Help with reviewing an LP equity investment in a ground-up development project

The project is a ground up multi deal located in an Opportunity Zone. Developer acquired 3 parcels circa 2016 before the Opp Zone came into existence. Developer paid $4MM in aggregate purchase price back in 2016, plus whatever additional costs and carry over the past 2-3 years.

They have now have it permit ready. They attempted to sell the site 6 months ago for $10MM. No takers. They approached my firm recently to discuss whether we would JV with them since we have been looking for Opp Zone deals. They are still insistent on a $10MM land value, and want to do a low co-invest (3-4% with my firm putting up the balance). So basically they are going to make $5M or so in profit on the land, put less than $500K back into the deal, and then be the developer and GC (they have their own in house GC) to earn more fees, plus a promote on the sale in 10 years.

The developer has a good track record of building this type of product, although this project would represent the largest deal they have ever done (the typically do 50-75 unit developments, this deal would be 140 units). They have historically used high net worth investor money, never institutional because their deals were generally too small for that type of capital source.

My knee jerk reaction to the high level proposal is that the developer is trying to take as much advantage of my firm as possible. That being said, I haven't worked on a ground up deal like this in over 10 years. I am trying to reasonably determine what type of controls the LP should have, etc. The partners of my firm are fairly laid back, they aren't the type to call bullshit and have asked me to "play nice" and at least review the projections to see if the project is viable from an underwriting/cash flow perspective.

My point to them is that even though the deal may be ok, giving the developer a huge mark up on the dirt, allowing them to cash out almost all of it day one, then allowing them to develop the site and make a promote seems like a sweet heart deal for them. They are trying to play it like they have multiple groups interested and we need to act fast, which I detect is total bullshit. I asked them where they were on getting a construction loan, and they don't even have a fucking term sheet to share, which also makes me skeptical. And since they are wanting to use their in house GC, I asked about cost overruns and they replied with "we would share them pro rata based on our equity ownership"

Is it me, or should I be running as fast as I can from this deal? What is considered normal practice and what should I be going back to them with (assuming I can bullshit and respond with a fair proposal)?

 

I’ve worked on similar deals. Usually I push for “market” prices and fees. Ask to have the land appraised. If it’s really worth $10mm then ok, but I’m guessing you can show the developer they are being greedy in a polite way.

 

Thanks. Another question, regarding cost overruns. Since the developer owns their own GC firm, would it be appropriate for me to expect a GMP to be in place such that any cost overruns are borne 100% by the developer/GC and will not be an additional capital cost to the LP equity? The developer is proposing that cost overruns are to be split based on the equity ownership %, but why should ANY cost overruns be the LP's problem? Am I off base on this?

 
Most Helpful

Land--ask to see real broker-verified comps of where dirt has actually traded at their proposed valuation.

Equity--do the returns still work with $10M land? I can't imagine they bought in at $4M projecting a 150% increase. I would want them to maintain as much skin in the game as possible--this forces them into more of a fiduciary role than if they cashed out upfront.

Fees--Because they are both GC, and developer, their fee stream comes from both places. I would cap their gross fee (i.e. look at it as dev fee + GC fee) and ensure GC savings below the GMP amount is shared between the developer/GC firm and you guys 50/50. This incentivizes them to manage costs appropriately, and share in savings if they are able to manage that. Reduced project cost results in lower development fee too assuming that's a % of TDC.

Legal--Give careful consideration to your ability to remove the developer pending breach of contract. If they shit the bed, you need to be able to get them out of the deal and bring in your own substitute.

Major decision rights--you will want as much as you can get in the JVA.

Hard Cost Overruns--strongly push for developer paying 100% of hard cost overruns up to 50% of his development fee. The fact that the developer is ALSO GC in this case makes that a key issue. If it gets that bad and he blows through that 50%, then partnership pro-rata overrun contributions are standard.

Feasibility--have you checked their rent comps? Are they reliable? Unit mix look ok?

 

Good points. To add:

  1. I'd make the sponsor/developer give a completion guaranty to the lender and not have the LP fund any cost overruns especially if the dev/gc are affiliates. In the OA I'd set a baseline budget with per line SOV changes and total project cost changes subject to a cap X% or $X without members approval

  2. I came across a smilar dev few years ago, but this was for a huge mall in the middle of nowhere. Dev wanted LP money a portion of it was to take out their payments and ivnestments on the land, which we definitely denied since incentives would not be properly aligned. If they want to have negative goodwill on the land of this $5MM, I'd structure it to be a pay out after the LP's hurdles are met upon project cash flowing, definitely it should not come out of LP initially equity being funded or any debt capital, not that I'd imagine any lender would even allow $1 going to the equity before CO of the asset.

  3. Definitely in the OA have rights to remove the sponsor with cause and for bad boy acts, any indemnity given to them should have bad boy/acts of bad faith carve outs so they're not protected

 

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