What types of companies provide capital to devlopers
I'm planning to go back for an MBA with a concentration in real estate.
I have no real estate experience, but it's what I've always wanted to do and I'm ultimately interested in starting my own development company. I would like when I graduate to get a few years experience working with a developer to learn how they do deals.
Before working for a developer, however, I'd like to get an internship or have a short stint at the type of company that provides capital for the deals. Reason being, I want to see how the capital side sees these deals which will help when I want to start doing my own projects.
Not sure what types of companies I should be targeting though.
Here's the question:
what types of companies work most closely with developers to finance projects? I'm thinking that it's primarily banks/ repe funds / insurance funds. Any other categories? And then what specific companies in these categories would see the most/most interesting deal flow?
i'm thinking that i wouldnt want the REIB groups at the banks because they don't see the asset/project level, right? Or do they/some?
Also not sure where the capital markets groups (or other groups) at a CW/JLL fit into this scenario.
Would appreciate some insight on the general "structure" of the industry.
thanks
until someone more qualified steps in i'll throw in my observations:
there are 2 ways developers are compensated - 1) fee basis, paid by the investor (no equity stake) and 2) and equity stake, usually in the form of a JV with a funding source / investment company.
as for the second type, if its a large development company, they may fund the projects entirely by themselves depending on cost. however i think most end up with the minority stake (like the 5% piece of 95 / 5 split for initial contribution) in a joint venture that could possibly include a waterfall / promote.
generally the large equity partners in these deals are going to be real estate investment firms (REPE / REITs / institutional asset managers) or non-real estate corporations who hire RE firms on a one-off basis to act as their fiduciary. in this case, since the developers equity contribution is relatively small, they may just have their own fundraising with individual investors
NealCaffrey is basically on point with his answer. A common scenario I've seen is where a developer will get a development site under contract and might even close on the purchase using its own equity and start pursuing entitlements. Somewhere between tying up the site and launching vertical development, the developer will seek institutional capital. Many developers have a go-to capital partner they have done deals with in the past that will be the logical money. As NealCaffrey said, the capital partner will probably pony up 90%+ of the equity. Together, the equity partners will usually seek a construction loan to fund much of the development cost.
The most logical capital partners for developers are RE PE opportunity funds. Most development capital is going to want a high teens to twenties IRR. Lifecos, institutional managers, etc., are typically looking for more stabilized core product and not development deals. Some pensions have in the past tried to bypass putting money into RE PE funds and give money to developers directly, but that hasn't really worked out so well for them (think CalPERS).
RE IB firms do some asset-level work, but you're right, it's mostly REIT work. Eastdil is a sort of hybrid between an investment bank and a traditional commercial real estate broker, and most of what they do is asset-level capital markets stuff. The asset level brokers like Eastdil/CBRE/CW/JLL are sometimes involved in selling or placing equity capital with development projects. On the debt placement side as well, they certainly get involved in the financing of dev projects.
Thank you re-ib-ny for another amazing post! You mentioned IRR. What are the ideal ranges of IRR for both office and retail properties nowadays?
I am very eager to learn about the topics. It is quiet identical and effective may be. Need special attention.
Thanks for the replies, some solid info and i have a few follow-ups....
I'm most interested in learning about the developer JV type deals. Are the REPE opportunity funds the only ones putting money in development JVs now? Sounds like most of the REITS/Asset Managers/Insurance Funds ect are sitting out the development deals. Anyone else that may be JVing with developers?
Then once the equity is raised what types of firms provide the construction financing? Are the REITS/Insurance/Instutitions still on the sidelines here? What banks/brokers (other than those mentioned) step in to arrange/provide the construction financing?
i can't really speak to the debt financing in detail but i know for a fact that institutional investors are developing a good amount. a lot of times it's pretty split between whether they want a JV or a fee developer. could depend on the market or past history with certain developers
Neal: thanks for the insight. what types of companies are you calling institutional investors? Are you talking about groups like : PREI, Metlife, CALPERS, Endowments, REITS, ect, that I've summarized above? Or are there more players that you're talking about that I'm missing?
re-ib-ny: can you comment on the debt side of this (part 2 of my question above)?
It sounds like everyone is on point above. In case anyone is interested in how it works in China... my experience working here for the last few years at a opportunistic repe fund has primarily been centered around trying to partner with developers on greenfield developments, whether that be on a project by project basis or through corporate investment in a development company, so I have an idea of the landscape. It's quite different. The developers have a lot more money, and the leverage comes a lot less from banks and a more from pre-sales financing, which is advanced payment (by homebuyers) for apartments. Even larger, mixed-use projects will typically be phased so that the frames of the apartment component are built first (concrete shells, essentially). Once these shells are finished, the apartments can be sold for full price (despite the fact units aren't delivered for another year or two), so then the developer can use that money to finish construction on those units and start construction on the other property types... sometimes retail can be pre-sold this way too... so what you've got in China is that equity often takes up only 30% of the capital structure, but debt also only takes up another 20%... the remaining 50% comes from pre-payments.
Do you see a lot of pre-sales and strata-titles among Class A Office buildings (and retail) nowadays? I think it would add complexity for Asset Management and be a nightmare for redevelopment, refurbishment and major works/change of use.
I wonder whether countries that have a lot of strata-titled commercial buildings do so because of having less developed project financing (debt) markets for real estate projects, or if it is a function of a lack of institutional (i.e. pension fund, REIT, Insurance co, Trusts) ownership of built real estate to provide exit opportunities for developers. Maybe its a mix of both.
