LP coming into deal at higher land basis. How to model returns to GP?
Having some difficulty modelling and understanding this.
Say I’m a GP ground-up developer. I bought the land in 2020 for $5M. Total project cost including land is $100M. Assume all equity financed for simplicity. Today I am raising LP equity at a 90/10 basis, so LP would contribute $90M on a cost basis.
However, the value of the land has 5x’ed to $25M. Now, if the LP were coming in at a 90/10 on the increased land basis, they would be contributing 90%*$120M = $108M, GP contributes $12M.
Also say the GP has put in $12M to date so no further contributions required. So if $88M of equity is actually required for the project but the LP is putting in $108M, how is the extra $20M treated? Is it going into GPs pocket as a profit? Or reduction of equity first and then profit? If reduction in GP equity to 0, how is pref calculated?
Feel like I’m missing something, thanks in advance
Navigating the complexities of modeling returns for a GP when an LP comes into a deal at a higher land basis can indeed be challenging. Here's a breakdown based on the most helpful WSO content and threads that have discussed similar scenarios:
Increased Land Value and Equity Contribution: The increase in land value from $5M to $25M significantly alters the equity structure of the deal. If the LP is contributing based on the increased land value, their contribution would indeed be higher, as you've calculated.
Treatment of Excess Equity Contribution: The excess $20M contributed by the LP (given the actual requirement of $88M for the project) can be treated in a few ways, depending on the agreement between the GP and LP:
Preferred Return Calculation: The calculation of preferred returns (pref) in this scenario would depend on how the excess equity is treated. If it's considered a reduction in GP equity, the pref would likely be calculated based on the new, adjusted equity contributions of both GP and LP. The specifics of this calculation would again depend on the terms agreed upon by the GP and LP.
Clarification and Agreement: It's crucial for both GP and LP to have a clear understanding and agreement on how such scenarios are treated. This includes how excess equity contributions are handled, the impact on ownership stakes, and the calculation of preferred returns. Detailed modeling and scenario analysis can help both parties understand the implications of different approaches.
Professional Advice: Given the complexity of these arrangements and the significant financial implications, consulting with a financial advisor or attorney specializing in real estate investments is advisable. They can provide guidance tailored to the specific details of your deal and ensure that all agreements are legally sound and financially beneficial for both parties.
Remember, every deal is unique, and the specifics of how excess equity contributions are treated can vary widely based on the agreement between the GP and LP. Clear communication and detailed documentation are key to ensuring a successful partnership.
Sources: Promote vs Carried Interest vs Catch up, Development where does the real comp come from? What made you successful?, Do you think it's justifiable to ask for 25% of the GP for being the fund raiser for the projects?, Capital partner and Developer splits, BlackRock Raising a $10-$20bn direct PE investment fund, “Long Term Private Capital”
Mind sharing your firm’s name so I know to insta delete any deals from y’all that hit my desk?
well I've seen Carlye give value for imputed equity, so maybe pass those deals to them?
Yeah turns out good deals are competitive. Imagine that.
Valuations are always at a point in time. It’s fine to mark up the land and many GP’s will do that. If the total capitalisation (total uses) is $100mm and 40% of that is equity, then the LP will fund 90% of that equity.
current value for land is negotiated between GPs and LPs. If you bought it 20 years ago and it appreciated then that counts as equity. so the gp can make money before the deal starts. this is why banks cap imputed equity in cash-out refis
I think that $20mm is GP profit that can be taken at closing since it's technically not needed in the deal, but I think you would have to be transparent as GP and say hey I'm taking money out of the deal to your LP and probably the lender at closing.
My firm does a lot with this so there are a few ways of looking at this.
Most common is that your land is your equity contribution. So if you have land that is valued at $25mm but you only need to contribute $12mm, then the LP will pay the remaining $13mm because you, the GP, have hit your max equity contribution. That is the external view between the GP and the LP.
Internally, since you bought the land at $5mm, you would have an upfront profit of (13-5) 8mm, repayment of your original $5mm purchase, and have 12mm of free equity invested. The developers would be happy to have their land paid back with upside up front while still giving them skin in the game at exit. You get payment for land up front and the sale's profit at the end. Not including any DM fees throughout.
If you don't want your profit upfront because you are called out for expensive land, then you can have a land price at completion/sale/valuation that backsolves to a set return metric, either Profit on Cost or IRR. Alt A W G that sh*t at the end.
Don't get confused between the internal and external reporting of a development. If you are marketing a project that costs $120mm all in, that's what LPs are buying. If you are marketing a project with a variable land cost, then your equity contribution needs to be calculated based on a return metric.
Easy way to think of this is if the development is in a vehicle. The vehicle needs to be funded to purchase the land. The land costs $25mm, so the GP puts in $12mm as their 10% equity, and the LP pays the rest. So now the vehicle is fully funded at $25mm to purchase the land. The Vehicle then pays the land owner, who so happens to be the GP, $25mm for the land. The GP bought the land for $5mm then funded an additional $12mm in the project, but gets $25mm back. Whether you look at that as 5 or 17mm as your cost basis, up to you, but that's how the cash flow would work in my mind. I would say total cost is 5mm because the 12mm to fund the vehicle washes out in the same month, week, or day depending on how quickly the vehicle buys the land after getting the cash.
Thank you for this and the detailed response, this is just what I was looking for.
Question on the internal view. If GP has put in $12M and the LP funds the remaining $13M of the appraised land value that essentially comes back to GP, would the LP still say that the GP has skin in the game? Or is it more likely that they would look at it as an early return of equity and that the GP is essentially out of the deal on a cash basis?
Yes there is skin in the game because the GP still has the 10% of equity in the project which needs to be return plus any profits earned pari passu. Calling it "free" equity is a bit cheeky of me because it is technically capital that the GP is entitled to and could use for a different project. You'd never give that up for free.
As for the equity returns and deal structure, that entirely depends on what cash flow and return metrics the GP is targeting. I come from a big-box logistics background where the developers are either there to collect fees or to develop to hold. If you develop to hold, you wouldn't have an LP and instead raise cash through shares, bonds, or debt, these are mostly done by reits. The second scenario, the GP is looking at a smooth cashflow because they'll want a DM Fee and promote or pari passu returns with minimal cash out. These developers range from small offices to big firms and prefer the steady cash flow for stability rather than having a massive year and the nothing. Like others have commented, if the deal is OK but not great, it is likely the GP would just sell the land at 5x and be done. Sorry to not give a straight answer but as with all things real estate, it's a deal by deal basis.
My only question on this scenario is if land increased 5X, why would ANYONE build it themselves and not just sell the land immediately? Talk about missing something here, maybe it’s just the Monday morning blues
This is what I was wondering as well when I wrote this. Based on Christophish’s response it seems like you can get both a pseudo-land sale profit from the LP and a build-out profit at sale.
Another option I think could be vending in the land at the 5x value as equity to another GP, turn into the LP, and get the distributions at the end of a build out sale. In which case you’d be giving up some IRR (probably) for a higher multiple.
I mean that's just the example for clarity's sake. I'm working on a deal where we bought unentitled land and some recent zoning changes make our project by-right, adding a decent chunk to the land value. It's not 5x, but also not enough that a straight flip would be satisfying from a returns perspective. So how do we calculate that land lift?
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