DHR Patio Homes, LLC: "for the sake of a nail, the kingdom was lost!" (1).

Sherman, Herbert ; Rowley, Daniel J.

CASE DESCRIPTION

This is a field-based, disguised case which describes the attempts of a small residential construction company to close on a large land deal, a deal that would net them over four million dollars in 12-16 months. The problem for the characters in question is how to raise the $2.5 million dollars needed to purchase the property. Every time the protagonists believed they have resolved the situation, another problem with the loan is introduced. Several factors complicate the transaction: the lending institution changed the loan down payment from 10% to 20%, the protagonists had transactional difficulties in terms of physically acquiring their down payment, and one of the lenders at the last minute insisted on a $50,000 set aside to be placed in an escrow account. The case has a difficulty level appropriate for a sophomore or junior level course. The case is designed to be taught in one to two class periods (may vary from fifty to one hundred minutes depending upon instructional approach employed, see instructor's note) and is expected to require between four to eight hours of outside preparation by students (again, depending upon instructor's choice of class preparation method).

CASE SYNOPSIS

Derived from observation and field interviews, the case describes how two college professors operating a home construction LLC are trying to close on a major land deal ($2.5 million dollars) that would net them over $4 million dollars in estimated profits in a 12-16 month time period. These professors have no experience in raising funds but luckily have the assistance of Justin Martin, the President of the Snowy Mountains, the firm that they will be purchasing their subdivision from (Mountain Trails). Through Justin Martin's connections Stephen Hodgetts and Richard Davis meet with Benefit Bank and arrange for the loan. Davis was under the impression that the bank required a 10% down payment ($250,000) which Davis and Hodgetts finally raise by borrowing on their retirement accounts and liquidating Hodgetts' stock holdings. However, the bank actually required a 20% down payment since Davis and Hodgetts were new customers. Justin Martin promised to lend Davis and Hodgetts this amount ($250,000) as a same day loan to be paid back by them from the proceedings of their closing on Justin Martin's mother-in-law's house. At the last minute, however, Justin Martin insisted that Davis and Hodgetts deposit $50,000 in an escrow account; $50,000 that Davis and Hodgetts did not have access to for at least a few days after the closing date. The case ends with Davis wondering how he is going to raise $50,000 in one day.

INTRODUCTION

"They did it again" moaned Richard Davis to his wife Adrienne. "@!X#$@*^!@, they did it again." He repeated more vehemently. "Just when I thought I had this land contract sewn up and had raised enough collateral to purchase the Mountain Trails subdivision they pull another fast one on me. It was tough enough raising the first $250,000, and then having to scramble last week to raise another quarter million when the bank suddenly wanted 20% rather than 10% collateral. BUT now Justin Martin's lawyer wants us to put $50,000 into an escrow account for a one day loan of $250,000; that's crazy! Given the numerous problems that we've already had trying to close, God only knows if Snowy Mountains will give us another closing date. If we lose this deal it means forgoing over $4,000,000 in profits. Where am I going to dig up another $50k in one day so we can close on this land deal tomorrow?"

COMPANY BACKGROUND AND HISTORY

DHR Construction LLC was formed in April, 2003 by two college professors (Stephen Hodgetts, 50% owner; and Richard Davis, 50% owner) as an offshoot of their real estate management firm, D & H Management, LLC. The construction company was started as a money-saving venture for finishing off the basements of their rental homes. The success of this little construction company lead Davis and Hodgetts to backward integrate their operation; they were going to build homes not only to be purchased by D & H as possible rental units but also for public consumption. DHR's mission was as follows:

 DHR is a locally-based semi-custom home builder.
 D H R believes in building homes of
 quality, style and distinction. No detail
 is too small and no consideration is too great. DHR builds
 homes as if we were building them for ourselves. In a
 spirit of wanting our home buyers to feel the
 same way, DHR designers, builders, and customer
 service personnel look forward to working directly
 with our perspective home buyers to assure that each
 customer gets just what they want. The result:
 homes of beauty and elegance that also reflect each
 owner's taste, personality, and sense of style.

DHR developed a simple business model. Homes would be priced at 20% above cost with Richard Davis acting as the architect and head of operations of construction. His job was to work with the subcontractors to ensure that their work met schedule and building code requirements and to make sure that subcontractors' bills coincided with the work provided.

The designs for DHR's new homes included some added features that differentiated these homes from other houses in a similar price range (i.e. more windows, including a garage window, nicer lighting fixtures, upgraded appliances, nicer counters, cabinets, and flooring), including a distinctive California design (i.e. oversized master bathroom with archways, high ceilings, and unique fireplaces). Davis and Hodgetts agreed with their real estate agent that many of these upgrades added minimal cost to the overall price of the homes and accentuated customer value.

Davis also became the principal owner/manager of the firm and handled the back office functions of the business with his wife Adrienne (hiring an accountant, pricing out homes, bidding out work to subcontractors, working with real estate agents, and mortgage companies) while Hodgetts played creditor and bankrolled the company's upfront expenses.

In May, 2003 DHR broke ground on their first construction project in the St. Andrews development and by January 2004 had completed three homes. They then shifted their building site to another location, the Florence Development, which they felt had a more up-scaled look and would allow them to build nicer and more expensive homes. By April of 2004 they had built three homes in Florence, were in the process of building four more in that area, and were looking at other developments for future growth and expansion. Their plans to continue to build in Florence on their four vacant lots stopped short in June of 2004 when a third party lien against their properties made it virtually impossible to close on their homes. A decision in court was pending as to how to resolve the liens.

THE IDYLLIC PROJECT--SNOWY MOUNTAINS

Davis and Hodgetts were putting together what Davis jokingly referred to as "the deal of the century." Davis in June of 2004 had located a brand new development about 10 miles east of where they currently were building several private homes (the Florence Development), in an area called Snowy Mountains. Snowy Mountains was a unique project for the area since the developers had built lakes, a golf course, and a club house (including a three star restaurant) and had very specific designs for community development. The housing currently in the development (phase one) ran the gamut of homes, from two bedroom condominiums (that started around $140,000) to million dollar estate homes on the lake. Every member of the community was given access to the club house (which included a pool and a play ground), the several lakes dotting the development, and a discount at the restaurant and golf course. The developers also sponsored fishing, golfing, boating, and concert events and even had an island that could be rented out for weddings and other parties and included fully equipped restrooms with showers, electricity and a kitchen service cabana.

