Developer run projects and development management agreements
By Matt Dolan
In the first part of our two-part series, we explored key elements found in development management agreements (DMAs) used to regulate fund through developments.
In this second and final part of the series, we explore DMAs where the development is controlled by the developer and the landowner accepts a passive role. Matt specifically looks at DMAs where the developer approaches a landowner with a proposal to realise their current asset through the creation of development lots (either flat land or strata title) for immediate sale after completion.
Developer run project
Developer run projects often arise where a developer is prepared to accept an additional development risk in exchange for a higher return.
A typical arrangement where these types of DMAs are found is set out below.
- The landowner holds a $10 million site (project site) that is currently tenanted and is a passive investment.
- The developer, who has experience in the locality of the project site, recognises the development potential and completes preliminary investigations on the project site for a 100-lot development.
- On satisfactory investigations, the developer approaches the landowner with a proposal for the landowner to fully realise the project site’s development capabilities. In this proposal, the developer calculates an uplift in the underlying freehold value to $15 million. The mechanics of the deal generally include –
- the developer obtains external funding and procures construction
- on the sale of each lot, the landowner obtains a fixed return of $150,000, representing consideration to the landowner for the increased freehold value
- the developer receives the remaining profit up to forecast profit level, and
- if certain profit thresholds are met (ie surplus profit), the landowner is entitled to a small share in the profit.
Here we discuss some of the key elements in a DMA for this type of arrangement.
It is of critical importance the DMA precisely and accurately sets out the parties’ position in relation to items such as funding, security, control, and who bears what risk. Conflicts between a landowner and developer generally arise when the DMA is not clear in relation to specific rights and obligations of the parties.
It is typical to see the developer take out a loan with a financier to fund the construction costs. However, the landowner would still be required to provide the project site as third party security for the funding.
Complications will arise where there is a current mortgage over the land. It is critical for the developer to navigate the potentially competing interests between any existing mortgagee and the requirements of the construction financier. At the very least, there will need to be some agreed priority arrangements between the existing mortgagee and the construction financier.
Generally, because the developer is responsible for the funding aspects of the project (along with other risks), the developer will be in a strong position to negotiate a position where the developer gains maximum control over the project and a higher profit share.
In these types of arrangements, the developer will often be required to deliver the project for a fixed price and bear the risk of ‘costs overruns’. Consequently, a developer will not (subject to broad constraints) be required to obtain the consent of the landowner to incur unsecured funding for construction.
In relation to construction finance which requires security over the project site, a landowner needs to consider the consequences of default by the developer and their remedies following failure by the developer to deliver a completed project.
A developer may be entitled to payments such as—
- an upfront fee to compensate the developer for their initial investigations (eg planning)
- a project management fee (monthly or quarterly) during the project, and
- a profit share payment on completion of the project and after sale of developed lots.
For a developer, it is a common feature of a developer run structure that they see the ‘bulk’ of their return on investment at the later stages of the project after completion of construction and the sell down of lots.
From a landowner perspective, this creates less risk and provides increased confidence that the developer is committed to completing the project to a high standard.
Security for development fees and project completion
As with a fund through development, the level of security afforded in relation to completion of the project, payment of development fees, and any profit share component is a major element in a DMA for both parties and this varies from project to project.
It is more common than not that a landowner would grant security in the form of a consent caveat and potentially a registered mortgage on title over the project site. This would secure payment of any development management fees and profit on sale of the completed lots.
For a landowner, security is generally afforded via the granting of step-in rights, to enable a landowner to ‘step into’ the shoes of the developer in the event of default.
As there are potentially more than three parties with a secured interest in the project site, third party funding and security arrangements can become fairly complicated. It is important both the developer and landowner closely consider the funding and security arrangements in a DMA.
Control and decision-making power
As a developer will typically be entitled to the bulk (if not all) the project profit on end sales after paying off project costs, debt and landowner fixed returns, they are invested in completing the development to a high standard. They are also generally afforded greater project control and an ability to complete the project as they see fit.
Initially, the developer prepares a project plan and budget, which requires the agreement of the landowner. The developer is then required to materially adhere to the plan and budget, with minor variations accepted.
Generally, there would be key construction stages whereby the developer is required to give notice to the landowner of key particulars and work carried out, or to be carried out.
If a landowner had more control in a developer run development, then the developer could be rightfully concerned about the impact this may have on the ability of the developer to complete the development to a high standard and be rewarded with increased profits. One of the classic risks in DMA arrangements is conflicts between a landowner and a developer. Where the DMA is clear the developer is controlling a project (within set parameters), points of potential conflict should be reduced.
Decision deadlock mechanisms
There are generally no material differences in the decision deadlock mechanism implemented under a DMA for a developer run development or fund through development.
If the decision to be made is capable of expert determination, such as confirmation on whether something is a project cost, then it can be referred to an expert and their decision will be binding on the parties.
If the decision to be made is not capable of expert determination, such as a material change to the direction of the development, then a dispute resolution process can be utilised.
In some circumstances where there is an unresolved deadlock, the developer may have negotiated into the DMA an option to buy-out the landowner or force sales.
Remedies on default
As with fund through developments, there is a wide range of remedies that can be negotiated into a developer run DMA for landowner or developer default. The remedies depend on the arrangements entered into between the parties.
On developer default, a landowner would typically have step-in rights in relation to all material contracts. They may also have a ‘security sum’ that is part of the project budget and held in escrow and released if the landowner has to step-in and complete the development.
If a developer has a registered mortgage over the project site, then the remedies would usually include the ability to suspend works, sue for damages, take possession of the property, and effect a power of sale (potentially, if first registered mortgagee).
Alternatively, and less common for a developer, is an arrangement whereby the landowner gives a call option in favour of the developer that can be exercised on default of the landowner. This would allow the buyer to purchase the property at market value, pay out an existing financier (if one), and continue the project as owner and developer.
Duty and tax implications
As with any type of DMA, there is a great deal of legal and commercial complexity involved and discrete tax and duty advice is a critical factor in proper consideration of the final terms of any fund through arrangement.
If you need to know more about developer run developments and DMAs, then please get in contact with a member of our Investment Funds Team.
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