fundamental skills for real estate development professionals ii – structuring the deal to be...

Real Estate Development Workshop: Fundamental Skills for Real Estate Development Professionals II

Structuring the DealWednesday, october 26, 2011

3:00 pm – 4:00 pm

Presented by TENNYSON WILLIAMS

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STRUCTURING THE DEAL

AgendaI. Deal/Project Analytics

– Front Door/Back Door Analysis

II. Deal Structuring To Control The Dirt– Purchase Agreements, Option Agreements,

ROFRs, Joint Ventures, Seller Financing, Lease-Purchase Options,

III. Deal Structuring To Attract Equity Capital– Preferred Returns, Promotes, Waterfall

Distributions, Language & Terms

Structuring The Deal Presented by

Tennyson Williams

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Project Mini-Pipeline(Project Could be derailed at any point during the process)

Land For Development

Re-Zoning Outcome

Feasibility Not Determined

Capital Raising

Permits

Completions, Profitability

Cost Feasible Rents Not Realized

Land Control/Acquisition

File Rezoning ApplicationOrder Environmental/SoilsStart MarketingCapital raising

HIERARCHY OF PAYOUTS

Structuring The Deal Presented by

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Profits/Return

Labor/Materials

LAND

Basic Development Profit Formula

Dev Profit

Structuring The Deal Presented by

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NOI

RAll-In Cost= -___

C-O-CNOI

All-In Cost=_____

(Unlevered)

I. Deal/Project Analytics

• Front Door Analysis– Holds development cost constant

& solves for minimum rent necessary to achieve target cash- on-cost return

• Back Door Analysis– Holds pro forma rent constant &

solves for max land cost necessary to achieve a target cash-on-cost return

Structuring The Deal Presented by

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Development AnalysisUniversity Shopping Center

(Atlanta, GA)

• Land size: 3.6 acres zoned C-1 General Retail• Land Cost: $1,000,000 per acre (There are 43,560 sf in 1 acre)• Maximum City Allowable FAR = .2958• Acme General Contractors has submitted a Guaranteed contract proposal for

construction for $76.50psf (hard costs) + $13.50 psf (soft costs) = $90 combined. • Anchor Tenant’s preferred prototype building size is 14,797 square feet. • Recent market survey of Tenant Leases suggests the following Structures:

– $8.25 psf NNNN for anchor space (cotenancy restrictions) fixed rent for 25 years– $20.00 psf NNNN for non-anchor space with 3%/yr inc.

• Local Market Vacancy reports suggest stabilized rate of 7.0% NON-ANCHOR ONLY.Oper Exps/psf: Taxes $2.00, Insurance $.25, CAM $3.00, M-Fee $.50

• Investor market appears to support cap rates ranging from 7.5% to 8.0%.

• QUESTIONS:

NP

Assuming a sale of the newly completed asset upon reaching 93% occupancy,

(1) Expected development profit range? $936,719 to $1,517,484(2) Estimated Cash-On-Cost Return (C-O-C) and Spread? 8.96%, 94 To 146 bps(3) Max land cost assuming a 10% required C-O-C? $776,229 per acre(4) Required Non-Anchor Rent Constant to earn a 10% C-O-C $22.31 p.s.f.

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• Step 1: Determine Maximum Allowable Building Size– 43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = (Max Building size)

43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = 46,386 square feet

Step 2: Determine Total Project Development Cost– Land Cost 3.6 acres X $1,000,000 = $3,600,000– Construction Cost @ $90 psf (hard & soft) X 46,386 square feet = $4,174,756– ALL IN DEVELOPMENT COST $7,774,756Step 3: Determine NOI– Anchor Tenant @ $8.25psf on 14,797 sf (31.9%) = $122,077 NNNN– Non Anchor Space @ $20.00psf on 31,589sf Less 7% Vac = $587,555

NNNN– Less Non-Reimburseables due to vacancy = ($12,714)

NOI 696,918 Step 4: Determine Value Range– NOI / Cap Rate $696,918 / .075 = $ 9,292,240– NOI / Cap Rate $696,918 / .080 = $ 8,711,475Step 5: Determine Development Profit Range– Profit = Stabilized Value – All In Project Costs – $9,292,240 – $7,774,756 = $1,517,484 (19.52% straight profit)– $8,711,475 – $7,774,756 = $ 936,719 (12.05% straight profit)Step 6: Determine Development Profit % Range (Including Land Cost)– 1,517,484 / 7,774,756 = 19.52%– 936,711 / 7,774,756 = 12.05%– Cash–On–Cost = Stabilized NOI / Total Project Cost $696,918 / $7,774,756 = 8.96%

