I am in the process of reviewing a development project where the sponsor/developer is also a licensed GC, and therefore wants to keep that function in-house.
They are unwilling to sign a GMAX contract and will only do the work under a Cost Plus agreement, which I understand means that they get a fixed fee and whatever the bids comes in at, it sorta is what it is. From the GC's perspective, this limits the financial exposure and basically shifts any labor/materials cost spikes onto the owners (of which the developer is 15% of the equity). However, since the Developer and GC are effectively one in the same, the Developer is stating that they will also not be financially responsible for any variance in labor/materials. Basically shifting any and all cost overruns to the project, meaning either putting in more equity or trying to find a mezz/gap loan to cover the overage.
The LP's attitude is that the developer/GC is trying to skirt any responsibility for cost overruns, which LP feels should at least partially be their responsibility.
Curious how others have seen these types of issues resolved, is there an industry norm for deals where the sponsor is also the GC on the project, i.e. are GMAX contracts more common to deal with what happens when a budget goes bust?
We’ve done this format before, we don’t like it but there are ways to structure it satisfactorily. We insisted on the contract being fixed price, the contractor earned a preagreed margin on tendered packages (open book basis). The figure for the tendered packages + margin became a fixed price, if they subsequently overrun that’s on them. We also require [80]% cost certainty before commencing construction to ensure it’s bankable. Bank lenders in our market won’t fund it if there isn’t a high degree of cost certainty.
We wouldn’t accept what they’re proposing. If you paired up with a traditional developer, you’d most likely go GMAX and the developer would be ensuring the GC delivered. Here, the developer is helping the GC win business, remove key risks, and won’t be holding them accountable if they don’t deliver. When you look at the various sources of income to the developer/GC here what’s the breakdown? If they blow the budget are they still getting an attractive margin and DM fee even if they don’t get into the promote?
I’d be interested in hearing developers’ take on this and if they’ve gotten LPs on board with it.
Thank you for the reply.
The development project is somewhat unique, in that it is an Opp Zone project with a 10-year investment hold period to maximize the tax benefits to the LP. The developer/GP is not using the Opp Zone benefits, and therefore they are simply staying the deal long term to satisfy the LP's requirements. Also, due to some specific Opp Zone rules, the developer is essentially a 15% partner straight through, no promote. All cash flow and residual gets split 15/85. So in this regard, they are also conceding the standard sponsor promote when the project eventually sells.
The total hard cost budget (inclusive of GC fees, general conditions, etc) is approximately $17MM, per the developer and based on the "cost plus" assumption. The GC fee being offered by the LP is $750,000 FIXED, so from a % basis it's about 4.5% GC fee on hard costs. Developer claims this is below market, should be closer to 6-8% for GC profit and overhead combined. The "development fee" being paid is $400,000 FIXED, so about 2.5% of the hard cost. Again, developer says this is below market.
So from developer/GC perspective, they are stating they are making less than market fees, no promote, and they are STILL willing to agree to that structure, but won't agree to guarantee hard costs. If they are responsible out of pocket for budget overruns (i.e. if lumber spikes in 9 months and burns through contingency), they could potentially wipe out their fees and basically be doing the deal for little to no financial incentive. Plus, they are a 15% equity partner and have some of the at-risk capital in the deal, so of course they would also be impacted if the budget goes over and hurts their returns.
I suppose developer has some valid arguments here?
Thanks for the additional context. This sounds like a pretty crappy deal for the developer then, makes a lot of sense why they’re only going with this structure. Why isn’t a promote being offered? Is this not possible due to the opp zone rules? I’d be pretty pissed if I’m putting up 15% of the equity and earning below market fees with no way to make it back. I definitely wouldn’t accept a GMAX contract in this case.
I have done many deals with Developer-GCs and think if the GC/Developer is experienced the projects are typically less risky from a construction perspective but typically there is a GMP (gmax), completion guarantee, and often resource during construction, so the sponsor has to be pretty sure he can deliver at the agreed-upon price. I would never get involved in a project with anything less.
