While the recession put residential real estate development into a tailspin in 2008-2009, developers and investors are seeing a 2013 comeback focused on urban living. Demographics and confidence inspired by the slow but steady recovery are spurring activity in the sector, and small developers are turning to individual investors to participate in financing.  

Following a developer’s lead through negotiations can be tempting, however investors must be certain they know what to ask for when structuring a deal to ensure a balanced transaction.  As activity heats up, both parties should avoid rushing into an agreement; laying out the necessary protections will help keep the relationship – and the project – in good standing.  

The discussion around careful deal-making is timely, as a window of opportunity has cracked open to service a flourishing population of renters hesitant to embrace mortgages in the current environment.  Developers are rushing to launch or restart projects that cater to the resurgent demographics, especially urban multi-family complexes of up to 75 units with a project price tag of $10–$50 million.  

Boston serves as a prime example.  As noted in a recent Boston Globe article, “In just one year alone – 2010 – Boston’s population grew by 7,500 people, and is now above 625,000, its highest level since the 1970s, according to city data.  The population surge has thoroughly reversed the suburban migration that began in the 1950s.”

The real estate market continues to trend in a promising direction, and developers will not be shy about lining up projects to supply inventory.  The list of considerations for investors and developers can be lengthy; here are four guidelines that should be considered for every deal:

Don’t Skimp On Due Diligence

The first and most important question for investors and developers alike is clear: who are you dealing with?  Both parties will want to work with partners who are reasonable and flexible when the situation demands it; the only way to find out in advance is to do the homework.  A thorough due diligence process is not a guarantee of success, but it does lay the groundwork for a relationship that is built on trust.   

Sophisticated investors may already have a system in place for due diligence and will be able to efficiently assess the project and participants.  For those embarking on their first real estate development venture, deploying a team to gather information about the developer, partners, and the project itself should be key to the decision making process.  

Investors should not be surprised if they become the subject of due diligence, as well.  Developers should practice the same caution by checking investors’ finance and project history.

Outline Liquidity Goals

Parties should determine the timeframe for liquidity events at the outset in order to protect the investment and determine the life cycle of the deal.  Investors may be focused on an exit, for example, while developers may prefer to maximize fees by keeping the project in play over a longer time frame.  Indeed, developers may plan their exit regardless of market conditions in order to fund a new opportunity, while an investor prefers to wait for a seller’s market.

These competing needs for cash should be addressed in a business plan drafted by the development team.  Investors can seek to schedule a sale in advance or invoke the right to obtain additional funds via refinancing, and developers can negotiate for the right to trigger or delay a sale.  The plan should lay out the complete sales strategy and expected cash flow fluctuations throughout the project.

Think Ahead To Cost Overruns And Additional Capital

Guarding against cost overruns has become a hotly contested issue.  Sophisticated investors often ask for a guarantee that the projected budgets are fixed, including estimated development costs and a built-in contingency.  

Investors should be certain to define terms upfront in order to avoid a situation that may lead to a heated battle.  They should investigate a developer’s history of cost overruns as part of the due diligence process, and know the difference between reasonable overruns and project management failures that are more indicative of default.  

Balance The Need For Control And Compromise

Control over decision making is another sensitive issue that should be sorted out before a deal is sealed. As with other elements, there is a direct correlation between due diligence and control: the more investors know, the more control they have.  A full understanding of the developer and the project will guide investors to the right questions, goals, and legal protections.  

When it comes to major decisions about construction, partners, financing, and exit planning, both investors and developers will vie for control.  From start to finish, an 18-month project could see significant shifts in the market that necessitate changes to the deal structure.  Once again, goals will not necessarily be aligned in these cases, as developers or investors may be inclined to stray from the plan.  

As the list of considerations grows, investors that are new to real estate deal-making should keep a fundamental phrase in mind: know what to ask for and who to ask.  Regardless of the project scope, knowing the parties and defining parameters will be essential to a successful relationship.  Investors and developers alike should do their homework, protect themselves, and have confidence in the structure of the deal.

Thomas L. Guidi is a partner at Hemenway & Barnes LLP.