(Spread = Cash on Cost – Market Cap Rate) 8.96 – 7.50 = 146bps, 8.96 – 8.00 = 94 bps

Shopping Center Mini-Case Solution(1) Profit Range, (2) C-O-C and Cap Rate Spread

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Shopping Center Mini-Case Solution(3) Solve For Max Land Cost Given Required C-O-C

• Step 1: Determine Maximum Allowable Building Size– 43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = (Max Building size)

43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = 46,386 square feet

Step 2: Determine Total Project Development Cost– Land Cost 3.6 acres X TBD = TBD– Construction Cost @ $90 psf (hard & soft) X 46,386 square feet = $4,174,756– TOTAL PROJECT DEVELOPMENT COST (Excluding Land) $4,174,756Step 3: Determine NOI– Anchor Tenant @ $8.25psf on 14,797 sf (31.9%) = $122,077 NNNN– Non Anchor Space @ $20.00psf on 31,589sf Less 7% Vac = $587,555 NNNN– Less Non-reimburseables due to vacancy = ($

12,714)NOI $

696,918

Step 4: Determine Maximum Total Project Cost (including land @ 10% C-O-C)– NOI / Desired C-O-C $696,918 / .10 = $6,969,180

Step 5: Determine Maximum Land Cost– Maximum Total Project Cost (including land) less Construction Cost– $6,969,180 - $4,174,756 = $2,794,424 ($776,229 per acre)

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Shopping Center Mini-Case Solution(4) Solve For Rent Constant on Non Anchor Space

• Step 1: Determine Maximum Allowable Building Size– 43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = (Max Building size)

43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = 46,386 square feet

Step 2: Determine Total Project Development Cost– Land Cost 3.6 acres X $1,000,000 per acre = $3,600,000– Construction Cost @ $90 psf (hard & soft) X 46,386 square feet = $4,174,756– TOTAL PROJECT DEVELOPMENT COST (Including Land) $7,774,756

Step 3: Determine NOI @ 10% C-O-C – Total Project Development Cost X 10% C-O-C = $777,476 NNNN– Less Anchor Space Rent @ $8.25psf = ($122,077) NNNN

Step 4: GROSS-UP NON ANCHOR RENT BY 1 – Vacancy Rate– Non-Anchor NNNN NOI / .93 = $704,730 / 31,589 sf = $22.31psf

$655,399

Structuring The Deal Presented by

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II. DEAL STRUCTURING TO CONTROL THE DIRT

Deal Structuring To Control Dirt

1. Option Contract

2. Right of First Refusal (ROFR)

3. Lease/Option

4. Seller Financing

5. Joint Venturing

6. A & D Loans

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THE TOOLS

1. Option Contracts

– Entitlements, – Growth plan amendment, – Rezoning, – Environmental analyses,

– Investor commitments, or

– Institutional commitment for development financing

Structuring The Deal Presented by Tennyson Williams

Options work as a hedge against not being able to assemble all the land needed or obtain necessary:

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HOW AN OPTION WORKS• Seller unconditionally agrees to sell to Buyer

– Seller can take back-up contract(s)

• Buyer pays consideration ($) to Seller– Amount is negotiable

• Buyer has to exercise option (go hard on the contract) within a specified period of time– Time period is negotiable

• Seller has no tax consequences until option is exercised or expires

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Structuring The Deal Presented by Tennyson Williams

BUYER’S GOALS: –Minimize option

money, maximize option period

–Control property against other potential buyers

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Structuring The Deal Presented by Tennyson Williams

STRATEGY: –Works best in a Buyer’s market; –May have to pay taxes, mortgage

and other carrying charges–Seller defers taxes until option is

exercised or expires

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Structuring The Deal Presented by Tennyson Williams

TACTICAL CONSIDERATIONS:–Apply some or all of the option money

to the purchase price (works toward equity portion for future loans)

–Make the option payments in installments (retain use of the funds for longer periods)

–Tie purchase to enhanced entitlements or zoning

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Structuring The Deal Presented by Tennyson Williams

TACTICS (continued):

−The ultimate purchase price may be contingent on changes to entitlements or zoning

−Allows buyer to control the land for little initial consideration

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Structuring The Deal Presented by Tennyson Williams

Rolling Options: – Allow development of contiguous parcels

incrementally– Initial take-down may be for signage, access,

sales/leasing center, models

street

Phase One

2010

Phase Two

2012

Phase Three

2014

Phase Four

2016

Phase Five

2018

1,000 Acres

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Structuring The Deal Presented by Tennyson Williams

1. b. Right Of First RefusalNEXT BEST THING TO AN OPTION

How It Works:– Does not entitle the holder of the right to force the

other party to sell or lease the asset.– If and when the other party decides to sell or lease

the asset to any third party, the holder of the right of first refusal can require the asset to be sold or leased to him or her for the same price and terms that the owner is willing to accept from the third party. 