Davis and Hodgetts were most impressed with the management team of Snowy Mountains, especially the CEO, Justin Martin. Justin Martin, a retired celebrity who bankrolled the operation, wanted first class builders who bought into his vision of an up-scaled community and could produce homes that fit the theme of the development, a mountain motif. (Exhibits 1 and 3 are available from the authors. Exhibit 2 for general description of the community including amenities.) He had already put together plans for developing not only the other side of the lake (phase two), but for a development on the bluff overlooking the lake, as well as an additional development farther up toward the mountain ranges. He had a ten year plan for this area and wanted builders who would stick with him throughout the development process.

Davis and his wife toured the development several times with their management team (real estate broker, mortgage specialist, and construction foreman), as well as with family members, and everyone agreed that these homes would sell themselves. Everyone who had toured the site wanted a home in the community (including Davis's son, Davis, and Hodgetts) and Davis had quickly gathered a list of eight buyers just waiting for DHR to take over the project. With eight pre-sold homes, Davis and Hodgetts knew that this construction project would be a winner.

OPPORTUNITY KNOCKS--MOUNTAIN TRAILS AT SNOWY MOUNTAINS

Timing is everything, and Davis and Hodgetts felt that this new undertaking was just in time. They had decided to no longer build any more homes in Florence until the lien issue was resolved and therefore they had expected to finish up the homes they were completing in Florence by October of 2004. No other projects were in the works and their work crew (although subcontracted rather than employed by the firm) would then be idle; something that Davis in particular wanted to avoid since this would negatively impact morale and his relationship with his work crews.

Davis believed that he and Hodgetts lucked out in that one of the home construction companies in the Snowy Mountains development pulled out of their project, Mountain Trails, after a disagreement with the developers. The company had built approximately ten patio homes2 starting in 2002 in a forty-five lot area, leaving the remaining lots vacant. Thirty-three of the lots had been sold back to Snowy Mountains; the other two lots were in foreclosure and held by two different banks. This was the last remaining section of Phase One which needed to be completed before Phase Two could be developed. Justin Martin was reluctant to open Phase Two without a commitment from a home builder for the rest of Phase One since he was afraid that the property would remain dormant. Homeowners in this section of the development were getting quite upset that no action had been taken to complete their part of Snowy Mountains and clearly a solution was needed before the developer faced possible legal action. After several discussions with the local residents, Davis and Hodgetts felt that they were like white knights coming to the rescue of both the developer and the neighborhood.

THE PROCESS MOVES AHEAD

After several meetings with Justin Martin's staff at Snowy Mountains, Mr. Martin asked two of his senior staff members to examine the homes that Davis and Hodgetts had built, specifically the newest homes in the Florence Development. This was a major hurdle for DHR Construction to overcome since Mr. Martin wanted his development to feature quality custom builders; distinctive homes that would add beauty to the picturesque scenery. The senior staff toured several of the homes that had been completed, as well as those still under construction. The homes ranged in size from approximately 1600 to 2400 square feet with the price range starting at slightly under $200,000. Mr. Martin's staff concluded that the homes where of high enough quality to warrant further discussion with DHR Construction.

In the interim, Davis and Hodgetts formed a new corporation, D H R Patio Homes, LLC, in order to separate their current construction projects in Florence from their new project, Mountain Trails. Davis and Hodgetts split the ownership 50/50 and decided that Davis should receive a 2% commission on each home constructed as senior partner and head of the business's operations.

Adrienne, Davis's wife, continued her activity in the businesses and became the information hub for the subcontractors and prospective home purchasers. Davis's son, Robert, got a part-time weekend job working at Snowy Mountains showing real-estate properties in Phase Two and became a natural link between DHR and Snowy Mountains. Davis had even managed to work out a deal with Snowy Mountains that for every DHR site that Snowy Mountains closed on, they would receive a $1000 commission; a much lower fee than any real estate broker would have charged.

PUTTING THE PACKAGE TOGETHER FOR MOUNTAIN TRAILS

One of the key stipulations that Snowy Mountains required prior to the signing of the land contract was for DHR to put together a portfolio of home designs with floor plans together with a price list. Davis spent numerous hours with his wife Adrienne looking through home design magazines as well as purchased a CAD/CAM program that would allow them to design homes on the fly on their home computer. Davis thought that the best way to price out the homes was not to separate the prices of the homes from the property but to sell them as a packaged deal; prices for interior lots would sell at a far lower price than those with lakefront property. The models, prices, square footage, and style are listed in Table 1, below. More specific descriptions are available in Exhibit Four.

Snowy Mountains approved the designs, as well as the home price ranges, and felt that these homes and their pricing would blend well with the homes that already existed within the Mountain Trails subdivision. Davis and Hodgetts also showed the designs to the existing residents at Mountain Trails to make sure that they also liked the designs. Davis and Hodgetts understood the delicacy of the situation with the current home owners and wanted their support and cooperation. Furthermore, since DHR was to be the majority land owner in the development, Davis became President of the Homeowners Association and started to work with the residents on landscaping designs for the entrance to Mountain Trails and its green areas.

WHAT'S FOUL IS FAIR AND WHAT'S FAIR IS FOUL

It was the 3 rd weekend in June of 2004 and Davis and Hodgetts were having their usual weekly meeting to go over business matters which Adrienne normally did not attend since she was usually actively engaged with real estate agents, potential renters, and home buyers.

"Hodgetts, I have good news and I have bad news" started Davis. "Go on" beckoned Hodgetts "you've perked my fancy. But let's get the bad news out of the way first." ""Well" Davis's voice cracked a bit from nervousness "you know that we had talked about working on a pay as you go plan with Snowy Mountains; that we would sign a contract to purchase all thirty-three lots but pay for the lots only once we broke ground on them." "Yes" muttered Hodgetts. With a moment's hesitation Davis blurted out " Well, that deal is dead."

