We are increasingly being asked to advise on property transactions that include a part exchange of another property. This is not surprising in the current property market as it is an added incentive that developers can offer in order to dispose of new build properties.
Whilst part exchanges are a good way to get the properties moving, we are concerned that in a vast number of cases where a part exchange is occurring the Funder, is more often than not, putting themselves into a position where there is a gap in their security following the completion of the new build property transaction. This is perhaps best explained through the use of a simplistic example (and ignoring the hope of development profit):
- The Developer receives a £100m facility from the Funder to develop a 100-plot site.
- The Funder takes security over the whole of the development site.
- As plots are sold to buyers the facility is repaid by the Developer (for the purposes of this example for each plot that is sold the Developer repays £1m to the Funder).
- After the Developer has sold 50 units it runs into difficulties in selling the remaining units and decides that it will offer a part exchange package to interested buyers. n Under the scheme, when a buyer decides to purchase a plot they pay £500K in cash and also transfer the ownership of their previous property to the Developer to make up the remaining £500K.
- Assuming that the Developer forwards the £500K cash on to the Funder, the Funder is still owed a further £500K (which it expects to receive once the part exchange property is sold).
- As more and more plots are disposed of, the value of the freehold land secured by the Funder under the original charge is diminishing.
Using the above example, it is easy to see that if the Developer sold the remaining 50 plots under a part exchange scheme, and the Developer was unable to sell the part exchange properties on, the Funder could be left in a position where there is still £25m remaining outstanding under the facility, but as all of the plots have been sold, it has no security to call on in respect of the outstanding amount, should the Developer default.
To properly protect the Funder, security must therefore be taken over properties acquired by the Developer in part exchange.
Where the intention is that the part exchange property will immediately be placed back on the market for a quick re-sale, it may seem cumbersome to the parties involved. However, whilst the intentions for a quick re-sale may be honestly held by all, the reality of the property market is something beyond the parties’ control, and it may be a considerable amount of time before a buyer can be found, during which time the Developer may fall into default under the facility. Added to this is the policy that some housebuilders take to not carrying out searches over properties taken in part exchange, preferring to rely on insurance against any adverse matters that would have been revealed had searches been undertaken. If a Funder has not taken a charge over the part exchange asset it is unlikely that such insurance will cover the Funder in the event of an incumbrance preventing a resale at the value originally attributed to the part exchange property.
Alternatively if the Funder is not keen on the idea of having its security for the facility comprised of lots of small parcels of property that were acquired through a series of part exchanges, we would advise Funders to negotiate a different form of security with the Developer with regard to the outstanding sums. This could be in the form of a charge over another larger property owned by the Developer (the value of which exceeds the amount outstanding under the facility) or an all assets debenture (if one has not already been taken).
However alternative security is not always going to be enough to protect the Funder’s position. In a situation where the Developer’s only asset is the original development site, an all assets debenture is likely to be of little worth. This is often the case even with large and well known developers who use special purpose vehicles to hold individual development sites unless there are appropriate cross guarantees or other security from parent companies. It is imperative that security is taken over the part exchange property.