Real Estate Law: Developing the East End

Everywhere that you turn in the Hamptons and on the North Fork there are newly constructed homes. Not only is the East End’s landscape filled with residential development, but, throughout the two forks, building spec homes has become a dominant industry. Spec developers first purchase a plot of land and then improve the land with a fabulous construction that they speculate will increase the property’s valuation far more than the composite cost of the land and the construction, individually.

However, such residential construction is speculative because the house is only marketed for sale once it has either been built or is close to a finished product. As a result, spec developers are selling finished products without any guaranteed purchaser, in contrast to offering their construction services to a consumer for a fee, as is done in a custom home job. In recent years, it appears that spec developers have been very successful, as more and more speculative construction is popping up throughout our East End neighborhoods. Here are the top five legal concepts that can make or break a speculative development project.

Getting the Financing
There are two types of financing: (1) equity investments, and (2) financial investments.

An equity investment is a situation where the developer brings in partners who expect a distribution of profits—whereas a financial investment is when the developer simply borrows money for a set rate of return, irrespective of the profitability of the venture. While financial investments are generally straightforward, equity investments can quickly become tricky and expensive because of both federal and state securities laws, which require their own specific disclosures and filings by the developer (aka issuer).

In equity investments, securities laws (i.e. the Federal Securities Act and the NYS Martin Act) are applicable if an investment of money is made in a common enterprise with the expectation of profit that will be earned solely through the efforts of another according to the SCOTUS in SEC v. W.J. Howey Co.

Nonetheless, astute counsel can enable the developer-clients to avoid this onerous burden by structuring the financing properly in order to satisfy Regulation D of the Securities Act, which offers a number of scenarios with exceptions to these onerous requirements. Even more handily, developers can avoid securities laws by structuring the equity investments as active, rather than passive, investments. Where the investors are permitted to exercise meaningful control over the business enterprise, then the financing is never a security and an equity investment will be available without any costly compliance protocols.

All of that being said, it’s far easier to find equity investors when a project does not have a built-in rate of return as opposed to first finding an acquisition loan, then a construction loan, and then, finally, permanent financing. However, developers should explore all options when starting a venture. A proper business plan is one that has been formed only after each alternative (i.e. a SWOT analysis) has been fleshed out—including those that are not selected—to establish that the chosen financing was the most beneficial option.

Structuring the Venture
Most developers use the term joint-venture when discussing their involvement of equity investors, but most joint-ventures are not actually joint-ventures (aka partnerships), but are instead Limited Liability Companies (LLCs). The reason why most developers structure their venture in an LLC is that it provides the tax benefits of a partnership with the liability insulation benefits of a corporation. In fact, most developers utilize separate LLCs for each project. If the developer is going to be active in the construction (e.g. serve as the General Contractor), then the developer should use an LLC for the development that is a separate entity from the entity that is actually doing the construction work. This separation is important because the liability insulation covers all of the entity’s assets, meaning that exposure for the development can create exposure for the construction company, and vice-versa. Yet, this separation cannot just be superficial. Instead, it requires a complete separation of books and records, bank accounts, staffing and the like.   

Setting a Realistic Vision
Many developers have grand plans but want to cut corners on the due diligence period, only to lose their shirt. Unfortunately, grand plans cannot be realized if the local zoning scheme does not permit the plans. Local towns and villages have restrictions, per district, on the land’s construction and its use. Waterfront property has other limits for tidal wetlands by both the DEC and Army Corps of Engineers. Beyond these general restrictions, the actual lot of land may be encumbered with easements by neighbors or utilities. Additionally, the lot’s title may have covenants and restrictions that prevent the project, or even just an aspect of it. Successful developers invest in due diligence and investigate all of these restrictions to know if their vision can be realized at the lot before putting a shovel into the ground.

Speaking of the ground, environmental studies may show that the lot is the site of contamination (inherited exposure). If due diligence isn’t performed—in an exclusive due diligence period (i.e. developers can pay sellers for an exclusive period of time, when the property will be taken off the market, in order to conduct due diligence)—prior to finalizing the deal, a developer may purchase a contaminated lot.

To avoid the due diligence period is to be penny wise and pound foolish.

Owning the Plans
Learning what a developer can’t do by setting a realistic vision is important to avoid loss, but creating the vision of what is planned to be developed is how the money is made. The point when plans are drawn is the best time to attract investors in the development. This, too, is not an area to cut corners, and an architect, duly licensed by the NYS Office of the Professions, should be utilized. Skipping this step and using plans found on the internet, or from a former job, can expose the developer to legal action (stealing construction drawings is considered copyright infringement pursuant to the Architectural Works Copyright Protection Act).

Hiring the Contractor
A licensed architect typically comes with a team that can either be referred to, or managed by, the architect in implementing the project. Nonetheless, and irrespective of whether the architect is involved with the General Contractor (GC), a developer should study a standard American Institute of Architects (AIA) contract (i.e. standard contract used in construction) before hiring both their architect and GC. This is because AIA contracts are made for the benefit of the architect and GC, not the developer. To protect the developer, it’s imperative that the AIA contract is amended to address issues of delays, change orders, allowances, costs not to be reimbursed, installment payments, and the like. Furthermore, the contract should include hold-back of payments to motivate the GC to finish the job. Lastly, the architect retains copyright ownership of the drawings and plans under the standard AIA contract, which will prevent the developer from reusing these plans on future projects—but a spec developer may want to compound their efforts by redoing the same project on a different lot as their next venture.

The key to a speculative development is not to speculate on your business planning. There’s enough risk inherent in this industry, given that the development may not appeal to consumers. This appeal risk cannot be controlled (except by surveying consumers), but the business planning risk can be greatly reduced. Smart developers will address the above five legal concepts in a  fleshed-out business plan in order to mitigate their risk and maximize the project’s return.   

Andrew M. Lieb, Esq., MPH, is the managing attorney of Lieb at Law P.C. and is a contributing writer for Behind the Hedges. Read his work here.