certain cases a two- or even three-stage procedure is adopted, with tenderers first establishing their claim to be included on a shortlist and subsequently being judged by elaborate presentations where (mainly of course with publicly owned land) the quality of the proposed development may be a major deciding factor. Interviews are sometimes conducted as the final selection process.
Problems can arise with non-contractual tenders, where the highest bidder, subject to planning, has been over-ambitious: later, when planning difficulties are encountered, he seeks to reduce his bid, perhaps below the underbidder, who by then may have lost interest.
“Seeing off the opposition” and later seeking to improve terms is by no means an uncommon tactic among purchasers where sites are put out to tender.
Partnerships
What, then, are the advantages of a partnership, and how does it differ from a normal sale? For the purposes of this paper I use the term in its widest sense to cover land transactions which reserve to the vendor the right to seek, by way of an additional payment, a share in the profit from the subsequent development.
Why should a vendor seek to share in the purchaser’s profit? Possibly the greatest reason is the seeming inability of any government to cure inflation.
It is an historic fact that over any long period today’s “ridiculously high price” is tomorrow’s bargain.
Successful developers can make large profits — frequently more than they had originally estimated. In a partnership transaction the vendor seeks to take some part of this excess.
The object of such transactions, therefore, is to secure for the vendor a higher eventual price than would have been obtained by a conventional sale. One must not assume that this is the route to inevitable success. Developers’ profits are not guaranteed, and a joint venture agreed at the height of the market might produce less in real terms than a conventional sale.
However, over any reasonable period, major developers do make profits, and consequently large landowners disposing of property over the medium to long term would be well advised to give serious consideration to partnership transactions. These include the Government, many public and former public authorities, and companies with substantial land holdings which they are rationalising over a long period.
Having defined partnerships in a very broad sense, I will now consider examples of the various types, with their advantages and disadvantages.
Partnerships can range from the cautious “toe in the water” top up to a full-blooded joint venture with a developer where the vendor shares equally in his risks and profits. The variations between these two extremes can be almost infinite, but I have restricted my analysis to five categories:
(1) A conventional sale at a full “market value” plus top up.
(2) An agreed downpayment below full “market value” plus larger profit share.
(3) A profit share with a guaranteed first charge to the vendor.
(4) A profit share with the developer having the “first charge”.
(5) Neither party having any prior claim to sale proceeds with each taking a percentage share.
(1) Top Up
This is the cautious approach of the landowner wishing to “have his cake and eat it”. Such an objective may well be perceived as highly desirable by the vendor but is difficult to achieve in practice in whatever circumstance the principle is applied.
Often it is impossible accurately to predict the success of a complicated scheme which is perhaps breaking new ground.
Developers may not be prepared to increase their assessment of the right price to pay as a downpayment for the site.
Where both parties perceive the possibility of a very profitable end-product, however, it is often attractive to conclude terms on the basis that if profits are larger than anticipated then a percentage of such addition will be paid over to the vendor. This causes no problem to the developer. It is attractive to the landowner, particularly a public authority, since it avoids the possibility of criticism from those who always knew the price was too low — but, surprisingly, never say so at the time.
But the developer, having paid a good price, is entitled to profit from his risk-taking and expertise: such “top ups” are therefore rarely substantial.
The final calculation of the “top up” can be made using a formula based upon profit (either total profit or excess over an agreed minimum). The formula could also relate not to profit but to sale price, irrespective of profit, or to the area of accommodation ultimately erected upon the site where there is some doubt as to the extent of planning permission which might be achieved.
(2) Agreed downpayment plus profit share
With this method the landowner puts part of his land value at risk, deliberately accepting a lower price in return for a share of profit.
Unless the price struck is substantially less than the perceived “market value”, the profit share will still be comparatively small, and can be regarded as a share of excess profit after the developer has covered all his costs plus profit (including of course holding charges and profit on the land price paid). The vendor’s share could be calculated in a number of ways, for example:
(a) A percentage of excess sale price.