Hodgetts looked stunned, as if he had been hit by a bullet from a 44 magnum at point blank range. "Dead, you say?' replied Hodgetts. "Dead? As in finished? Gone? Over? Wasted? Mortem? Cooked?" Hodgetts' face turned from a vibrant red to an ashen gray since he realized that if this project was dead the firm would have no other projects to work on and no homes to build.

"Hear me out," Davis cried. "I said that that particular deal was dead, not that the total deal was dead!" "Oh?" countered Hodgetts. "Yes, yes my friend" Davis responded. "The good news is that we still do have a deal, however, the deal is that we must purchase all thirty-three lots at once." "All at once?" Hodgetts exclaimed. "Ok," Hodgetts sarcastically spoke, "and how much are these thirty-three lots going to cost us, all at once?" "Why," retorted Davis. "The cost will only be about $76,000 per lot. A very reasonable price given the fact that individually they were going to charge us $ 70,000 for the inside lots and $ 205,000 for a lakeside lot. Given the mix of lakeside lots to interior lots we're getting at least a 10% break."

Hodgetts was getting angry. "Yes we're getting a break alright, a break in our necks! At approximately $76,000 per lot you're telling me that we're going to have to raise approximately $2.5 million dollars. I've already leant the company over $250,000 and I have about the same in reserve. Where in God's name do you think I can get this amount of money from? I am not a bank you know!"

FOOLS GOLD?

"Wait a minute, wait a minute--let's get this train back on track. I have yet to give you the really good news." Davis was trying to calm Hodgetts down and at the same time finish his line of reasoning. If he failed to convince Hodgetts of the efficacy of the deal right now, the deal was as good as dead. "I have calculated what our cash flow and profits would be from the sales of these homes and I must admit that they're impressive." Hodgetts harrumphed in the background, crossed his arms, but allowed Davis to resume. Davis then handed Hodgetts a sheet of paper and the asked him to take a few minutes to peruse the fact sheet. See Table 2, below.

Hodgetts kept looking and looking at the numbers until they were nothing but a blur. "How did you get these numbers?" he asked Davis incredulously. "Well" Davis began "I took our historic building costs per square foot, which have been around $85, and figured in a fudge factor of $15 a square foot given our need to produce a high quality product as well as to have some contingency funds. I then added the average lot cost in order derive our total cost. Lakeside homes sell at a premium price so I added the profit margin on these lots, the additional sales price minus the average property costs, for the seven lakeside properties to obtain the total profit for this building project. Over four million dollars even if we sold only the least profitable model; not a bad piece of change I might say!"

Dollar signs started dancing in Hodgetts' head and all that a now jubilant Hodgetts could fathom was that he and his excellent friend Davis were going to be rich enough to retire at an early age. Davis gave Hodgetts a few moments to gather his composure so that they could move onto the more pressing issue, the raising of the purchase price of the land, $2.5 million dollars. It was evident that neither he nor Hodgetts had the where-with-all to raise this type of capital on their own and he knew that they would have to go to either banks or venture capitalists to raise the funds they would need. He and Hodgetts knew very little about raising capital and decided that they should do some research before they tackled such a critical issue.

JUSTIN MARTIN TO THE RESCUE

Davis and Hodgetts could not meet the following week to discuss what research they both had come up with. Davis however e-mailed Hodgetts the following message:

 I got a call yesterday from Justin Martin that
 apparently he has arranged a $2 million+ loan
 for us to take down all the properties for the
 patio homes and another $1 million from Benefit Bank
 for construction.3 I have also found several investors
 who would be willing to buy patio homes, rent
 them back to us as show homes for a year, and
 then sell the homes on their own. Furthermore, our
 [own] mortgage lender is willing to offer mortgages
 based upon the retail value of our patio homes
 to qualified buyers and close on these mortgages
 prior to actual construction. This gives us lots and
 lots of resources to cover the cost of the property
 and have solid operating capital with minimal "out-of-pocket"
 expenses. I'll look into this further and get back to you.

How the Loans Would Work

The Davis's arranged a meeting with the bank president and it went just as planned. The Davis's showed off their approved home designs, their price list, Richard's cost estimates, as well as Adrienne's list of all of their subcontractors and support personnel. The bank president and the senior loan officer, good friends of Justin Martin, were quite impressed with what they deemed as a superior presentation; they had worked with many home builders before but none who had such a good command of the situation, especially the numbers. The Davis's and Stephen Hodgetts' credit check came back quite positive, supported by their rental and construction businesses.

The Benefit Bank loan seemed straight forward enough but dealt with only the land purchase. Hodgetts and Davis would have to go through their own mortgage lender for the construction loans, thereby providing cash flow throughout the building of the home. The construction loan, would be paid out as a percentage of the work completed, and would in the end cover a total of 80% of the assessed value of the home. The construction loan could be taken over by the home owner and converted to a permanent loan at minimal expense.

Davis and Hodgetts felt that they had their cash flow covered. For example, once Davis and Hodgetts started to build on a property, with a construction loan they could immediately recover 80% of the retail value of the property (calculated as a percentage of the value of the home). Since the property, if it was an inside lot, was worth approximately 1/3 of the value of the home (see Table 2 above), Davis and Hodgetts could expect to receive at a minimum around $ 90,000 (assuming they sold the least expensive home) or as much as $ 131,000 (for the most expensive home).4

Davis and Hodgetts estimated that it would take approximately three months to build each home and therefore they felt that this construction loan would actually provide them not only cash to pay the bank loan on the land back but also additional funds beyond their construction costs (their profit margins were over 20% per home) to pay off the interest on the construction loan (at 6%).

