Many Partners—Trust Your Nose
Virtually all of us have heard horror stories of a married or unmarried couple, or friends, where things go wrong on a personal level, and one spouse or partner skips out leaving the remaining partner alone with the cost, expense and liability on land, farm or single-family residential housing. Obviously, this often results in a struggle to carry the debts, many times resulting in material adverse credit and financial consequences. That situation is not limited to personal relationship-based partnerships. It happens in arms-length transactions between partners in small and large real estate deals everywhere, all the time, and with increasing frequency in today’s economic climate. Refer to the “PPPPP” rule. It is not the end all/be all shield against financial, mental and emotional stress when there’s a breakdown of any type in a partnership or ownership of real estate, but proper preparation can afford you legal rights, and a structure to partially protect yourself, or take the adversarial steps you must to make a partner live up to their responsibilities, or divest them of their interest and authority.
Long ago, back in the 70s when things were rocking and rolling in residential and multifamily real estate (prior to the four-year tenure of Jimmy Carter), I was approached by a man slightly older than me whom we shall call BM.
BM had optioned a well located, twenty-six-acre parcel that nestled just off the interchange of a major arterial and Interstate 25, in a booming area just north of Denver. Multifamily units and apartments were a hot ticket, and enjoyed all sorts of tax benefits. The land met our criteria for that type of intended use—it laid out beautifully over rolling hills, had great access and exposure, full utilities, the end product was perfectly suited for that micro market and the view of Denver’s skyline was terrific.
I had doubts about BM from the first time he shook my hand. He didn’t look me in the eye as he told me about this “great piece of property” that he had just optioned, wanted to build two hundred apartment units on, and was now offering to joint venture with my construction company.
For those of you about to skip forward because twenty-six acres of land on the fringe of an urban area, planned for a two hundred-unit apartment complex, “doesn’t apply to your situation,” hold your horses. This, and the other stories in this section, contain universal truths about real estate, partnerships, money, short memories and how the acts and lack of acts of others can cause untold financial and emotional strain, if you are not properly prepared.
We liked the land, the due diligence checked out, the market was perfect and I convinced myself that with the right joint venture agreement, including stiff protections and safeguards learned from previous partnership type deals, we could protect ourselves if my gut instincts about BM proved to be true.
A lengthy joint venture agreement was drawn, with extensive protections, particularly for our side of the venture. We maintained virtually all control. BM had some say in the design of the units and like matters. BM had to sign the dotted line for the bank right alongside us, even though it was our financial capacity that provided most of the foundation for the financing.
The units were designed, development work began on the land, financing was obtained, and the project was underway. I noticed on several occasions during the planning process that BM would pretend to be unable to approve this or that in the design scheme. A few weeks would always elapse while he supposedly “intensely pondered” what he really wanted. This caused delays and ran the interest meter, but he would always come back with an approval, providing he received some type of additional “bone,” which usually involved money, percentage or interest. He was obviously wheedling the deal.
Two years into the Carter presidency the project was completed, our management company achieved a quick lease-up and we were pleased with the end result. Carter’s concept of high taxation (70% top rate), expanding government and printing money to fuel the expansion, was beginning to have its inevitable effect. Unemployment rose, inflation crept rapidly upwards, fuel prices exploded, interest rates rose and demand fell.
The note on the property was a floating-rate note. We were protected with a ceiling (top possible rate), and the bank was protected with a floor (lowest possible rate). We foolishly agreed to a ceiling higher than the project could support without an increase in rents thinking (also foolishly) that interest rates could never get that high. Wrong. Macro events far beyond your control, (as discussed in Sections II and III of this first volume of Land for Love and Money) can and will reach out and grab you. You will have little, if any control.
Interest rates quickly rose to stratospheric levels, and the project could not generate income sufficient enough to pay the debt. The loan had been structured as an intermediate term (three-year) acquisition/development/construction loan, which would roll over into a long-term permanent mortgage. If checks had to be written for any reason, the joint venture agreement called for BM to put in money equal to his smaller percentage, along with our much larger share of the expense pie.
BM conjured up a plethora of excuses, accusations and complaints about how the apartments had been built—though he had approved every step of the planning and construction process, management of the joint venture, management of the apartments and more. Using these excuses he refused to write his share of checks, though he had eagerly grabbed his earlier share of proceeds. He also refused to sign on the dotted line for the rollover of the intermediate term loan to a long-term mortgage (on which I had negotiated a significantly lower interest rate than what we were paying on the shorter-term, floating-rate financing).
The situation became tense. Threats of legal action flew back and forth, though from our vantage I knew nothing could be gained and the real estate would suffer.
I finally called BM one day and said, in essence, “If this continues we will lose the property and no one will have anything. What’s it going to take to get this resolved?”
BM’s reply was what I expected. “I don’t care if we lose the property. I have been paid my fees, the economic outlook is bleak, I am not collectible and it will be years before there’s a profit. Since I have minimal assets, the only signature that means anything down at the bank is yours, so in reality you have all the risk.”
