In the five or so years prior to 2022, the market was abuzz with news of the latest forward-purchase or forward-fund transaction. With demand for high-quality commercial and residential real estate exceeding supply, certain cohorts of real-estate investors were willing to take greater risks in order to obtain higher yields – by entering into forward-fund or forward-purchase agreements for real-estate assets that had not yet been completed.
The key differences between the two approaches will be discussed below, but both require the purchaser to speculate upon the prevailing investment conditions when the asset will be completed. Given recent press releases from various stakeholders, it is clear that forward purchase arrangements are going to re-emerge in the residential sector as a prevalent means of acquiring residential units in order to address the current housing shortage. In that context, we explore the key issues and risks associated with this approach.
Forward-purchase and forward-fund transactions – what’s the difference?
It can sometimes appear that the terms ‘forward-purchase’ and ‘forward-fund’ refer to the same types of transaction, as the terms are sometimes used interchangeably. But they are not the same thing.
While forward-fund and forward-purchase transactions can both offer attractive means of acquiring real-estate assets, the key differences of which an investor needs to be aware are set out below.
The focus of this article is forward-purchase transactions, which we look at in more detail below.
Why enter into a forward-purchase agreement?
There are many advantages for a developer in entering into a forward-purchase agreement, including:
- Speculative building: Entering a forward-purchase agreement can eliminate the speculation risk for the developer as the future purchase price for the development has been determined in advance.
- Exit: The agreement provides a clear exit strategy for the developer.
- Finance: Having certainty of exit will give the developer a greater chance of securing construction finance, and of securing more favourable terms for that finance. Financing can be repaid on receipt of the funds from the purchaser.
- Hold period: With the land and the development transferring to the purchaser on completion, the developer avoids incurring the cost and time associated with the usual post-completion marketing and bidding processes, and can avoid accruing interest liabilities on its financing during that period.
- Rate of return: The developer will likely see an increased RoR given the short hold period following completion. We are typically seeing a closing period of 15 working days following practical completion.
- Future projects: With prior knowledge of the return expected for the development, the developer can look for future projects sooner and can minimise any period of stagnation between developments.
There are also advantages for purchasers, including:
- Expertise: While a forward-purchaser may desire to undertake the development itself, it simply may not have the capacity or the expertise to do so. By entering into a forward-purchase agreement, the purchaser will be able to rely on the expertise of the developer’s team.
- Shovel-ready: Typically, but not always, a forward-purchased project will have planning in place, and will have the developer’s design team and contractor appointed and ready to start on site. This permits the purchaser to avoid a lengthy design-stage delay prior to works commencing on the site. Perhaps more importantly in the current market, it permits the purchaser to avoid the risk of planning-stage delays.
- Specification of the development: As the purchaser is involved in the development from an early stage it will have a far better understanding of the development and the capacity to select the primary materials used, the particular systems installed, etc..
- Purchase price: The development will be purchased for a locked-in purchase price. While the purchaser will have paid a deposit (which is refundable in certain instances) the remainder of the purchase price will not have to be paid until the development has been completed. The price is subject to the forward-purchase agreement, but it is generally only adjusted in limited scenarios, e.g. where the purchaser utilises a right to vary the development specification during construction.
- Finance: The developer retains responsibility for funding the project during the construction stage, and therefore generally bears construction-related risk. A purchaser will be in a better position to obtain financing where it is only drawing down funds for a completed development – after construction risks have largely been eliminated.
- Competitive purchase: By entering into the forward-purchase agreement the purchaser avoids having to participate in a typical bidding process with other prospective purchasers of a completed development.
The importance of good drafting
This is where the lawyers get the chance to add their value to the transaction. Having a team of lawyers experienced in a transaction that involves a yet-to-be-completed asset is imperative for both parties – to ensure the proper allocation of risk, the smooth running of the construction phase, and the successful completion of the sale of the completed development.
Key Drafting Points to Consider
- The asset: The agreement must accurately capture the expectations of both parties as to what the completed development will look like. Appending a pre-agreed specification to the agreement will provide certainty in this regard.
- Variations: Whilst a specification may have been agreed, an agreement should still allow for some flexibility, including:
- a change in the market or a change in purchaser strategy may lead the purchaser to want to seek certain changes to the development (although this may add to the agreed purchase price). It is in the interests of both parties that the forward-purchase agreement should include clear drafting around this issue;
- permitting a change to an agreed material where the specified material is no longer readily available – something that has become far more common in recent years; and
- changes in legislation may also require the developer to make certain changes to the agreed development and specification.
- Monitoring: The ability to attend and access the site at regular intervals will be essential for the majority of forward-purchasers. For the benefit of the project and the developer, however, such access should be subject to reasonable limits.
- Delays: No matter what steps are taken to avoid a delay on a construction project, it is very rare that a project will entirely avoid delay. The forward-purchase agreement should therefore seek to prioritise the effective management of delays. It is essential that the agreement clearly allocates to each party the risk of different classes of delay, and specifies the steps to be followed by the parties where a delay event occurs.
- Long-stop: Whilst delay of some nature may be unavoidable, the impact of delay on the project should be controlled by the agreement. Where the development has been unduly delayed for an extended period, there comes a point where one or both parties may need, or want, to walk away from the forward-purchase agreement. It may therefore be necessary to specify a pre-agreed long-stop date, by which point one or both parties can terminate the agreement if the development has not been completed.
- Practical completion: The works will need to be practically completed before the sale of the development can be completed pursuant to the forward-purchase agreement. The agreement should clearly specify how the parties should determine whether or not the development has been practically completed. This is especially important in a changeable market. A good agreement should also specify how the parties will resolve a dispute regarding whether or not practical completion has occurred.
- Completion: A clear understanding of the completion deliverables will benefit both parties by eliminating uncertainty at completion – the developer should know what it has to provide and the purchaser should know what it is entitled to receive.
- Future strategy: The purchaser will need to be mindful of its future strategy for the development when negotiating the forward-purchase agreement. Will the development be rented to one entity or numerous entities? Will the asset be sold shortly after completion? The agreement should be tailored to reflect the forward-purchaser’s plans, and the risk that those plans will change.
- Residual defects risk: The agreement should specify which of the parties bears the risk of latent defects in the development and, where the parties agree it is necessary, make provision for latent defects insurance.
This is merely a selection of some of the key elements that should be captured in a well-drafted forward-purchase agreement.
Forward-purchase transactions remain popular in the residential market, and have many benefits for both developers and purchasers. In order to protect both parties, however, forward-purchase agreements need to foresee and cater for the risks that arise at the various stages of the forward-purchased development: transaction, construction, practical completion, and lease or onward-sale.
A&L Goodbody has market-leading lawyers in our construction and real estate departments who are highly experienced in collaborating upon forward-purchase and forward-fund transactions, on both developer and purchaser-side mandates.
For further information in relation to such transactions or any related matter, please contact Conor Owens (Partner, Construction & Engineering), Jamie Rattigan (Partner, Construction & Engineering), Ger O’Toole (Partner, Real Estate), Jack Kennedy (Senior Associate, Construction and Engineering) or any member of A&L Goodbody’s Construction & Engineering or Real Estate teams.