Benefit Bank would loan Davis and Hodgetts the amount requested to purchase the land ($2.5 million dollars) at 6% (2 points over the prime lending rate) which they would be responsible to pay back over the life of the development (approximately 12-16 months). The amount of each monthly payment could be as low as interest only or as much as the entire loan amount; the amount was left up to DHR's discretion. In order to make the loan happen, however, Davis understood that DHR would have to come up with 10% of the requested loan amount as a down payment ($250,000) and both DHR Patio Homes and Davis and Hodgetts personally would guarantee the loans.5 Before they left the bank, Richard Davis, as senior partner of DHR Patio Homes, LLC, made sure to sign the loan agreement on behalf of the corporation.

PLANS OF MICE AND MEN

That night Davis and Hodgetts got together to figure out exactly how they were going to raise the $ 250,000. Hodgetts still had the ability to lend the firm $ 250,000 but both he and Davis agreed that they would prefer not to touch this money unless they absolutely had to since this would involve Hodgetts liquidating some of his assets (selling stocks and bonds). Davis's first idea was to form an investment group.

"We really do need investor help getting our $250,000 together" explained Richard Davis. "I met with David our mortgage broker yesterday about forming an investor group that could raise that money. I'm not sure what their incentive is yet, but I'm working on it. One thing we talked about before was to sell them spec homes and let them earn a profit." "A good idea" replied Hodgetts "but that doesn't help us with the down payment for the loan--you can't sell a home on property you don't yet own!"

"That's true" Davis countered. "My second idea was to form a real estate investment trust (REIT).6 We could find, let's say ten individuals, excluding ourselves, who would purchase certificates of ownership in the trust, each unit being worth $25,000, which would in turn use the money for our loan collateral. The investment trust would then get paid for lending us the money and distribute a minimum of 90% of their income to the investors free of corporate income tax." (http://www.reitnet.com/reits101/index.html, August 12, 2004). "And what type of return on investment might these REIT investors look for?" slyly answered Hodgetts. "Well" retorted Davis. "If the average dividend yield on REITs is 7.3%, then I would expect that our investors might want a slightly higher return since, unlike publicly traded REITs, their units would be much harder to liquidate. I'd figure that they'd want at least an 8% return on their investment."

"OK" Hodgetts agreed "they'd certainly want a very good return, I know that I would! However, who is going to find these ten wise investors and how long would it take to establish a REIT?" Davis quickly responded. "In terms of the investors, one or two of our colleagues have shown an interest in our real estate ventures, however, their interest has been mainly in buying homes for rental purposes. I know that we are precluded from investing in the REIT but that does not stop our family members. In terms of how long it would take to form a REIT, I would assume that the paperwork would be similar to forming a LLC; we would need to gather all of the investors in order to form the trust. Let me make a note on this to call our lawyer and verify what I've told you."

"OK" Hodgetts continued. "Let's assume that we could neither get enough investors together nor could form this REIT in time, what is our other backup plan?" Davis had to clear his throat for his upcoming answer since he knew that Hodgetts would not be at all happy with their remaining options. "We have several choices. First, we both have retirement plans with TIAACREF through our college. We are allowed to borrow against our retirement plans up to $50,000, assuming we move enough funds out of stock accounts and into their basic annuity account to cover the loan; that raises $100,000. Secondly, we both could apply for second mortgages. Our mortgage broker tells me that between our two homes we could get another $150,000; and there you have it, $250,000 dollars!"

Davis was about to repeat his last sentence when Hodgetts finally broke out of his daze and asked Davis how quickly they could implement the latter solution. Davis went over the procedure for applying for a loan on-line from TIAA-CREF as well as what paperwork would need to be completed for the home equity loans. Hodgetts seemed satisfied with the process and expressed his thanks for Davis's good work.

THE FIRST FEW TWISTS OF FATE

The next day Hodgetts decided that he needed to learn about REITs so he could understand what they were and how they worked. A little on-line surfing informed Hodgetts that the REIT must have a minimum of 100 shareholders. (http://www.private-placement-attorney. com/reit.htm, August 13, 2004.) Certainly they could form an investor group as a LLC but the LLC, unlike a REIT, would be taxed by the IRS as either a partnership (profits and losses are passed through to the members of the LLC) or a corporation. (Mancuso, 2004) Several discussions with potential investors quickly lead Hodgetts and Davis to conclude that they could not wait for an investor group to form and decided to move ahead with their alternative plan; borrowing from their retirement funds and getting a 2nd mortgage on their homes (equity lines of credit). In the interim, Justin Martin was pressing for a closing date on the properties and they settled on July 15th. He FAX'ed over the land contract and asked Davis to get back to him if he had any questions (See Exhibit 5). That gave them two weeks to get both their credit lines and loans, a difficult but not impossible task.

It was July 4th weekend and Hodgetts was at his home when he received the following e-mail from Davis:

 Mountain Trails is getting closer. I'm having
 to send additional figures to
 Benefit Bank to show that we are
 making profits on our homes (what they have seen
 is our analysis using cost per square foot--they
 now want statements that shows each
 home's profit margin based upon actual
 labor and material costs given our
 architectural designs). Plus, their figures
 did not show the income we get from our
 rental homes nor the amount of depreciation
 we have realized. With all these in hand,
 they think they will be able to close within 10 day to 2 weeks.

 They did give me a bit of a shock in
 that since we are new7 and not super
 strong financially, they are now only
 willing to finance 80% of the loan which means
 that we need to come up with $500,000 instead of
 $250,000. After the initial shock,
 I did start to do some figuring and I think we may be alright.

 Also, the Florence development is still a
 problem in terms of the liens, but I
 am hopeful we'll be out of the houses
 there within 6 weeks (we only getting stuck
 with four lots of land). Our mortgage broker
 says he may have a buyer or two for the
 homes there and that he is trying to put
 together his own investment group to
 purchase the other homes for rental purposes.
 He wants a 10% discount, not a real
 problem since we save 6% on real estate brokerage fees.

 I'm putting together numbers and you
 and I will have to scheme in terms of
 timing, but I think I've got a handle
 on most of the beast.