(b) A percentage of excess profits.
(c) A small percentage of total sale price.
(d) A larger percentage of sale price over a stated minimum.
Since for reasons already indicated the vendor’s share is likely to be a modest percentage of the total value of the development, it is perhaps simplest for it to be assessed on the basis of sale price or rents achieved, payable when the developer obtains his financial return. This relieves both parties of complicated checking and accounting for costs and expenses.
The vendor is of course playing safe in that he will require a substantial percentage of land value “up front”. The developer will thus be carrying all holding charges and will remain the major risk taker, and in consequence will not unnaturally look to retain the lion’s share of profit.
(3) Profit share with vendor’s guarantee
In this situation the landowner elects to defer receipt of his land value and take his share from the profits or sale proceeds. He still wishes to protect himself, however, and by demanding a guaranteed first payment from the proceeds of sale (not, you will notice, profits) cannot of course lose since he will require a first charge. The developer is not buying the site in the conventional way and in consequence he will have no holding charges. He is having to guarantee a sum even if he makes little or no profit. He may well therefore look for a profit on the land price unless it is a comparatively low figure — low enough for the vendor to argue that at such a price there is no risk.
Having made the agreed payment for the land, the developer would then look for the recovery of his costs. In many cases a profit percentage is also added. This is not recommended. The developer’s gain should be on the success of the scheme measured by profit, not based on his expenditure — in that way he stands to profit by his mistakes. Thereafter, any further profit would be divided between the partners. The lion’s share of any excess may again go to the developer in recognition of the fact that he had been at risk. The vendor has merely deferred his entitlement to land value in order to obtain a higher price.
(4) Profit share (developer’s guarantee)
Possibly the reverse of category 3. In this case the landowner elects to take the majority of the risk. The developer’s costs are virtually guaranteed, unless of course he is so appallingly inefficient that the sale price does not cover his costs — leaving the landlowner with nothing!
One can scarcely contemplate a developer so inefficient as to be incapable of profiting from developing on free land.
One can structure such a scheme so that the developer recovers only his costs (no profit) as the first slice. The residue can then be divided in agreed proportions (the majority of course going to the vendor who until then has received nothing for his land).
As an alternative, the vendor can take out an agreed land price (after the developer has taken his share) with any residue again being shared.
In any permutation of methods 3 and 4 it is necessary to give the developer a share of the final slice. The developer is there because of his expertise and experience. He is rewarded for his risk-taking in proportion to the degree to which he is at risk. There must also of course be an incentive to strive to make the largest profit. This will be present only where the developer sees additional rewards flowing from success.
(5) No prior claims
This is perhaps the true partnership, since both parties are sharing fully in the risk and will profit in equal degrees. The share need not be in equal proportions, but this could be achieved where one party (usually the landowner) is willing to put up extra cash to achieve a 50-50 balance.
I am aware of a recent case where a major company (the potential occupier) jointly acquired a site with a developer. This company leased part of the subsequent development, bore all costs and expenses equally with the developer and shared in all income and profit generated, including its own rental payments.
In most cases, however, the partner is the landowner already and a problem immediately arises in assessing the value of his land. This need not be insuperable — such a transaction as envisaged could be achieved by some form of competitive bid. The vendor would then have the task of selecting the scheme likely to produce the largest profit. This may not necessarily be that produced by the developer who offered the largest land price.
It will be apparent that with all partnership arrangements neither party can be sure of the amount of its share. If the development came on stream when the market was depressed, then the landowner who could have sold perhaps at the height of the market would lose out. Likewise a developer committed to paying the landowner a fixed percentage of sale price could even fail to recover all his own costs.
However, as will be seen from the example, the rewards to the landowner can be great — if he gets his timing right.
While there is an infinite variety of methods by which shares can be calculated, there are only three main bases upon which such calculations can be made.
These are (a) profit (b) sale price and (c) planning consent.
Profit share
Basing calculations upon profit share has the advantage of appearing fair to both parties. Landowner and developer put in their capital and share in the profit produced by their joint efforts. Problems can arise because of obvious complications:
(a) Defining the exact value of the land.
