Merchant build vs long term hold

Curious about these two models of development - what are the pros and cons of each approach?  Why would a developer pursue one vs the other? Would you say there are more merchant builders out there vs long term holders?  What type of company would you rather work for as a development employee? 

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Feb 15, 2021 - 2:11am

This is a great question. 


Pros of Merchant building:

1. You can make a lot more money in a relatively shorter period of time and you recoup your initial investment as well and redeploy your capital into the next project. Let's say for example you buy a parcel of land for $500k, spend $500k to build it and then sell it for $2mm in 1 year. You make $1mm and also recoup whatever equity you put into the deal initially. You can then quickly use that capital to look for new projects. Merchant building is a good strategy if you are a "real estate start up" with limited funds because it allows you to redeploy capital quickly and if you are successful, then you can grow your capital quickly by doing many projects. Now you might ask why doesn't the developer just refi and pull out equity, well you really need a home run deal in order for the As-Complete, newly developed property's valuation to be high enough that 75%-80% of the as-complete value is enough to not only pay down the construction loan, but also have enough remaining to pull out equity and even if the valuation is high enough, you'll never be able to pull out more equity than if you sold (unless the appraised value was significantly different from actuals, in which case the appraiser fucked up)

2. Don't need property management

Cons of Merchant building:

1. During acquisitions, you are likely at a disadvantage in terms of how much you can pay compared to other developers who are buying to hold. If you are a merchant builder, there is probably a certain return or nominal profit that you want to hit in order to make all the risk and work worth it. Developers/investors who are looking to rent and hold for the long run usually have more lax risk-return needs. If the goal of a "buy and hold developer" is just to hit a certain cash-on-cash return and to take advantage of future rent growth/appreciation and claim depreciation etc... then in 9/10 scenarios, the buy and hold developer can afford to pay more. 

2.) Taxes. Merchant builders are taxed at ordinary income. Buy and hold are taxed at capital gains if the property is held for longer than a year before selling. You also miss out on other benefits like claiming depreciation

3.) This 3rd one is probably the biggest Con and it is the instability and volatility of cash flow. You do NOT make a penny until you sell. Think about this for a second. When you work for a receive a reliable pay check bi-monthly so that you can pay the bills etc...Merchant builders do not see any positive cash flow until they sell (now if you have a good lender, they may be willing to finance your salary as part of the construction loan, but still..your ability to pay back the loan is dependent on you selling (not totally true because if shit hits the fan and you can't sell for the price you wanted, you can probably ask the lender to convert the loan to perm financing and then rent the property..but still...)). 1 project may take you over a year to construct and sell. 

Why would a developer choose one vs the other?

To be honest, most successful merchant builders probably have some rental properties because they understand the instability of cash flow of a pure merchant development model and don't like it. If someone were a pure merchant builder, the only reason I can think of is that they are small/new and can only afford to own 1-2 properties at a time and they really need to roll their capital into other projects asap. And now that I think about it, probably the main reason for merchant vs buy and hold strategy is how much capital you have at your disposal. If you don't have much then you merchant build. But if you have deep pockets or are backed by someone with deep pockets, then you probably want to buy and hold because your goal is to maximize return on each dollar. For example, if you had $100mm to deploy and you find a project where you only need to invest $1mm, but you can make $3mm at sale. That's a good deal, but wtf do you do with the extra $3mm? It's difficult enough to allocate the initial $100mm to good investments and now you need to allocate an extra $3mm. Maybe its better to rent the property instead and generate a decent cash on cash return on the $1mm and then move on to deploy the other $99mm. This is why a lot of REITs buy and hold and are low leveraged because 1.) they have a shit ton of capital and 2.) merchant building is terrible for their stock price. Could you imagine for a REIT if for 2 years they report $0 net income to investors and then $100mm the 3rd year and then $0 again?


More Merchant Builders or Buy & Hold

There are by FAR less merchant builders than buy and hold. There are higher barriers to entry to becoming a merchant builder. Any one with capital or the means to raise capital can invest in real estate and hold it. Very few people have the development/construction knowledge/means to merchant build. Also there are a lot less projects where merchant building works financially.


Which would I rather work for?

Any merchant builder that is big enough to hire you, I guarantee has a decent pool of properties they hold for passive income. So the real question is would you want to work for a company (such as a REIT) that only buys and holds and basically never sells. And to be honest, who cares. The strategy of buying and holding or selling is not meaningfully different. Both firms can do the hard part ie target a site, acquire it, finance it, entitle it, construct it (and thats what you really want to learn) whether you hire a real estate brokerage firm to lease it up or sell it is not rocket science. 

Feb 15, 2021 - 10:09am

Fred Fredburger

You do NOT make a penny until you sell. Think about this for a second. When you work for a receive a reliable pay check bi-monthly so that you can pay the bills etc...Merchant builders do not see any positive cash flow until they sell (now if you have a good lender, they may be willing to finance your salary as part of the construction loan, but still..your ability to pay back the loan is dependent on you selling (not totally true because if shit hits the fan and you can't sell for the price you wanted, you can probably ask the lender to convert the loan to perm financing and then rent the property..but still...)). 1 project may take you over a year to construct and sell. 

