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Using Purchaserís Deposits Ė Lessons from the Past Eight Months

By James Speakman                            September 15, 2005 

In our January Feature Article, "Using Purchasersí Deposits: A windfall for Developers?" we set out what we thought the process would be for developers of multifamily residential projects wishing to access and use purchasersí deposits to fund project costs, and discussed the possible advantages and disadvantages for those choosing to do so. At that time, we wrote that we would provide an update on the use of purchasersí deposits as we learned more about the actual practices of insurers and developers in British Columbia.

Eight months later, and after being involved in several releases of deposits to our developer clients, we are providing this update report to set out our experience with how the process has generally worked and what we have learned in terms of dealing with insurers, purchasers, purchase agreements and the release of deposits.

Background

For background purposes, the opportunity for developers of multifamily residential projects to access purchasersí deposits was established when the Real Estate Development Marketing Act was brought into force on January 1, 2005. The new Act replaced Part 2 of the former Real Estate Act. Among the several changes provided in the new Act was the provision in section 19 permitting developers to have the purchaserís deposit released to them for their use in payment of project costs (but not for other projects or for the developerís own purposes). In order to do so, developers are required to provide purchasers with insurance in the form of a "deposit protection contract", provide purchasers with notice of the release of the deposit, and satisfy certain other conditions.

Having the ability to use the purchasersí deposits provides developers with access to cash equity which was not previously available, may allow them to use appraisal surplus not recognized by conventional construction lenders as equity to secure the insurance repayment obligation, and may be less expensive than the interest and other costs and fees of charged by second mortgage lenders. However, depending on the circumstances, the insurer may require the developer to have a minimum amount of equity in the project equity in the project in order to secure the developerís obligations to the insurer, may establish draw requirements along the lines of a construction mortgage for the releases of deposits, and may require second mortgage security for the insurance.

How the process has worked

In our previous article, we set out our understanding of the practices of deposit insurance companies in Ontario, and predicted that the same process, at least initially, would be implemented in British Columbia. That has indeed been the case for one of the projects in which we have been involved in the release of deposits.

That is, the insurer acts act in essence like a bank, with deposits being released to the developer on a draw basis as costs are incurred and the construction mortgage advanced, rather than paid out in a lump sum payment. The developer has granted second mortgage security to the insurer, with a postponement agreement being negotiated and executed with the first mortgage (construction) lender. Individual deposit protection contracts are provided in respect of each residential unit, and deposits are released in whole or in part on a unit by unit basis. This has resulted in dozens of deposit protection contracts being issued and a similar number of accounts being maintained. It has added another level of reporting for the developer and a further requirement for administrative effort.

A second project in which we have been involved in the release of deposits (by a different insurer) was handled differently, in that deposits will be released in two tranches: the first upon the execution of the insurance contracts and the second scheduled for a later date. In this case, one global "deposit protection contract" has been put into place which covers all deposits paid by all purchasers, which involved significantly less administrative time for the developer, the deposit holder and the bank.

Important Lessons for the Developer

Developers wishing to take advantage of the deposit release regime should be aware of requirements for both the Disclosure Statement and the Purchase Agreement.

Disclosure Statement Requirement

Section 19 of the new Act provides that a developer wishing to use the purchasersí deposits must provide notice of the deposit protection contract to the purchaser in accordance with the Regulations. Section 10 of the Real Estate Development Marketing Regulations provides that the developer must include the following information in the Disclosure Statement for the project:

  • the name and business address of the insurer;
  • the name of the developer who entered into the deposit protection contract (this applies in the case where there are more than one developer jointly developing a project, but only one enters into the deposit protection contract); and

  • the date on which the insurance takes effect.

Even though we had started setting out in Disclosure Statements last Fall that our developer clients reserved the right to take advantage of the deposit release opportunity, in order to comply with the Regulations an amendment to the Disclosure Statement was required to be filed and delivered to purchasers. We expect that, in most cases, at the time a developer prepares its Disclosure Statement (prior to pre-sales) it will not have this required information, so that it will have to prepare an amendment to the Disclosure Statement at the time of the deposit release transaction.

Purchase Agreement

Most forms of project Purchase Agreements prepared by developers or their lawyers include provisions dealing with the manner in which the deposit will be held (by the developerís agent or lawyer or, in some cases, the developer itself) and how interest will be dealt with (accrued for the benefit of the purchaser or the developer). Although it is arguable that the provisions of the new Act and Regulations will allow the release of the deposit without amendment to the Purchase Agreement, we are of the view that a prudent developer will ensure that the Purchase Agreement contain specific terms allowing the release of the purchaserís deposit upon a deposit protection contract being delivered, or that an appropriate amendment be entered into with the purchaser before the deposit is released.

As well, the trust accounting requirements of many law firms require funds to be confirmed in their trust accounts before they are released (this is satisfied by the receipt of a bank draft or certified cheque). If a developer intends to take a release of purchasersí deposits before they clear the banking system (which may take seven to ten days), they should provide in Purchase Agreements that deposits be paid by certified cheque or bank draft.

Are Developers Taking Advantage of Deposit Releases?

As set out above, we have been involved in several releases of deposits for our developer clients. However, given the high level of activity in the real estate market, our experience is that the proportion of clients taking advantage of this opportunity is still relatively small. We understand that this is the case throughout the market. That is, although the interest in using purchasersí deposits is very high (with insurers receiving many inquiries from interested developers), the percentage of developers who actually elect to go through the process is small. This is because of the short time frame between the release of deposits and the completion of construction (particularly the case for phased wood frame developments), the administrative time and cost and the cost of insurance premiums, and the stringent process which has been proposed by insurers. Given these factors, in our experience it has made more sense for developers of high rise projects to take advantage of the deposit release opportunity.

An evolving process

Our experience is that the deposit release process is evolving, as developers become aware of what is available to them and at what cost, and insurers become more attuned to the British Columbia market. One example is the initial misunderstanding by Ontario based insurers of the relatively standard ownership structure in British Columbia, where a nominee corporation is registered owner of a development property as bare trustee for the true developer, which apparently is not so prevalent in Ontario. While this may have caused some initial confusion, that has been resolved now.

We expect that as more insurers come into the British Columbia marketplace to offer deposit protection insurance, the process for completing the release of deposits will evolve and become less stringent (we understand that this has already started to happen, for certain established developers in certain circumstances). This may include the developer being able to provide alternate security to the insurer to avoid having to grant a second mortgage of the development project, and further relaxation of the release process. If so, we expect more developers, even those with short term, phased wood frame projects, to take advantage of this opportunity.

James Speakman
 

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