I am having a hard time understanding the logic of allowing developers to count their fee in required equity.
Conceptionally, all equity should go in before the senior debt. Allowing them to put in $1-3MM as non-cash effectively increases your risk profile with no offset.
How are teams getting comfortable with allowing developers to do this?
How do you model this? i.e. how is the developer fee draw paid and to whom?
It's the same concept as marking up the land when forming a new venture. Not sure I follow how it increases your risk profile.
You can model it like you normally would because the development fee is still part of the capitalization of the deal, but there's never a draw.
Developer Fee + Rest of Cost = Developer Equity Stake + Rest of Equity + Debt
Let's say you are 12 months into a 24 month construction (drawing on the senior loan) and the developer leaves.
They "contributed" their fee, so all equity is "in" and you have to find another developer
That new developer is going to expect loan draws to start funding a percentage of completion fee, right? Wouldn't you have a gap in the capital stack?
Sure, but the odds you're selling that half finished building at par are... minimal. The new developer is going to bid 75 cents on the dollar and capitalize their developer fee. Since you as the senior lender just wiped out a ton of equity, you're not losing on this either.
And if it's economic conditions causing the original developer to abandon... well, it's a question of what you think motivates developers. Under the traditional model, that developer can walk away with a substantial portion of their developer fee and leave you the site, meaning you still have a problem. Maybe you don't have quite as large of a "gap", but by withholding all fee from a developer until you're loan is taken out on completion, you remove any possible incentive to walk from a project.
Can you break down what this looks like for an LP/GP equity situation? For example what do you mean by "selling at par" ? I imagine if the GP quits, then the GP equity that was invested up front becomes the LP's? And then the LP gets another GP to "bid" on the equity abandoned by the original GP?
Put very briefly, if I am Developer A, and I am building my project for a $100mm total development cost, I have probably raised somewhere in the region of 35-40mm of that in equity (60-65% financed).
If my lender takes back the keys, my equity position gets absorbed by the bank. Two advantages to that. One, is that if my building is 50% built, it means that 35mm of my money is poured into it and only 15mm of the bank's, because equity is almost always the first dollars out the door in construction projects. Second, my lender is now sitting on a "basis" of 65mm. They own the property, and their investment in it was only 65mm. Assuming that the cost overruns haven't been truly absurd or the market truly atrocious, that means the bank is sitting on an asset worth substantially more than their basis in the project.
So when I say "selling at par" I mean the bank is not selling that half finished building at a $100mm valuation. They're selling it at an 80mm valuation. There are additional costs to restart the process halfway through, but that still represents a real discount to market for Developer B who buys it at a distressed asset auction. That probably includes restructuring the existing debt as well, so Developer B can still take a fee under the new financing structure, too.
I don't think you understand the concept fully, if you are discussing paying the developer fee through draws/requisitions.
The fee is part of the whole capital stack but never gets drawn. So there is no difference to the risk profile for the lender. In fact, it can be less risky. Think about developers who go an syndicate out all their equity and keep their fee. That's a borrower who is, from the perspective of a lender, able to walk away with little financial downside. If that developer is investing their fee in the deal you know they're less likely to walk.
If you do not allow the fee to be contributed, they have to invest cash equity. Allowing it reduces their cash equity contribution, as the fee is more along the lines of sweat equity (at least up front).
Cash is cash. In the traditional model, the developer gets paid a cash fee. Aside from the slight value of that money being paid out over time vs up front, what's the difference? It may be booked differently but at the end of the day that money is coming from the borrower either way. What do you care where it comes from? From the perspective of a senior lender, having the dev fee be part of the capital stack means ensuring that your borrower is actually putting in real money.
Appreciate the insights.
Piggybacking, feel free to have me start a new topic. Would this be the same as an "acquisition fee" and is this common for younger people just getting their start?
In other words, I want to start investing in properties but don't have nearly the capital to be considered a serious partner. How would you structure my equity contribution as an acquisition fee that gets lumped into the capital stack as a way of paying for all of the legwork to structure the deal and have it close?
Both are part of the capital stack as they are both project costs however acquisition fee is paid upon close of the land in a lump sum while the development fee is meant to pay the operator/developer’s back office/fixed fees and is typically released on a monthly basis through the duration of the project.
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