Hodgetts' face nearly hit the floor. Where were they going to come up with another $250,000 in less than two weeks? Davis's answer of selling homes prior to the closing made no sense; how could you sell homes when you didn't even own the property they were going to be built upon? Also, was Davis hoping that the liens on the Florence development would be resolved in the next two weeks so that these homes could be sold and the profit used as part of this additional down payment? Hodgetts called Davis to discuss the matter and to develop an alternative plan for raising another quarter of a million dollars. They always had Hodgetts' stock portfolio but Hodgetts was quite loathe to liquidate these funds given he'd have to pay capital gains taxes and also he and Davis would be left with no backup resources.

THE HERO RETURNS BUT DHR IS NOT OUT OF THE WOODS YET

Hodgetts and Davis, after a long talk, agreed that they should discuss the issue of needing an additional 1/4 million dollars with Justin Martin and see what advice he would give them. They thought perhaps that he could talk with his friends at Benefit Bank and get the bank to rethink their position. Worst case scenario, they would have to put the closing off until they could raise the money. Davis told Justin Martin everything, including their problems in the Florence Development. Justin Martin, to Davis's amazement, offered to loan Davis and Hodgetts the money as a short bridge loan to be paid back as soon as possible so they could close on the deal. Justin Martin for the second time had acted as DHR's guardian angel and Davis immediately agreed to this deal.

While Justin Martin bailed out DHR for the 2nd $250,000, Davis and Hodgetts were having real problems getting their first 1/4 million dollars together in a timely fashion. First TIAA-CREF, rather than wiring $ 50,000 to Davis's savings account, decided to send him a check instead. Davis received the check 5 days before the closing, not in enough time to cash the check (his bank's policy was that checks over $5,000 would take seven business days to clear). Secondly, TIAA-CREF did wire the money to Hodgetts' savings account, however, they wired him $ 100,000 instead of $ 50,000. It seemed that two wires were sent on different days, each for $ 50,000. When Hodgetts' bank went to correct the error, TIAA-CREF voided both transactions. Every time Hodgetts' bank would credit his account for $ 50,000, TIAA-CREF would withdraw the amount. The bank froze Hodgetts' account until they could clarify the situation with TIAA-CREF.

The news was no better from Davis and Hodgetts' mortgage company. Between the two of them, neither Davis and Hodgetts could not obtain a second mortgage even though they had a positive net worth of approximately $ 5 million dollars. Given the fact that both Davis and Hodgetts were both heavily leveraged through their other companies which they had personally signed for (the rental firm had property debts of nearly $ 1.5 million dollars), the mortgage company was reluctant to extend them any credit, even unsecured loans, since they did not believe that Davis and Hodgetts would have the cash flow to pay back the loans. Their analysis of the situation excluded the Snowy Mountains deal.

The problem was that most of Davis and Hodgetts' assets were tied up in either real estate or in retirement accounts; the real estate could not be liquidated quickly (and those in the Florence Development had liens placed upon them and could not be liquidated at all) and the retirement accounts had highly restrictive clauses for liquidating accounts and large penalties (not to mention the tax implications and Hodgetts' bank problems). Simply stated, Davis and Hodgetts were asset rich but cash poor. Hodgetts reluctantly agreed to liquidate his stock holdings, and on July 12th Davis and Hodgetts had just enough funds to go to closing.

AND IN THE END

It was July 14th and Richard Davis was verifying the paperwork on the pre-construction sale of several of the patio homes to be built in Mountain Trails, when he received a call from Justin Martin's lawyer to verify the closing date as the 15th and to make sure that all the details had been covered. It had been verified that Hodgetts' funds had been wired to Benefit Bank and that Justin Martin's funds were also at the bank.

All the bases seemed to have been covered when the lawyer started discussing the establishment of an escrow account. Davis was quite confused and asked the lawyer what was the escrow account for. The lawyer explained that the loan that Justin Martin was making to DHR required that $50,000 be put up as collateral for the loan--the escrow account would retain those funds until the loan was paid back. Davis insisted that there was never any mention of collateral and that it made no sense for DHR to borrow $250,000 while putting $50,000 in escrow, leaving them $50,000 short of the funds they needed for the closing. Although the lawyer agreed with Hodgetts that the loan amount should have then been for $300,000 if Justin Martin wanted to have $ 50,000 set aside in an escrow account, Justin Martin's orders to the lawyer were quite explicit--no escrow account, no loan.

Davis was dumb struck and felt that he had just been run over by a Bradley tank. Hodgetts was tapped out of funds and his bank account was frozen while Davis's TIAA-CREF check for $50,000 would not clear until at least Monday, the 19th. Where was he going to get $50,000 in one day? More importantly, how could he tell Justin Martin that DHR could not go through with the land deal because Justin Martin, the man who not only arranged for the bank loan but also personally leant DHR money, the man who would make him and Hodgetts rich beyond both their wildest imaginations, screwed up the deal by his own requirement of a $ 50,000 set aside escrow account? Davis discussed the situation with Adrienne and then picked up the phone to call Hodgetts to see if the two of them could work their way out of this mess.

Exhibit 1: Mountain Style Homes--The Club House at Snowy Mountains

Exhibit 1 is a picture of the Club House at Snowy Mountains and may be obtained from the authors.

Exhibit 2: Development Description--Snowy Mountains

Snowy Mountains is a premier lake front community, featuring superior master-planning and a full complement of amenities for today's active western lifestyle. With 700 acres of planned lakes and open space, living at Snowy Mountains makes everyday a vacation.

Snowy Mountains has continually placed a great importance on creating and maintaining a quality, environmentally-friendly, enjoyable marine environment. The abundant wildlife includes the pelican, eagles, several varieties of herons, deer and foxes. Incorporating the mature natural character of the local lakes with professionally-engineered real estate development,

Beaches

The designers placed sand throughout the subdivision in areas where grass would traditionally be installed in non-lake front real estate. The sand is 3-4 feet deep and was a by-product of the sand and gravel operation that at one time occupied the site. Sand curbs delineate property lines for those homes situated on beach front property. The sand gives the homeowners the opportunity to enjoy their own private beach and allows them to walk down to the water's edge from the back of their lots.

