Hi all,
My firm is under contract to sell land to a homebuilder. We sold at the top of the market in 2021 and closing was meant to happen in June 2023. The price was $5.85m. Now the homebuilder is seeing softness in the market and wants to modify the deal to hit their 15% IRR target. They are proposing:
1) Close with $4.85m in June 2023, then offer profit sharing on the homes sales after completion in 2027 up to $5.85m plus maybe additional profit on top. The hurdle will be their 15% IRR, we get anything above that, so total could exceed the original $5.85m. But if they make less than 15% IRR we get nothing (only $4.85m guaranteed).
2) Close with $3m in 2023 and then $2.85m in 2026 (full $5.85m guaranteed).
3) Close with $4m in 2023 and then $1.85m in 2027 (full $5.85m guaranteed).
Any advice would be greatly appreciated. We are considering the first option but are not sure how realistic a 15%+ IRR on homes is, given where rates/the economy are today.
Many thanks.
I would run some basic analyses on your own returns under the 3 scenarios, maybe sensitizing the first scenario for a couple brackets (i.e. no profit share, 50% profit share, full $1mm profit share - something like that). Economics aside, I have done a deferred profit share deal with a homebuilder and it was a pain in the ass from a manpower standpoint. Having to check the accounting on home sales, especially when it's gameable from their end (area figures, model home expense, seller incentives, etc.) is more work than it sounds.
Thanks for insight, we definitely don't have the manpower to verify their figures and would need to outsource. Would tying the home sale prices to our land sale price be a better option than tying to builder's IRR? Would IRR be based on their gross profits? Thanks again.
Tough to comment on the 15% IRR without knowing more about their business model - ie, price point, specs vs on order, land banking methods, etc.
What’s the reasoning behind sales in 2027? Is that their first anticipated closings or do they not want to cut you in on earlier sales? Seems like a very long time to develop, sell, build, and close if the site is shovel ready at land closing. That would likely tank IRR off the bat.
I’d ask yourself two questions - (1) what’s your cost basis/anticipated margin on the $4.85M now and (2) what price do you think you could get selling on the market now?
True ups/profit sharing are a nightmare if they have financing. I’d be inclined to take the most money now, but figure out if you can secure the remaining $1M against the property in a strong position.
Thanks, re the IRR: the homes are in a high-barrier to entry market and will command around $700+ psf. The builder will carry no interest costs on deferring the land payment to seller. 2023 is the initial payment and 2027 is the last payment to conform with 1031 rules. They plan to finish and start selling homes by 2025.
We are worried the builder may cut corners in their IRR calculations and thus end up paying less. We could proposes to tie the land sale price to the home sale prices, but don't think the homebuilder is willing to take on the additional risk.
Would IRR be based on their gross profits? Thanks again.
IRR will be based on net profits, not gross. A sales price of $700/SF sounds high, but I don’t know your specific market. You’ll have to do some DD on your market to figure out if they’re selling at a mid, high, or very high price point in your market to judge the risk. Slow sales will crush their IRR.
Some builders will pay land prices (or a kicker on top of a base lot price) as a percentage of sales price. It’s not preferred, but it’s probably 10x easier than doing a true-up based on IRR. Just get them to pay you at each closing on the settlement sheet to have backup verification.
Historically homebuilder margins have been in the 10-15% range but have gotten as high as 30%+ in the past few years.
Thanks. Would IRR be based on their gross profits?
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