Exit and Risk

Exit Strategy

If everything goes as planned, a venture’s exit strategy is about harvesting the fruits of a successful operation. Phase I is the construction of the building which will be sold off as condominiums to the owners/residents. When the units are sold, Phase I terminates and the remaining equity is distributed to the shareholders.

Phase 2 is the operation of the condominium by the Board of Trustees. An owner exits by selling his or her unit.

However, as with any venture, things may not go as planned, and it may be necessary to exit leaving an incomplete project. The project plan must include a number of checkpoints with “go-no-go” decisions. A “no-go” means terminating the project early, taking a loss to prevent a more serious loss later. After each of the following events, the viability of the project must be re-examined. Each event has a potentially higher loss.

Preliminary market research to see if there is general interest in the concept.
Extensive and complete market research to determine the number of people who would be very likely to join the Musicians Retirement Community.
First efforts to find a developer interested in the project.
Preliminary research into the financing of the project.
Commitments of a significant number of prospective residents.
Selection and engagement of a developer/partner.
Selection of land.
Purchase of land, with complete information on all subsequent costs such as permits, clearing. At this point, potential loss becomes very high, but there is little cost of abandoning the project beyond sunk costs.
Selection and engagement of a construction company.
Land preparation.
Groundbreaking.

The last, groundbreaking, is almost the point of no return. At some point the cost of abandoning the project, cleaning up the land and paying off contractors becomes higher than completing the project. After construction begins, the best alternative is for the developer to take over the project and continue it as a normal condominium development, building residential units but no music rooms, performance space or cafeteria / dining area.

Risks

There are many potential risks to the project. The general strategy is to take steps to minimize the risks before much capital is invested, and to terminate the project early if it is determined not to be viable.

Market risk is the risk that when the project is complete, there are not enough buyers. This breaks down to the following risks:

Not enough musicians. There are too few people interested in living in a musicians’ retirement community.
Too pricey. Musicians are interested but they find that the condo price and monthly expense are not affordable. They find it more expensive than living in their current home. At worst, they can no longer afford their current home either and have to downsize anyway. The solution, the Musicians Retirement Community, unfortunately does not work for them.
Too cheap. Musicians are interested but the quality is inadequate: poor quality construction, bad neighborhood, too noisy, inadequate parking, cheap-looking units, etc. They prefer their current home even though the community would be less expensive.

Mitigation for this risk is to do adequate market research and line up a large number of potential buyers, getting commitments if possible. Also, during construction, buyers must be informed of any changes affecting quality; ideally, these changes need to be approved by the buyers.

Construction risk: Any construction project is subject to almost unlimited risks of loss and damage. We must have appropriate insurance up to the standards for this kind of project.

The Iron Triangle is a set of three elements that affect every project: cost, time and quality. Optimizing any single one – reducing cost, reducing time or enhancing quality – has a negative effect on one or both of the others. In this project, cost and quality should be controlled. It follows that time schedules must be flexible; it is almost certain that delays will occur. These delays must be planned for.

Real estate risk: The real estate market is constantly changing. As an example, when I bought my condo near Boston several decades ago, I paid $30,000. Ten years after that, equivalent units were selling for $90,000. Five years after that, I sold it for $45,000. We may find that committed buyers cannot keep their commitments, particularly those selling their current houses to buy into the community.

There are many web sites that list the risks of condo construction. It should be understood that these are not academic sources. Often they are insurance brokers, law firms or CPA firms and the articles are actually marketing materials, but the information is still valid for consideration. Three of these are listed in the Appendix. Here is a summary from one in particular, “Consider Your Condo Conundrum” from Cavignac & Associates, Insurance Brokers:

Top 10 worries:

Highly leveraged developers. If they get into financial difficulties, they have no assets.
Low-bid designers, poor quality.
Narrow scope of services. Cutting activities such as construction observation.
Low-bid construction, “value engineering”.
One design used for many units. A design or construction error will be in all the units.
Unsophisticated buyers with unrealistic expectations.
Poorly run homeowners’ associations.
Legal pitfalls such as specific “homeowners protection” state laws. When the doctrine of joint and several liability is applied, a designer / contractor can find itself fully liable for all damages.
Aggressive lawyers.
Costly and hard-to find insurance.

Advice from the article:

Only work with developers with a successful track record of quality.
Choose developers who understand risk management.
Set up legal protections and requirements.
Make sure the project is adequately funded.
Avoid single-purpose LLCs that may disappear.
Insist on getting a full scope of services.
Avoid low-bid contractors.
Examine developer’s marketing approach.
Insist on approving all substitutions and changes in materials and design.
Schedule and conduct regular communications.