(b) Keeping a close check upon expenditure incurred by the developer and ensuring this is all “at arm’s length”.
(c) Where the developer has a right to a profit based on his expenditure there is an incentive to overspend. The developer suffers no penalty if he is profligate, failing to keep proper control of costs.
Sale price
An arrangement where the shares are based on sale price has the merit of reflecting inflation and directly benefiting from good planning and market research. There are, however, problems where cost escalates. Increased costs would normally fall on the developer. This might be particularly hard to justify where some improvement costing more resulted in higher sale prices which were subsequently shared with the landowner.
It will be seen that it is essential where this method is followed that the scheme is fully thought out and fixed from the start. No changes should be made which might affect cost or sale price.
Alternatively, of course, it is open to the parties to renegotiate, particularly where it is seen that increased costs or improvements, or perhaps some additional area of development, will produce a profit. The terms agreed could make it uneconomic for the developer to take advantage of the opportunity, but if a profit were available it should not be beyond the wit of both parties to renegotiate terms to enable them to take advantage of the changed circumstances.
Planning consent
A calculation based on planning consent has the advantage of simplicity: the developer knows in advance the price he has to pay for each additional square foot. Clearly he will take advantage of an improved planning consent only if it is profitable, and again the parties are free to amend the partnership agreement if it prevents a perceived profit from being realised.
However, such a basis does not take account of inflation nor any increase or decrease in the sale price or rental levels. It is a fairly crude yardstick but uncomplicated.
Conclusion
To summarise, therefore, there is an infinite variety of partnership schemes which can be negotiated between the parties. At one extreme we have the cautious landowner wishing to obtain the best price for his land plus a top-up. This can be based on higher than anticipated profit, a better planning consent or a percentage of additional sale price or rent.
At the other extreme (and a very rare animal indeed) is the landowner wishing to be equally at risk with the developer. Both parties could even contract to divide the sale price in agreed proportions, leaving no fixed sum to be recovered in respect of land price or developer’s costs!
I have attempted to emphasise that joint ventures are profitable to landowners in times of rising prices — but not necessarily at the commencement of a recession! The reader will not therefore be surprised that in the following example I have assumed a modest rental increase, a hardening of investment yields and a small reduction in interest rates.
I have assumed a site of 2 acres with consent to erect some 40,000 sq ft of light-industrial space which would let at £6.25 per sq ft.
I have set out an abbreviated form of conventional residual valuation (ignoring VAT). This indicates a site value of £607,000. I have then assumed that the vendor has agreed to contribute his land plus costs attributable thereto to establish the percentage relationship of the parties which will determine the share of the ultimate proceeds (see below).
The next stage is to ascertain the relative percentage “inputs” of developer and landowner in order to calculate their respective shares of actual sale price. It will be apparent that we are assuming our landowner wishes to go for a true partnership with no prior claim available to either party on the sale proceeds. The calculation showing the percentages is:
It is now assumed that the landowner would transfer the land to the joint venture company, bearing all costs attributable to the land (including “purchase price”) and 31.4% of common expenditure (eg agent’s letting costs, etc).
During the development I have assumed:
(1) Rents rising by some 10% to £6.87 psf.
(2) Investment yields hardening to 7.5%.
(3) Six months’ actual voids incurred.
(4) Interest reduced to 14.5%.
The valuation based on actual costs follows.
As mentioned earlier, the calculations have been simplified. It will be seen that even where there is only a modest improvement during development, the landowner stands to gain considerably in terms of real value where he has accepted the risk of development with a partner. It will be appreciated that the landowner will have to bear the fees and costs directly attributable to the land element plus 31.4% of general costs such as sale fees, promotion etc.
It would have been possible for the landowner to have restricted his contribution to the land only, in which case his percentage share of the sale proceeds would have been less. The landowner’s final cash-in-hand situation will be:
This compares with the initial site valuation of £607,000
