With so much investment capital chasing so few viable multifamily development prospects these days, you’d think investors would be offering attractive partnership terms to developers controlling promising sites.
And you would be right.
Investors are asking their partners to put up less cash, work with them on more and bigger deals, and meet lower hurdles before taking a larger share of the returns.
Deal terms calling for developers to put up 10 percent or more of a venture’s required equity were once the norm, but today local operating partners are typically putting up 5 percent or less—even none in some cases.
Plus, investors are providing some developers with opportunities to participate in multiple $10 million-plus deals, boosting their potential profits. Equity investors also are lowering the return hurdles development partners need to clear in order to trigger their “promoted interest” profit-sharing incentives.
Promoted interests, or “promotes,” are the arrangements through which a development partner shares profits equally with the capital partner after a joint venture achieves pre-designated internal rates of return (IRRs). Before reaching these IRR hurdles, profits are generally pro-rated according to each partner’s actual capital contribution, with the development partner also getting compensated through developer fees for overseeing day-to-day activities.
Add it all up, and developers who can handle multiple large-scale projects are in a position to reap a much higher share of the profits from their joint ventures than they were in the past. “It’s a reflection of the unprecedented competition we’re now seeing among equity investors,” said Charles Foschini, managing director with CBRE/Melody in Miami. “It’s just easier for the development partner to call the shots today.”
Yield depression
Still, not all the news for developers is rosy. The flood of equity in the market has depressed targeted investment returns from joint venture developments, and the ventures are tending to hold properties longer to boost yields.
Also, heavy bidding for sites, combined with increased labor and materials costs, is effectively reducing the universe of development opportunities that might pencil out.
So equity partners are generally looking to work with top-tier apartment entrepreneurs able to source multiple development deals in the most promising, highest barrier-to-entry markets. These investors tend to offer the most attractive terms to developers who have strong reputations in their markets and who can demonstrate exceptional cost-controlling expertise, said Michael White, a managing director with Holliday Fenoglio Fowler in Irvine, Calif.
Now that exit strategies might have to run seven years or more to produce an attractive yield, equity joint venture partners value expense-efficient development and operational expertise more than ever, said White. “Capital managers are drawn to where they can expect tight control over expenses,” he said.
Less equity required
Investment advisors and developers declined to give details of individual transactions, but did explain how joint venture terms have changed generally.
Although in the past, operating partners typically were required to contribute 10 percent to 15 percent of a venture’s equity—and even 20 percent in some cases—today that share tends to top out at 5 percent. In many cases, it amounts to just 2 percent to 3 percent, said joint venture specialist Doug Weil, director of equity finance at NorthMarq Capital in San Francisco.
If a capital partner has worked repeatedly and successfully with the developer, the investor might in some cases provide all the equity, he added. And in cases where the developer has particular niche expertise, HFF’s White has put together deals even between first-time teams in which the capital partner put up all the equity. Especially if developers have the ability to source plentiful deals in major markets, capital partners will often be more flexible about equity requirements.
Doling out the profits
More investors are getting flexible about profit-splitting these days as well.
The IRR hurdles developers must clear in order to start claiming an equal share of venture profits have been re-set at levels that allow the development partner to “get to the promote more quickly,” Melody’s Foschini said. “Compared to two years ago, it’s much easier today for the development partner to (negotiate) a 50 percent share” of profits beyond the pre-designated IRR parameters, Weil said.
While IRR hurdles were typically in the mid or high teens just a few years back, today promotes tend to hit the 50-50 profit-sharing point once investors receive yields amounting to 12.5 percent to 13 percent, White said. In cases where the capital manager is particularly intent on investing with a top player in a highly coveted marketplace, partners might go even lower and structure ventures providing a 50-50 promote after investors receive an IRR of just 11 percent to 12 percent.
White cited a recent transaction through which a “major pension fund” formed a venture with a well-known apartment developer to pursue a project requiring $50 million in equity. The operating partner contributed 5 percent of the equity, with profits to be split on that 95-5 basis until the venture’s overall IRR reaches 10 percent. The developer gets 20 percent of the profits from there through the 12.5 percent IRR hurdle, and half thereafter.
Size is everything
These days, big institutions and commingled equity funds are rarely interested in ventures requiring investments below the $20 million mark. To get such investors interested in deals smaller than $10 million would take a clearly promising project teaming an investment manager with one of its successful, multiple-venture development partners, said Nate Prouty, a NorthMarq vice president.
These solid development opportunities are becoming increasingly rare, though, as tight competition over viable project sites thins the profit prospects, while labor and materials costs keep rising.
Site costs in some South Florida submarkets today are so prohibitive that high-rise apartment developers must plan on earning $3-per-square-foot rents to make projects pencil, Foschini said. And that’s a risky proposition given that lots of new high-end condos are available for rent at more like $2.25 a foot, he added. “So we’re not seeing much new rental product come out of the ground.”
As a result, many equity pools are targeting markets with good demographics and strong supply-demand fundamentals, such as Seattle, Denver, and Austin, Texas, White said. And some are seeking development partners with expertise in product niches such as student and military housing, as well as affordable developments.
Holding the line on fees
While today’s lower yields are pushing institutional investors to hold joint venture developments substantially longer than the typical three years seen in the past, they’ve held the line on standard developer fees, said Weil.
The standard fee for overseeing the development process still averages 5 percent of hard costs or 3 percent of total costs, he said, adding that the fees might be adjusted a bit depending on the co-investment contribution. Foschini’s fee-structure recommendation: “This all still needs to be negotiated on a deal-by-deal basis.”
A break from the past more in the developer’s favor: Joint ventures today tend to credit an operating partner’s contribution of land at its current (read: peak) valuation regardless of the actual cost at purchase. “Because the market’s so frothy and it’s so time-consuming and costly to secure entitlements, they can get away with it today,” Foschini said.
Few institutions are willing to risk investing in a development joint venture before allowed uses and densities match the planned project, said White.
With multifamily debt readily available, developers might be tempted to avoid equity partners, but they need to be aware that doing so means they won’t have those investors’ deep pockets to dig into if things get rough, cautioned industry veterans. Coupling recourse construction debt with mezzanine capital might cover well over 90 percent of costs, “but as a developer you’ve got to ask whether you want to be that exposed,” Weil said.
Institutional partners tend to be a lot more patient and flexible than mortgage lenders when conditions sour, he added. “That’s the nice thing about institutional partners: They won’t be all over you like lenders will.”