Shortly thereafter, though he had no legal or equitable basis for the request, BM agreed to take $25,000 to relinquish his entire right, title and interest to the real estate, and be removed from the joint venture. In context, that $25,000 would be roughly $125,000 in today’s dollars. The money was paid, BM was removed (though not without further foot dragging and additional attempts at extortion) and ultimately the project was saved and sold at a profit. However, the gain was much smaller than it would have been due to the time and expense involved in the dispute with BM, the deteriorating economic conditions and the delay in getting the high interest rate, intermediate loan converted to a lower rate, long-term loan. Not to mention brain damage and diversion of time and energy.
The Inescapable Truths
There are five universal land and real estate morals to this story.
1) If you have a gut feeling about someone and it’s less than perfect, heed your instincts.
2) If a potential partner has exhibited any propensity to delay, leverage, use subterfuge to gain advantage (tangible or intangible), particularly if the delay or impediment is detrimental to that partner also, this person is absolutely going to be what I call an “extortion partner.” They will not change. Run, don’t walk from the deal.
3) Never do business—or fight—with someone who has nothing to lose.
4) There will be macro-economic events, including government policy, taxation and market conditions which will affect your land and real estate—and your partners. Try to plan for the worst case.
5) The most carefully drawn partnership, Limited Liability Company, joint venture or other type of agreement that creates a multi-person interest in land and real estate, or that entails shared responsibility, means nothing unless the person on the
other side of the paper intends to follow the agreement.
Many Partners—Potentially Many Problems
Flash forward to current times, and a beautiful, eight-thousand-acre ranch property in a western state. The land has water, mountains, agriculture, fisheries, big game and excellent grazing, and took many years to put together. The property occupies an exceptional location with exceptional resource attributes and the appraised (and real market value) is far higher than the debt. Various ranches were assembled to create this beauty using a combination of structures, including a LP, a LLC and a pre-existing “C Corporation”1, which the seller of the property foolishly formed when it was in vogue in the 1950s.
The LP had owned other ranch properties since the late 1980s. There were seventeen partners in the LP. At that time, I had no interest. Rather, my ranch management and consulting firm acted as advisor and consultant to the owners, supervised their due diligence, advised them (along with their counsel and CPA) on business aspects of acquisitions, planning, formation of the LP and other structures. We managed all of their various ranches. I knew each and every one of the partners individually. There were some that I liked more than others, but all seemed to be standup, financially capable folks who shared common interests, primarily the preservation of wild and agricultural lands, hunting and fishing.
From the late 1980s up until 2008 things went very well for this group. At their invite, I purchased an interest in their Limited Partnership and became President of the General Partner in 1999. It was a shoulder to shoulder deal. Everybody had skin in the game, i.e., investment. The other person with management authority (an attorney) and I guaranteed the financing of property and property acquisitions. The partnership documents allowed the general partner to ask for money if it was needed, but no Limited Partner was obligated to loan money to the LP unless they wished to. However, the partnership agreement allowed for dilution—the increase in ownership for partners writing checks and the decrease in interest for those who did not.
Things progressed nicely. The partners were happy, the LP was profitable overall, fishing was good, there was little discussion and certainly no dissension at the annual partnership meetings. Many of the partners became good friends with one another. Then came the economic meltdown of 2008.
Also at that time, one partner ran into medical issues. Another had purchased a business that began to flounder. A third suffered a death in the family with various estate problems. A fourth, also for estate purposes, including the looming re-enactment of the 55% death tax after expiration of the Bush tax cuts, split his interest out 25% to each of his four children. Many of the partners, some just retired, and many approaching retirement age saw their retirement accounts materially adversely impacted in the economic wreck. Many saw income from other investments reduced and values plummet. Some had extraordinary expenses such as weddings, or college for their children.
Difficulties were engendered by generally deteriorating economic conditions, personal situations of a number of partners, a slowdown in demand for several years for any type of real estate, anti-wealth policies of both the Federal—and on this ranch—the State government and problems the smaller bank which had financed the ranch was having on a number of loans that had nothing to do with this group or this land. These unforeseen nasties were exponentially exacerbated by the macro whammy of expanding government (much the same as Jimmy Carter’s but on steroids) and a rapidly expanding regulatory environment in the brave new world of Dodd–Frank Wall Street Reform and Consumer Protection Act (Dodd–Frank).
All this unexpected macro “fun” attendant to the financial meltdown, and the Great Recession, materialized after the initial financing had been done. Then the deal was “blessed” with Dodd–Frank. Though all other terms of loans had been complied with, and the loans provided for extensions and longer-term financing in 2006 when the ranch was finally fully assembled, the new regulations and soft market adversely affected other loans in the lender’s portfolio, and tied the bank’s hands. To prevent its loans from being classified (see Section III) they had to take the position that the loan would be renewed only if there was a 10% annual principal reduction ($250,000 per year) in addition to semi-annual prepaid interest.