Lakes

The lakes are man-made bodies of water. Like the beaches, they were made as a result of the sand and gravel mining operation which previously occupied the site. The State has classified the lakes as certified water storage reservoirs which will insure their integrity over the years. The lake shores have been sculpted to a gradual, aesthetically pleasing incline to allow for recreational activities in the lakes, and the sand on the beaches descends past the water line to emulate natural beach front settings.

The depth of water in the lakes is in the 20-25 foot depth range and Snowy Mountains operates a continuous water quality system to assure enjoyable, clean conditions. Included in the water quality control system are several oxygenation systems, similar to the air pumps used in aquariums. This maximizes living conditions for aquatic life as well as aesthetically pleasing water quality.

Exhibit 2: Development Description--Snowy Mountains

Jogging Trails

Snowy Mountains boasts over 7.5 miles of on-site recreational trails. The trails are designed for activities such as jogging, biking, roller blading, walking or simply the enjoyment of the area's natural character.

Snowy Mountains is a unique setting for discriminating homeowners who wish to purchase a home with enduring, quality-of-life prerequisites. Homes are available in a variety of sizes and shapes to fit every income and lifestyle. Biking, boating, golfing, tennis, swimming, fishing, and of course.... relaxing. Prices range from $150,000 to $750,000.

Exhibit Three: Site Plan for Mountain Trail At Snowy Mountains

Exhibit 3 is a picture of the Site Plan for Mountain Trail and may be obtained from the authors.

Exhibit Four: Mountain Trail Models

The Pine

* 1400 Square Feet of total finished space

* 2 bedrooms

* Dining room with tray ceiling

* Large kitchen with breakfast nook and butler's pantry

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $339,900 (interior lot)

The Spruce

* Ranch with 1620 Square Feet of total finished space

* 2 bedrooms, 2 1/2 baths

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $354,900 (interior lot)

The Cedar

* Ranch with 1680 Square Feet of total finished space

* 3 bedrooms, 2 baths

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $369,900 (interior lot)

The Oak

* Ranch with 1680 Square Feet of total finished space

* 2 bedrooms, 2 baths

* Den (or 3rd. bedrom)

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle * Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $369,900 (interior lot)

The Sierra

* Ranch with 2275 Square Feet of total finished space

* 3 bedroom, 3 1/2 baths

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $449,500 (interior lot)

Exhibit Four: Mountain Trail Models The Olympia

* 2-Story with 2030 Square 2275 Square Feet of total finished space

* 3 bedroom, 3 baths

* Beamed study

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $385,000 (interior lot)

The Aspen

* 2-story with 2324 Square Feet of total finished space

* 3 bedrooms, 3 baths

* Den with beamed ceiling

* Dining room with tray ceiling

* Large kitchen with breakfast nook

* Large 5 piece master bath

* Master bedroom walk in closet

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $434,900 (interior lot)

Vail

* 2-story with 2577 Square Feet of total finished space

* 3 bedrooms, 2 1/2 baths

* Prices begin at $469,900 (interior lot) Vail II

* 2-story with 3104 Square Feet of total finished pace

* 3 bedrooms, 3 1/2 baths

* Paneled den with beamed ceiling

* Dining room with tray ceiling

* Large kitchen with breakfast nook with granite slab island

* Large 6 piece master bath

* Master bedroom walk in closet

* 266 sq ft bonus room

* Gas log fireplace with wood mantle

* Large spacious rear covered porch

* 420 foot garage with garage door opener

* Full unfinished basement with rough-in

* Prices begin at $494,900 (interior lot)

Exhibit Five: Land Contract--Mountain Trails Subdivision of Snowy Mountains VACANT LAND/FARM AND RANCH CONTRACT TO BUY AND SELL REAL ESTATE (FINANCING SECTIONS OMITTED)--, 2004

1. PARTIES AND PROPERTY. D H R Patio Homes, LLC, ("Buyer"), agrees to buy, and Snowy Mountains, LLC, ("Seller"), agrees to sell on the terms and conditions set forth in this contract, the following described real estate, to wit: Lots 1, 2, 6 through 10, 12, 13, 19 through 26, 28 through 35 and 38 through 45, Snowy Mountains Subdivision Sixth Filing also known as Vacant Land--(Insert Addresses) together with all interest of Seller in all easements and other appurtenances thereto, except as herein excluded (collectively the "Property").

2. EXCLUSIONS. N/A

3. PURCHASE PRICE AND TERMS. See attached Addendum

4. FINANCING CONDITIONS AND OBLIGATIONS. Intentionally deleted.

5. APPRAISAL PROVISION. Intentionally deleted.

6. COST OF APPRAISAL. Intentionally deleted.

7. ASSIGNABLE. This contract may be assigned by Buyer.

8. EVIDENCE OF TITLE. Seller shall furnish to Buyer, at Seller's expense, a current commitment for owner's title insurance policy issued by Weld County Title Company ("Title Company") in an amount equal to the purchase price, within five (5) days from the Effective Date of this Contract, as such term is defined on the attached Addendum ("Title Deadline"). Upon delivery of the title insurance commitment, Seller will provide legible copies of instruments listed in the schedule of exceptions ("Exceptions") to the title insurance commitment to Buyer, at Seller's expense. This requirement shall pertain only to instruments shown of record in the office of the clerk and recorder of the designated county or counties. The title insurance commitment, together with any copies or abstracts of instruments furnished pursuant to this Section 8, constitute the title documents ("Title Documents"). Seller will pay the premium for the title insurance policy at closing and have the title insurance policy delivered to Buyer as soon as practicable after closing.

9. TITLE.

(a) Title Review. Buyer shall have the right to inspect the Title Documents or abstract. Written notice by Buyer of unmerchantability of title or of any other unsatisfactory title condition shown by the Title Documents or abstract shall be signed by or on behalf of Buyer and given to Seller on or before ten days (10) days after the Effective Date of this Contract (as such term is defined on the attached Addendum) (the "Title Deadline"). If Seller does not receive Buyer's notice by the date(s) specified above, Buyer accepts the condition of title as disclosed by the Title Documents as satisfactory.

