I’m in the process of leaving my development REIT position to join some guys who are starting a new development company - my dream. My issue is that one of the two other parties will also be the GC. I see this as a positive because of the efficiencies he can bring and his CRE building experience. However, at my REIT we would never work with a sponsor who is also the GC because of the potential conflicts of interest (all of which I think can be mitigated). What’s your experience with this? How do other institutional guys look at this issue and will it impede us getting institutional funds (or funds from other sources as well)?
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There are a bunch of considerations with a self-performing sponsor arrangement, but here are a couple of thoughts (by no means is this a full list):
In my experience, these self-performing arrangements usually are done through lump-sum contracts which could potentially serve as a big profit generator for GCs as they keep the difference between actual costs incurred and the price of the lump-sum contract. Often time, the sponsor/GC will not provide visibility into these contracts to their LPs/lenders. From the lens of an LP, this could create a misalignment of interests as the sponsor might just want to have a project built, so they can generate GC profits/developer fees/management fees (upon delivery), with a free option to capture promote if the project is successful and performs well. It also might lead to the sponsor/GC's questionable value-engineering (they might use cheap materials that impacts the end-product) for cost savings, so their GC operation profits more. From a lender's point of view, they care to the extent that there needs to be a method in which they can receive proof of no liens on the property before advancing funds (which could potentially be solved by having the GC provide a backstop assuming they have an adequate balance sheet) and that the sponsor/GC is not building a lesser quality product for cost savings (as it will tarnish the lender's collateral).
On a positive note, this arrangement helps mitigate cost overrun risk, as the sponsor is hyper-incentivized to keep costs to an absolute minimum.
Wow, awesome reply, thank you. You bring up some great issues the lender/LP will have. Are these surmountable in your opinion in any way or would a new development company (with individual trackrecords but not company records) have too much to overcome for a potential finance partner to want to touch us? Like, would it help enough if he had a minority stake and the senior developer called all the shots about everything?
There is a pretty easy way to avoid this conflict. 1) Bid the job competitively so that your LPs can get insight as to what third party contractors would offer to build the job, also on a lump sum basis; and 2) Utilize a performance spec for those trade items/materials with which you are concerned about workmanship quality. For example, you may provide a design narrative stating that a window needs to comply with a certain u-value, thickness, manufacturing location, and shade coefficient. This forces the contractor to meet your specifications on performance where concerned.
As long as the fees are in line with market and the contract outlines performance and schedule requirements, I don't see how you can't easily mitigate the conflict of interest question.
I think your group needs to determine its core competency. If you guys create the most value through managing the development process then you guys need to focus on that rather than having a third of your human capital focused on managing subs and the construction process. There is a reason that most sponsors do not have an in house GC. It doesn’t mean that he couldn’t be the go-to in house guy that works directly with the GC.
In theory that makes sense but for us he also brings the best CRE track record and largest balance sheet. So we need him, but not if it will impede our ability to get funded.
I'm not sure how you're structuring internal agreements with your GC being part of your development team, but check out AIA contract agreement A133– 2009 Standard Form of Agreement Between Owner and Construction Manager as Constructor where the basis of payment is the Cost of the Work Plus a Fee with a Guaranteed Maximum Price. This could potentially alleviate any transparency issues that may come into question from your funding sources. Not sure your GC guy will like it because it opens his ledger up to everyone.
https://www.aiacontracts.org/contract-documents/19916-owner-constructio…
Also, I do know a midsize developer that owns a construction company, but I have no idea how that is structured. The construction company runs under a completely different name. Projects are typically bid out, and their construction arm does not always win the work even if they helped with some pre-construction stuff.
Thank you, that document is helpful for transparency. I guess there must be some important reason that developer you know keeps their GC separate.
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