– Doesn’t tie the land up; seller can still try to market the property

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Structuring The Deal Presented by Tennyson Williams

2. Lease with Option to Purchase

How It Works: Buyer leases the property from Seller for a

specified period of time at an agreed upon rent

Lease contains a right of Buyer to exercise an option to purchase the leased property

Best to have the price and terms spelled out in the lease or attached as a proposed contract

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Structuring The Deal Presented by Tennyson Williams

BUYER’S GOALS: Minimize invested capital/maximize leasehold period Control property against other potential buyers Gain use of the property

24/7 Access Post signs advertising the coming project

Assemble all the land needed, or Obtain necessary: entitlements, plan amendment,

rezoning, environmental analyses, investor commitments, or institutional commitment for development financing

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Structuring The Deal Presented by Tennyson Williams

STRATEGY: –Works best in a Buyer’s market (no

demand); • Seller earns income from the property

until lease expires or the option is exercised

–Exercise of option must occur by determinable specific date

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Structuring The Deal Presented by Tennyson Williams

TACTICAL CONSIDERATIONS:–Annual rent can be based on a

percentage of the land’s market value

–Pay taxes, mortgage and other carrying charges

–Tie purchase to enhanced entitlements or zoning

–Some of the lease payments may be applied toward the purchase price (negotiable)

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Structuring The Deal Presented by Tennyson Williams

3. Seller Financinga/k/a Purchase Money Mortgages

• Generally involves the seller’s level of sophistication (more is better) as well as his or her financial circumstances, plus the current market situation

• Down payments typically range from 10% to 30% of the purchase price

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Structuring The Deal Presented by Tennyson Williams

GOALS:

Acquire land:• With minimal equity upfront• Avoid institutional lenders• Avoid additional investors• Better mortgage terms• Less cost involved

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Structuring The Deal Presented by Tennyson Williams

STRATEGY:–Minimize down payment

–Minimize interest rate

–Maximize term

–Get releases

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Structuring The Deal Presented by Tennyson Williams

TACTICAL CONSIDERATIONS– Under current tax law sellers, but not dealers (as

defined in the tax code), of real property generally can structure the purchase money mortgage as an installment transaction for tax purposes, allowing them to defer income taxes until each mortgage payment is received.

– Always try to get the seller to agree to subordinate to the development loan(s); otherwise, the purchase money mortgage will have to be paid off so that the construction and permanent lenders can have first liens

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Structuring The Deal Presented by Tennyson Williams

4. Joint Ventures

• Usually a type of partnership with a single specific purpose in mind for example:

Partner A = Landowner Partner B = Developer Partner C (maybe) = Investor (Capital Partner)

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Structuring The Deal Presented by Tennyson Williams

How It Works:– Seller contributes the land in exchange for

an equity interest equal to the agreed upon value of the land vis-à-vis the overall value of the project

– Seller’s interest equates to an interest in profits

– Seller agrees to subordinate title to a construction loan

– Developer provides equity and/or sweat equity, knowledge and experience, and does the grunt work

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Structuring The Deal Presented by Tennyson Williams

1. landowner receives equity land value

2. landowner receives a preferred return (cumulative or noncumulative) on the equity value of the land

3. developer receives agreed upon amount or percentage compensation (in lieu of or in addition to developer fees received during the construction and leasing periods)

4. landowner and developer split balance per an agreed upon formula for priorities and percentages

5. a 3-tiered structure may be used if third party equity investors are involved

Sample Structuring:

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Structuring The Deal Presented by Tennyson Williams

BUYER’S GOALS:–Avoidance of equity investment

in the land–Optimize developer’s equity for

other uses, such as entitlement, planning, and construction

–Boost Equity Yield

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• Plan ahead for partnership disputes

• Be prepared for dissolution of the venture use buy-sell

• Don’t put yourself in a position to lose control of the venture

• Have a viable backup plan

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Tips For Joint Ventures

Structuring The Deal Presented by Tennyson Williams

5. Land Acquisition Loans• Generally institutional lenders loan

only to their strongest and best customers who have fully entitled land and other assets or sources from which to repay the loan

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Structuring The Deal Presented by Tennyson Williams

CAVEAT: Institutional lenders generally say they will finance “up to 50%” of the acquisition price of unimproved land if at all, but the actual loan-to-value may be less depending on:1. The lender’s risk tolerance2. The lender’s determination of the actual value

versus the contract price3. The extent of the borrower’s equity contribution4. The borrower’s relationship with the lender5. The borrower’s financial strength and credit

history6. The borrower’s level of experience with the

planned development7. Estimated time before take-out will occur8. Conditions in the market