(b) Matters Not Shown by the Public Records. Seller shall deliver to Buyer, on or before the Title Deadline set forth in Section 8, true copies of all lease(s) and survey(s) in Seller's possession pertaining to the Property and shall disclose to Buyer all easements, liens or other title matters not shown by the public records of which Seller has actual knowledge. Buyer shall have the right to inspect the Property to determine if any third party(s) has any right in the Property not shown by the public records (such as an unrecorded easement, unrecorded lease, or boundary line discrepancy). Written notice of any unsatisfactory condition(s) disclosed by Seller or revealed by such inspection shall be signed by or on behalf of Buyer and given to Seller on or before five (5) calendar days after the Title Deadline. If Seller does not receive Buyer's notice by said date, Buyer accepts title subject to such rights, if any, of third parties of which Buyer has actual knowledge.

(c) Special Taxing Districts. Special taxing districts may be subject to general obligation indebtedness that is paid by revenues produced from annual tax levies on the taxable property within such districts. Property owners in such districts may be placed at risk for increased mill levies and excessive tax burdens to support the servicing of such debt where circumstances arise resulting in the inability of such a district to discharge such indebtedness without such an increase in mill levies. Buyer should investigate the debt financing requirements of the authorized general obligation indebtedness of such districts, existing mill levies of such district servicing such indebtedness, and the potential for an increase in such mill levies.

In the event the Property is located within a special taxing district and Buyer desires to terminate this contract as a result, if written notice is given to Seller on or before the date set forth in Subsection 9(b), this contract shall then terminate. If Seller does not receive Buyer's notice by the date specified above, Buyer accepts the effect of the Property's inclusion in such special taxing district(s) and waives the right to so terminate. (d) Right to Cure. If Seller receives notice of unmerchantability of title or any other unsatisfactory title condition(s) as provided in subsection (a) or (b) above, Seller shall use reasonable effort to correct said title condition(s) prior to the date of closing. If Seller fails to correct said unsatisfactory title condition(s) on or before the date of closing, this contract shall then terminate; provided, however, Buyer may, by written notice received by Seller, on or before closing, waive objection to said unsatisfactory title condition(s).

10. INSPECTION. See attached Addendum

11. DATE OF CLOSING. The date of closing shall be held 14 days after the Effective Date (as such term as defined in the attached addendum).

12 TRANSFER OF TITLE. Subject to tender or payment at closing as required herein and compliance by Buyer with the other terms and provisions hereof, Seller shall execute and deliver a good and sufficient general warranty deed to Buyer, on closing, conveying the Property free and clear of all taxes except the general taxes for the year of closing, and except N/A Title shall be conveyed free and clear of all liens for special improvements installed as of the date of Buyer's signature hereon, whether assessed or not; except (i) distribution utility easements (including cable TV), (ii) those matters reflected by the Title Documents accepted by Buyer in accordance with subsection 9(a), (iii) those rights, if any, of third parties in the Property not shown by the public records in accordance with subsection 9(b), (iv) inclusion of the Property within any special taxing district, and (v) subject to building and zoning regulations.

13. PAYMENT OF ENCUMBRANCES. Any encumbrance required to be paid shall be paid at or before closing from the proceeds of this transaction or from any other source.

14. CLOSING COSTS, DOCUMENTS AND SERVICES. Buyer and Seller shall pay, in Good Funds, their respective closing costs and all other items required to be paid at closing, except as otherwise provided herein. Buyer and Seller shall sign and complete all customary or required documents at or before closing. Fees for real estate closing services shall not exceed $300.00 and shall be paid at closing by one-half by Buyer and one-half by Seller. The local transfer tax of N/A % of the purchase price shall be paid at closing by N/A Any sales and use tax that may accrue because of this transaction shall be paid when due by Buyer .

15. PRORATIONS. General taxes for the year of closing, based on the taxes for the calendar year immediately preceding closing, rents, water and sewer charges, owner's association dues, and interest on continuing loan(s), if any, and N/A shall be prorated to date of closing. 16. POSSESSION. Possession of the Property shall be delivered to Buyer as follows: date of closing, subject to the following lease(s) or tenancy(s): N/A. If Seller, after closing fails to deliver possession on the date herein specified, Seller shall be subject to eviction and shall be additionally liable to Buyer for payment of $ per day from the date of agreed possession until possession is delivered.

17. CONDITION OF AND DAMAGE TO PROPERTY . Except as otherwise provided in this contract, the Property and Inclusions shall be delivered in the condition existing as of the date of this contract, ordinary wear and tear excepted. In the event the Property shall be damaged by fire or other casualty prior to time of closing, in an amount of not more than ten percent of the total purchase price, Seller shall be obligated to repair the same before the date of closing. In the event such damage is not repaired within said time or if the damages exceed such sum, this contract may be terminated at the option of Buyer. Should Buyer elect to carry out this contract despite such damage, Buyer shall be entitled to credit for all the insurance proceeds resulting from such damage to the Property and Inclusions, not exceeding, however, the total purchase price. Should any Inclusion(s) or service(s) fail or be damaged between the date of this contract and the date of closing or the date of possession, whichever shall be earlier, then Seller shall be liable for the repair or replacement of such Inclusion(s) or service(s) with a unit of similar size, age and quality, or an equivalent credit, less any insurance proceeds received by Buyer covering such repair or replacement. The risk of loss for any damage to growing crops, by fire or other casualty, shall be borne by the party entitled to the growing crops, if any, as provided in Section 2 and such party shall be entitled to such insurance proceeds or benefits for the growing crops, if any.

18. TIME OF ESSENCE/REMEDIES. Time is of the essence hereof. If any note or check received as earnest money hereunder or any other payment due hereunder is not paid, honored or tendered when due, or if any other obligation hereunder is not performed or waived as herein provided, there shall be the following remedies:

(a) IF BUYER IS IN DEFAULT:

Seller may elect to treat this contract as cancelled, in which case all payments and things of value received hereunder shall be forfeited and retained on behalf of Seller, and Seller may recover such damages as may be proper, or Seller may elect to treat this contract as being in full force and effect and Seller shall have the right to specific performance or damages, or both.

