Aspiring developers often inquire how they can stay invested in a development deal long term, rather than selling the project upon approval or completion. Deals that successfully structure this outcome take advantage of imputed equity and developer partnerships, while also managing the expectations of GP, co-GP, and/or LP equity.
“I want to start building and not selling all of these opportunities. What are my options and how much money can I make in these different scenarios?” – Developer Client.
Capitalizing Imputed Equity
Imputed equity exists when the current market value of a project is greater than the total cost spent for and/or on the site to date. Actions or costs that add value to the project create this equity and can be capitalized by the downstream debt and equity sources.
Many lenders and investors will look at the calendar and point to asset appreciation over a minimum of 3 years as support. However, there are many other defensible ways to create value in the short term, including:
- Timing a zoning change or up-zone that allows a more valuable development (thereby increasing land residual value).
- Navigating the entitlement and approval process for the specific project, especially in a notoriously difficult jurisdiction.
- Concocting an intelligent design that allows a more valuable build than previously considered by the market. This is especially true for architect-developers.
- Finding an off-market deal and securing a below-market price for the land.
- Aggregating multiple parcels from individual sellers.
- Structuring a favorable price/deal with a seller that may contribute land to the venture.
- Performing a substantial portion of the pre-development acquisition, architectural, engineering, and pre-construction tasks in-house and valuing those services at a market rate.
If successful, a developer can contribute that imputed equity (current market value less cost to date) to the capital stack of the vertical build in addition to, or in lieu of, cash equity.
It’s important to keep in mind that costs which don’t contribute to the assets’ value are usually not recognized as “basis” unless there are other demonstrable value increases. These mainly include financing costs or excessive management fees. A developer’s choice to use leverage does not improve the asset, nor does oversized overhead (ex: a one-person shop that is accruing a $50k per month management fee).
Under traditionally levered deals (65-70% debt, 35-30% equity), developers can contribute equity equal to 3% of the total project cost (10% of a 90/10 joint venture, which represents the 30 points of equity needed to balance a 70% construction loan). Therefore, putting aside (for now) the cash needed for site control, entitlements, consultants, and design, cash and imputed equity totaling $1MM satisfies the equity needed for the joint venture on a $33MM project.
From here, a sponsor with deep building expertise should be able to attract the remaining debt and equity required to capitalize the project.
A partnership with an experienced developer offers a viable option for emerging sponsors that lack experience or sufficient liquidity to backstop cost overruns.
With sufficient imputed equity and a financially viable project (more on that below), a developer might opt to partner. This strategy is particularly effective in a highly competitive acquisition environment where viable sites are scarce. The incoming group benefits from the work/process already complete (most likely at a below-market basis) and adds value by mitigating execution risk, especially if they are also a seasoned builder or general contractor. The partnership could also benefit from a stronger balance sheet and lower cost of capital, which would improve project-level levered economics and increase the attractiveness of the deal for downstream LP equity raise if required. The sponsor, depending on their level of sophistication and involvement, might also participate in a portion of the development fees, promote, and in the return of capital pro rata to equity regardless of cash invested.
Additional considerations include the initial underwriting and price at which a developer partner “buys in” to the sponsor’s venture. The lower the “price,” the juicier the deal and the bigger the developers’ promote. A development partner will also want a very lucrative deal to pitch to the LP investor marketplace. The sponsor will want it just fat enough to maximize their equity contribution. That said, it is important to diligently vet the unit mix, rents, building efficiency, hard and soft costs, path to permits, etc. with your team and advisors before pitching the developer community as a potential partner. They will vet that same feasibility and likely error in their favor, pushing down the sponsor’s basis to solve for a financially feasible project.
As a rule of thumb, financially viable projects attractive enough for the downstream LP investors and debt providers have a target yield on cost that is 130 bps over the terminal cap rate. Ideally, it should be 150 bps wide of the exit cap with appropriate contingencies for an early-stage project. Anything better than that and your partnership with a developer has not marked up the land (and sponsor’s equity) sufficiently.
Fident has facilitated these successes in the past via an early engagement in an advisory capacity. This allows us to bring a few developer partners forward, giving each a chance to “buy” the site at a marked-up value in a cash efficient manner. In one instance, the sponsor was able to stay in the deal with almost no cash invested. The lower off-market basis resulted in a strong deal that attracted LP equity and a loan sized off a budget that included the market value of the land, not the original purchase price.
The equity side of the capital stack greatly influences long-term strategy. There are three main places to invest into a deal, General Partner (GP) equity, Co-GP equity, or Limited Partner (LP) equity. The high-level expectations below outline the economics needed to pique the interest for each and should be achievable with a financially viable project (noted above).
- The LP is going to seek something along the lines of a 1.7x to 2.0x on invested equity and a 20%-25% IRR over 3-5 years to build new MF units (depending on the market risk). Groups of this nature will likely not invest until the project is shovel ready and will close concurrently or slightly before the construction loan. Most will look to sell after stabilization. Some may opt to crystalize the ownership via a synthetic sale and hold long term.
- The GP (developer/sponsor) can expect to earn 35% to 45% of the project’s total profit on a 10% co-invest. Those multiples are often on the order of 3x to 4x and as high as 8x or 9x depending on the strength of the deal and joint venture. After all, they are leveraging off the entire project with only 3% of the capital stack contributed. (10% of 30% of that project’s equity on top of a 70% construction loan). Besides sponsor equity, syndicating capital from friends, family, and acquaintances may offer the most control over hold strategy.
- Co-GP is money that is either a part of the 10% GP investment in a 90/10 JV (ex: a developer-sponsor has 1% of the capital contributed, and the Co-GP or development partner puts in 2 points) or is something that increases the amount of GP capital contributed into the GP/LP capital stack to maybe 20% or even 30% of the total equity need. This decreases some of the risk of the LP and earns better promotes for the GP. If as high as 15% of the project costs, the team might have enough capital to source preferred equity with traditional construction debt and retain all project profits. The Co-GP investor can expect to earn an amount that falls somewhere between the LP’s returns and the GP’s returns. They will get the same “money is money” returns as the LP plus some of the promote paid to the developer. Let us call this a 2.5x and a 35% to 40% IRR.
Circling back to the potential value creation mentioned above, is GP/Co-GP cash equity, or is it land lift (Imputed equity)? The sponsor needs to make the distinction between cash and land lift to get a true sense of project level returns.
If demonstrable imputed equity exists and the deal still provides market-rate returns with that elevated basis, there’s no reason a developer wouldn’t “pay” a sponsor that amount and form a venture that recognizes that imputed equity as part of their go-forward capital stack. The partnership would still need to account for the sponsors actual cash equity spent to date on acquisition/control, on soft costs, and how to cover the remaining predevelopment soft costs associated with getting to a building permit. The more a sponsor is willing to sit on the equity and give a development partner low-cost access to/control of the project, the more value they can create, and the better everyone can do.
We see deals like this completed when intelligently crafted. Keep in mind that circumstances dictate all and the desire for input and control also deserve attention. For example, does the sponsor want to be involved in the development and have any input over the design and direction of the deal? Or do they just want to go for a ride and get a check at the end? A sponsor’s level of expertise and background could bring additional value (and participation) in the go-forward venture. If a sponsor wants to be engaged in the process, a smaller development partner is probably a better fit. If the goal is to just sell their position into a venture and wait to get paid, a bigger group will almost certainly be interested.