Several partners pulled a “BM” and refused to write checks. Other partners stepped in and loaned monies over their pro rata. The bank acquiesced to a cessation of the unanticipated principal pay downs (after approximately $500,000 had been paid), and lowered the interest rate to market from several percentage points over market. Because the various LLC and LP documents were properly drawn, the final result for those partners who stepped up to the plate will be a much larger percentage of any gains from the sale of the ranch. Those partners who drummed up excuses to not pay, will suffer the opposite consequence. Had these worst case mechanisms not been put in place up front more than twenty years ago, the contributing partners would have had no incentive to do so, and the ranch most probably would have been lost, along with everyone’s investment.
1A corporate entity in which profits are trapped (i.e., do not flow through to the shareholders [partners]) and which pays tax at the maximum rate at the entity level, such profits taxed and then again when distributed as a dividend to the shareholders.
I am astonished at how many people call or contact me, their hearts set on a certain location in a particular state, for various reasons—they visited there in the past and liked it, they heard about it from friends, it’s close to family, it holds some special mystique for them based on their life experiences, word-of-mouth or other reasons. Few, if any have ever investigated the fiscal, tax, economic and political trends. It’s as if—in their minds—that land simply sits out there on its own, immune to all other influence. The land is not immune.
Remember, land is both a tangible and long-term asset. You have heard the stories of one purported real estate guru or the other who bought houses and flipped them for quick profits in days, bought land that tripled overnight and similar tales. These are the rare exception—they are by no means the rule. Real estate is a long-term asset. If you’re planning on buying something to turn quickly, perhaps you’ll be lucky, but I strongly urge you to have a long-term contingency plan. So far in this volume—and we have barely scratched the surface—you’re becoming aware of events, circumstances, personalities, government and gotchas that can slow a deal down or roll it upside down. Some of the other stories later in this first volume of Land for Love and Money will make you blink. You will scarcely believe them, but they are true.
Because land is a fixed, tangible, long-term asset it cannot be moved. If things start to go sour in the community, the county, the state or even the region in which the land is located, you’re pretty much stuck. If property taxes double because local government is broke, or schools are under water, too bad for you. In a desperate state, sales tax, personal income tax rates, surcharges, fuel tax and service charges will increase. There will be attempts at covert levies upon any increases in the value of your land. Again, you are pretty much stuck. If the state or locality is prone to strict and ever-increasing land use or environmental controls, zoning mutations, an ever-burgeoning bureaucracy and governance of private property rights, the trend is far more likely to accelerate then regress.
Be aware of the area in which you are purchasing. In this and upcoming volumes of Land for Love and Money, we discuss your gut perceptions of the people in the community. How friendly and helpful they are, or are not. How tolerant of divergent views of “outsiders” they are, or are not. However, in this chapter I’m alerting you to something far more mechanical, and potentially devastating.
If a local, county or state government is broke, running huge annual budget deficits, has been unwilling or unable to change its course of out-of-control spending, this could mean a significant problem for you and your land in the future. In addition to the better publicized annual budget deficits governments run, and whether or not they have a cumulative surplus or negative number on
their balance sheet, all governments have unfunded liabilities.
You’ve heard much of the primary national debt of the United States which, as this book is written, is $16 trillion and climbing. But the unfunded liabilities, Social Security, Medicare, Medicaid, government pensions are estimated—depending upon the expert—at an additional $60–$100 trillion. No, that is not a typo!
The same is true for governments at local and state levels. For instance, California, depending upon who is cooking the books in Sacramento in a particular year, admits to being $16+/- billion underwater on its cumulative balance sheet. It runs an annual deficit of hundreds of millions of dollars—and that number is with fast and loose accounting. The unfunded liabilities of California, however, such as social programs and especially pensions, are estimated to be between $105 billion and $210 billion. That is not a typo, either. This is a state where limited offshore drilling rights, if leased, would result in royalties which would balance the budget and make significant inroads in state debt. The state refuses to take that step. This is a state which is not only curtailing spending, but keeps increasing social programs and entitlements for citizens and noncitizens alike. It is a state that is losing jobs, losing population, losing industry, has increasing income tax rates and sky high and increasing property tax rates, all with the icing of increasing state and local sales taxes.
I’m not picking on California. New York has many of the same problems, as do several other states. Connecticut, for instance, currently has a governor and legislature hell-bent on raising taxes to some of the highest levels in the United States. Illinois, despite the great economic recovery examples of its neighbors in Indiana and Ohio, continues on the same path as California.
Wyoming has no income or corporate tax, and low sales tax. Nevada is the same as are several other states. In some years Alaska actually writes a check to its citizens in amounts which can range from $1-$6,000 depending upon the year and the price of oil, all derived from excess royalty revenues from energy production and transport. Texas has seen significant job growth and a net in-migration of three million folks over the past five years—many of them from California. Florida is another state with no income tax and certain other beneficial, citizen and business friendly structures. Montana has no sales tax, but relatively high personal income tax brackets.
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