Someone needs to bear the overrun risk, whether it be the GC, or the Sponsor. The odd thing here is it seems the sponsor is not actually reaping the benefits that usually come with being the sponsor (promote). My first concern is alignment—what incentivizes the GP to outperform if they aren’t getting a promote? This sounds more like a fee deal for the Development Manager.
Historically, we have seen LPs require the GP bear hard cost overrun burden up to some % of their DM fee (50% seems to be the most common). That usually gets paid back to GP in the waterfall after ROC. Beyond that, the GP/LP would fund pro rata per the JVA and each would have a guarantor entity on the line for these additional contributions.
If you tell the GC to sign a GMAX, this effectively shifts all risk to the subs who are signing up to deliver contracts at a fixed price. Cost plus would actually be somewhat scary in this environment, as material prices are highly variable.
So GMAX contracts can have provisions for cost overruns on "uncontrollable" items and frankly given the nature of rising costs/inflation today, I think a lot of riders to GMPs are being added that state that price increases due to certain unforeseen circumstances will be passed along to client (clearly, this would be limited and negotiated). GMAX is never really "gmax" in the most strict, literal sense of it. Just try submitting a change order, or see what happens when they call and say "hey your architect fucked up".
In this situation, I think you should have the benefit of a gmax/completion guarantee from this developer-gc, I mean, what else is the point? If you really go with a form of cost plus, the fees and other "controllable" items of the GC should be fixed or set with maximums (i.e., they shouldn't get to tack on more GC fees because of cost overruns).
Are they saying certain pricing is not lockable at the moment, and that is why they wont sign a GMP? Not sure why this makes sense in their eyes.
To that end, if the developer has zero exposure to cost overruns, then are they really just fee developers (as others ask above)? If you go with such a "no risk" deal, I would limit them to basic fee + small promote (with high hurdle).. or just pass.
To your point, the GC is not getting any incremental fees if the hard costs spike. They are fixed in terms of what they are receiving as their fees. Also, the plans for the project are only 70% complete. The expected groundbreaking is still 6 months away, another reason why developer is stating they cannot in full confidence nail down hard cost pricing. The LP is on a time deadline to invest due to the Opp Zone rules, so basically they are putting money into a project that is still not fully baked. Yes they are asking developer to commit to a budget as part of the JV agreement, which seems a tad premature?
So this added detail makes it all more logical. Since you are only 70% docs, and not on clear path NOC, the GC can't reasonably lock prices and buy out the subs. So, they really couldn't offer you a GMP right now. In fairness, this sounds like a smart/fair up front admission. They could give you a GMP with lots of terms/conditions that would stick you with the overruns anyway, plus the change orders and other design issues by locking with only 70% docs could be horrendous (you would be in cost plus land governed by a GMP de facto).
Since the LP is on the timeline, they need to commit with some risk on their end. This is what sucks about all these gov't programs, force bad investment decisions to make a good tax decision (1031 buyers are equally fucked in this regard, and well known as a class of buyer that overpays).
The real questions then are 1. how good is deal period (like if costs escalates, is that okay?) 2. is this devco-gc combo good at this product type for both development AND construction. If the answer is yes to both, and especially the latter... then you can be reasonable at the risk (not sure a good idea, but I get it). If this GC isn't really good at this type of construction (like done many, and recently, and in this market), I would be hesitant as their "guesstimates" at this stage will be further off. If it is in their wheelhouse, then they can probably make reasonable assumptions, and the real risk are like lumber prices exploding and stuff like that (like legit market moves).
Good luck with this one!
Honestly, I've done this in the past, I try to increase their equity to the 25%-50% range so that there is some sort of alignment and they bleed when you do..in that case the "cost plus basis" is OK. We usually cap dev and/or GC fee at construction start number with a cost consultant stamping the numbers..Below 15%, I'd think it's too low ..you can always set up an option with a maximum price once the project reach X% of confirmed costs..
I'm currently on the LP side..used to be on the GP dev/gc side..the returns including fees (and cost margins) are crazy/huge..
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