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Structuring The Deal Presented by Tennyson Williams

–Expect to provide personal guarantees to adjust for the absence of an income stream produced by the land

–Consider using a revolving line of credit–Use builders’ precommitments,

presales, preleasing, agricultural leases

TACTICAL CONSIDERATIONS:

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Structuring The Deal Presented by Tennyson Williams

III. Deal Structuring To Attract Capital

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The Cost of Equity Vs. Debt

Generally, the cost of equity is considered

to range between 4% and 8% above the

effective cost of debt

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Structuring The Deal Presented by Tennyson Williams

BUYER’S GOALS:–Obtain capital for acquisition,

planning, and entitlement of land–Maintain control of the enterprise–Identify a compatible partner or

partners who can provide or raise equity

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Structuring The Deal Presented by Tennyson Williams

STRATEGIES:– Don’t give away the farm up front – if your

projections are off, you lose– Carefully balance all participants’ risks and

rewards– Retain control and be clear about it– Prepare from the beginning for the

possibility of dissolution of the venture – use buy-sell agreements “you cut, I choose”

– Communicate frequently and clearly with the investors

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Structuring The Deal Presented by Tennyson Williams

TACTICAL CONSIDERATIONS:

The major areas requiring careful consideration and negotiation skills for distributing cash flows include:

1. Preferred returns on equity invested

2. Priorities of payback of equity invested versus sweat equity

3. How any remaining balance will be split, if at all

4. Developer fees/Management fees

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Distributions of Cash Flow from Operations

• Pari Passu – the developer receives a % of the distributable cash proportionate to the % of his equity contribution

• Preferred Return (“Pref”) – initial distribution of cash flow to investors in a specified % before any other distribution

• Promote – distribution of the remaining cash to the developer in an amount disproportionate to his actual % of equity invested (as an incentive)

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Distribution of Cash Flow from Sale

• After payment of expenses of sale and repayment of debt• Then distributed to all parties in the amount of their initial

capital investment• The balance is distributed in predetermined proportions

(50/50; 60/40, etc.)• Exception: IRR Preference, an investor’s specified IRR must

be achieved before the balance is distributed• IRR Lookback – if an investor was to receive a specified IRR

and it isn’t achieved in the final distribution, then the proportions of other investors are adjusted to cover it

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Distributions – Example slide 1

Outside investors put up 90% of the equity and developer puts up 10%.

Project is 3 years in development stage, then produces cash flow for 5 years of operations.

Property is sold at the end of the 5th year of operations.

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Distributions – Example slide 2

1. Annual cash flow is distributed to outside investors until a specified hurdle return (c.f., 9%) is received (the “pref”);

2. Then the developer may receive a disproportionately larger share (than his 10%) of any additional distributions (the “promote”);

3. All remaining money may then go to the investors;

4. At sale, the net proceeds after repayment of debt may go first to the outside investors to repay their invested capital, then to repay the developer’s capital, then be divided in a specified split.

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Structuring The Deal Presented by Tennyson Williams

1. all cash goes to investors until they have received return of equity in full

2. cash then goes to investors until they have received their priority return on equity (cumulative or noncumulative)

3. next cash goes to developer until agreed amount of percentage is reached (perhaps in addition to developer fees paid during operations)

4. the balance is divided according to negotiated split

Sample Structuring (“waterfall”):

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Developer & Management Fees

• Developer’s fees for overseeing the development of the project; typically 3%-4% of hard and soft costs

• Management fees for overseeing day-to-day management of the project: typically 3%-4% of effective gross income (adjusted gross income)

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Structuring The Deal Presented by Tennyson Williams

The investment vehicle can be can be a: –Partnership, –Limited partnership, –LLC, or –Corporation (C or S)

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Structuring The Deal Presented by Tennyson Williams

A Word About Syndications: –Syndicators, promoters, or sponsors

raise capital from investors and charge fees and/or may retain an interest in the venture

–Complex tax and securities laws are involved•Violation of the securities laws carries severe penalties

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Structuring The Deal Presented by Tennyson Williams

• Some Institutional Investment Entities:

–REITs

–Pension Funds

– Insurance Companies

–Venture Capitalists

–Opportunity Funds

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Structuring The Deal Presented by Tennyson Williams

Example:–XYZ, an opportunity fund, is actively

seeking investments in joint ventures with current owners and developers. 1. The developer monetizes part of the

asset value of entitled raw land, or 2. Acquires a financial partner for

acquisition and development financing.

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Q & A

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