(b) IF SELLER IS IN DEFAULT:

Buyer may elect to treat this contract as cancelled, in which case all payments and things of value received hereunder shall be returned and Buyer may recover such damages as may be proper, or Buyer may elect to treat this contract as being in full force and effect and Buyer shall have the right to specific performance or damages, or both.

(c) COSTS AND EXPENSES:

Anything to the contrary herein notwithstanding, in the event of any arbitration or litigation arising out of this contract, the arbitrator or court shall award to the prevailing party all reasonable costs and expenses, including attorney fees.

19. EARNEST MONEY DISPUTE. Notwithstanding any termination of this contract, Buyer and Seller agree that, in the event of any controversy regarding the earnest money and things of value held by broker or closing agent, unless mutual written instructions are received by the holder of the earnest money and things of value, broker or closing agent shall not be required to take any action but may await any proceeding, or at broker's or closing agent's option and sole discretion, may interplead all parties and deposit any moneys or things of value into a court of competent jurisdiction and shall recover court costs and reasonable attorney fees.

20. ALTERNATIVE DISPUTE RESOLUTION: MEDIATION. N/A

21. ADDITIONAL PROVISIONS: (The language of these additional provisions has not been approved by the Colorado Real Estate Commission.) See attached Addendum

22. RECOMMENDATION OF LEGAL COUNSEL. By signing this document, Buyer and Seller acknowledge that this document has important legal consequences and had recommended the examination of title and consultation with legal and tax or other counsel before signing this contract.

23. TERMINATION. In the event this contract is terminated, all payments and things of value received hereunder shall be returned and the parties shall be relieved of all obligations hereunder, subject to Section 19.

24. SELLING COMPANY BROKER RELATIONSHIP. N/A

25. NOTICE TO BUYER. See attached Addendum

26. NOTICE TO SELLER. See attached Addendum.

27. MODIFICATION OF THIS CONTRACT. No subsequent modification of any of the terms of this contract shall be valid, binding upon the parties, or enforceable unless made in writing and signed by the parties.

28. ENTIRE AGREEMENT. This contract and the attached Addendum and Exhibit A, the terms of which are incorporated herein by reference constitutes the entire contract between the parties relating to the subject hereof, and any prior agreements pertaining thereto, whether oral or written, have been merged and integrated into this contract.

29. COUNTERPARTS. A copy of this document may be executed by each party, separately, and when each party has executed a copy thereof, such copies taken together shall be deemed to be a full and complete contract between the parties.

ENDNOTES

(1) All information in this case is factual in nature. The names of the company and the characters in the case have been changed at the request of the owners.

(2) A patio home is a detached form of condominium. The homeowners association performs all exterior maintenance and collects fees from the individual homeowners.

(3) Single-close Construction-To-Permanent Loan: "This is the most common and cost-efficient construction loan option. The single-close allows homeowners to qualify and close with one application--one set of fees--one closing--one loan. This loan provides funds that are disbursed as needed during the construction phase and then converts to a permanent, fully-amortized mortgage at time of completion. The loan requires 'interest-only' payments be made on the monies disbursed during the construction phase." http://www.rehabhome.com/newhomeconstruction loan_loans.htm, January 15, 2005.

(4) To calculate the construction loan payment, take 80% of 1/3 the sales price of the home

(5) Davis and Hodgetts' combined total net worth at that time, approximately $ 5 million dollars, was deemed adequate by the bank to cover the loan.

(6) A corporation or trust that uses the pooled capital of many investors to purchase and manage income property (equity REIT) and/or mortgage loans (mortgage REIT).

(7) Benefit Banks' policy on first-time corporate loans was to finance only 80% of the total loan. This was not disclosed to Davis at his first meeting with the bank although it was in the paperwork associated with the loan agreement.

REFERENCES

Mancuso, A. (2004). Your Limited Liability Company: An Operating Manual. 3rd Edition. Berkeley, CA.: Nolo http://www.private-placement-attorney. com/reit.htm, August 13, 2004. http://www.reitnet.com/reits101/index.html, August 12, 2004.

Herbert Sherman, Southampton College--Long Island University

Daniel J. Rowley, University of Northern Colorado

Table 1: Models for Mountain Trails

 Square
Model Feet * Style Price ^

Pine 1400 Ranch $339,900
Spruce 1620 Ranch $354,900
Cedar 1680 Ranch $369,900
Elm 1680 Ranch $369,900
Sierra 2275 Ranch $449,500
Olympia 2030 Two Story $385,900
Aspen 2321 Two Story $434,900
Vail I 2577 Two Story $469,000
(no bonus room)
Vail II 3104 Two Story $494,900

* Does not include finished basement.

^ Interior lot--For Lakeside Lot add $165,000.

Table 2: Estimated Profits from Mountain Trails Subdivision

Models Price Building Cost Property Total Profit
 Per Sq. Ft. * Cost Cost

Pine $339,900 $140,000 $76,000 $216,000 $123,900
Spruce $354,900 $162,000 $76,000 $238,000 $116,900
Cedar $369,900 $168,000 $76,000 $244,000 $125,900
Elm $369,900 $168,000 $76,000 $244,000 $125,900
Sierra $449,500 $227,500 $76,000 $303,500 $146,000
Olympia $385,900 $203,000 $76,000 $279,000 $106,900
Aspen $434,900 $232,100 $76,000 $308,100 $126,800
Vail I $469,000 $257,700 $76,000 $333,700 $135,300
(no bonus
room)
Vail II $494,900 $310,400 $76,000 $386,400 $108,500

* $100/square foot; profit for a lakeside lot is an additional $89,000.
Minimum profit = 33 lots ($106,900/per lot) + 7 lakeside lots
($89,000) = $3,527,700 + $623,000 = $4,150,700