I want to counter this with fees - development fees, construction fees, asset management fees, etc. 

You earn fees during development, which is what you use to pay your bills. 

Commercial Real Estate Developer

  • 1
Feb 15, 2021 - 10:34am

Fair enough, but it also depends on your lender and if you have an equity backer. Some lenders don't allow for development fees/construction fees if it's going straight into the developer's pocket. Also if fees are allowed, the other issue is at one point in construction are you allowed to draw it. Currently working on a project where I can't draw the construction/development fee until construction is complete.

Feb 15, 2021 - 11:11am

This is a good answer but I think there are some additional concerns you miss.

Some of it is dependent on sub-asset class.  If you build condominiums, you are by definition a merchant builder.  Sometimes it depends on the personality of the principals at the firm.  I know some smaller shops where the folks are deal junkies.  They want to do a bunch of deals, and do them by themselves.  They aren't interested in running a 50 person company with asset/property management, and just all the ancillary staff that comes with it.  At some point, growth means delegating additional tasks to subordinate while you take on a role that doesn't touch the RE portion of the business as often.  Or maybe you don't believe in a market, or you think you're at the top of a bubble.  Lots of other reasons come into play beyond availability of capital.

Feb 16, 2021 - 1:16pm

A few points:

1. Even merchant builders need to have some AM, you won't just sell an empty building, few buyers are looking to take on leasing risk, so you have some AM for 1-2 years until stabilization. 

2. Successful merchant builders don't necessarily rely on rental properties for stable cash flows, they rely on multiple projects at different phases to generate fees. 

3. REITs obviously have a very different investment philosophy, they have shareholders they are beholden to and have to either pay out or deploy their income, they don't have the option of sitting on dry powder. You can have large developers who have cash waiting for the right opportunities, keep the lights on with fees (see above), and let the promote provide their real returns (however lumpy they are). A smaller merchant will just have to accept the lumpiness, a larger one will space our their developments that effectively smooth it. A lot of real estate investors are OK with that type of return, think about normal LP funds, you lock up your cash for 5-7 years in the hopes of a solid IRR and EM over that time. 

Feb 15, 2021 - 6:58am

Good comment above. One additional benefit of buy and hold is that it makes the company better at development. If you have a portfolio of rental properties you're getting accurate, real-time information about rents and expenses that helps you better model new deals. And you develop a fine-grained understanding of the subtleties of tenant behavior and management logistics that allows you to design new properties more efficiently.

Feb 15, 2021 - 7:54am

Good comments above. I think the way to go would be start off as a merchant trader and as you get more track record/cash then aim to re-finance and hold as opposed to always selling.

End goal should be to position yourself so that you don't have to do any deals that aren't no brainers and it is much easier to be more disciplined and patient on that front if you have regular income.

Far better to grow slowly and only go for knockout deals.

Feb 15, 2021 - 9:23am

I would point out that the choice of holding period has a lot to do with how the firm is capitalized. Some essentially need to sell in order to redraw equity and lending capacity. Meaning, all else equal, "merchant" builders can do "more" deals (assuming a fixed sum of capital). Portfolio developers (like REITs who do development), have different intentions due to their capital structure. 

Clearly, the potential value creation from the "merchant" build is substantially higher than a long-term hold, so even those firms tend to "recapitalize" one way or another. 

Like a lot of things that get asked on WSO, there is a tendency to confuse business strategy (or deal type/mode) with firm type. A developer that looks like a "buy and holder" may recapitalize substantially in ways that basically make them equal to a merchant strategy. Plus, these decisions are independent (i.e. build then sell or hold). So, to premise that final disposition strategy will change your life working for a firm, is a minimally useful concept. Firms can do both, switch strategies, or just change as market factors change. Really not a dimension I would consider from the career front. 

  • Analyst 2 in RE - Comm
Feb 15, 2021 - 10:48am

So if you're looking at positions starting would you say that most major merchant builders have larger deal flow due to their business strategy?

Feb 15, 2021 - 2:05pm

No way to generalize that. How "active" a developer is dependent on so many factors it would be impossible to make generalizations. Plus, this can ebb and flow year to year anyway. That said, so called "merchant builders" (btw that term could be considered derogatory so use it sparingly when talking in public or on interviews), may be in need of development fees to keep paying firm expenses (including your salary), so that tends to keep the pressure up. Firms with operating portfolios potentially have more diverse revenue streams that fluctuate less by market cycle (the inverse of this is exposed to risk of problems in an aging portfolio, so not really a free lunch). 

Bottom line, this is the wrong way to attempt to characterize or measure development firms. Not very useful. 

Feb 17, 2021 - 12:07pm

All good points above. I'd add that it doesn't have to be either or. For example, you go into a deal 80/20 with an investor and come completion, the investor buys you out to reflect an ownership of 95/5. That way you as a developer get a piece of the holding income but also get some money to run off onto your next project with (or lavish your employees with bonuses...)

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