Alternative structures from the boom times:
In terms of development financing during the boom times in the US, you had mezz funds, the real estate debt arms of pension funds and insurance companies and those types of investors fill the gap from the 60-65% LTC construction financing (provided by banks generally) up to as high as 80%+ LTC with the developer / equity covering the balance. This is a very different situation from today. Another type of deal structure that I've seen in the UK in better times was securing financing based on a pre-let office building development, e.g. you get a pharmaceutical company to agree to sign a lease with you for the office space that you're developing, you find a bank that would lend you part of the funds to develop the project based on that security. Another variation is where you have agreed to sell the completed and leased building to an insurance company once complete at a pre-agreed cap rate/price. The bank can better underwrite this risk. Again, this was during better/ more aggressive lending times.
I think this is one of the things that makes real estate in developed markets interesting. Depending on the stage in the cycle some players are more active that others in a particular part of the capital structure. There is opportunity for people who are entrepreneurial enough and reputable enough to navigate this. This is before you even consider what people can do with the actual assets/buildings.
Awesome explanation! This is very much like the condo-hotel model that was so popular in the U.S during the bubble but has been virtually dead since.
In light of the apparent cooling down of the real estate market in China, do you think a model like this that heavily relies on pre-payments would run into troubles? Already we are hearing anecdotal stories about people putting down the down payments on not yet finished new apartment only to find out that they are already 30% under water before they can even move in. This is sparking riots and demands for refunds in many locales.
The concept of pre-payment is very much predicated upon the assumption that apartment prices will continue to rise indefinitely, at least in the near future. If the market cools down then the urgency to pay upfront also disappears. So how will the developers make up for the 50% pre-sales if the buyers are no longer there to foot the bills for them?
On the debt side you'll mostly see construction financing from banks and debt funds. Banks are your obvious choice if you are doing a deal in a core market with relatively straightforward execution, as they'll provide the best terms. Generally they'll underwrite to a ~60-65% loan to cost ratio, a target stabilized debt yield, and will want a recourse completion guaranty from the developer. Hairier deals or higher leverage deals will have to be financed by a debt fund, which gets more expensive. It's too hard to securitize development deals, so you're not likely to see CMBS shops play here.
Note that while REITs will sometimes engage in development to build and hold when property markets heat up and assets sell above replacement cost, you'll almost never see REITs put up the equity as the capital partner in a short-term JV with a developer (except for the few REITs that operate side pulls of quasi-PE money, which most REITs who had them have been scaling down in recent years). REITs are designed (from a tax perspective) to pass on operating cash flow from the ownership of property, and don't get the same benefit from developing and selling for a gain on sale. It's also difficult for public markets to value that business model.
I was specifically referring to the large institutional non-REITs. REITs might develop too but as re-ib-ny said, they typically are more interested in cash flow and not capital gains due to their purpose (dividends) and special tax status.
Also, as others have said, in order for these firms and funds to get involved in development, it is usually infill urban markets in gateway cities with strong demand. You're not going to find PREI developing spec office in a tertiary market any time soon. Also, regardless of the strategy, when the development pipeline gets too big in certain markets (like multifamily is in some major markets) you will see everyone scaling back development as to avoid oversupply, which could kill your project before you even hit the punchlist.
This brings up another interesting point about how fee structure will affect these types of decisions. If you're an opportunity fund you might be charging 1.5% management and 20% profit over some hurdle. You're getting a huge piece from the reversion so your incentive is to develop, stabilize, sell, rinse and repeat. This way you can capture as much value from the capital gains as possible, which is what your investors will want as well.
If you are a core / value-add fund at an institutional shop, you might only have a few hundred basis points of management fee for compensation, in which case you want to develop and hold to capture the AUM fees. In this case your investors are most likely seeking income rather than appreciation so this model aligns your interests.
awesome forum thread
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Everything said is spot on. Skin in game developers generally like putting in as little equity as possible or simply contributing the land if previously acquired/banked so you'll see a lot of REPE shops pursuing 90/10 / 80/20 structures providing the majority of the cash equity leverage. Developers are more interested in the fees and promote they could earn to pull off outrageous returns if the deal pans out. There's also fee developers who simply do the job, earn a fee and perhaps lock in a promote - this includes build-to-suit guys. From what i've seen REPEs including lifeco investment arms are chasing only multifamily urban infill type stuff and some industrial on ground-up side. Anything that diverts from that and you're looking at family office, hnw/friends and family type equity at the moment. Lots of larger funds and REITs just team up with reputable development companies.
On construction loan side as mentioned above and you have your traditional players Wells, BofA, PNC, BB&T, and other regionals etc. maxing out at 65% ltv and some of the more aggressive ones stretching into the 70's. Rates are primarily floating LIBOR
The arena was obviously a lot bigger back in the heyday and the word construction still makes a lot of past participants quiver, but they're tip-toeing back in the game starting off in the best areas/product classes as acquisitions begin to not pencil out for them.
This is a great discussion, thanks everyone for commenting.
I'm actually most interested in doing urban infill multifamily/mixed use projects, fwiw.
Sounds like most of the equity funds have a network of developer contacts that they regularly work with or work only with established developers. Do any of the funds partner with new developers?
Every long-standing partnership had a first deal. Once.
^you do see a lot of strata title sales of solid quality office in China these days (though not the best of the best in Beijing/Shanghai). It's for many of the reasons you mentioned - i.e. the lack of institutional buyers, all kinds of weird constraints on PE firms buying completed assets, etc... In terms of shopping malls / major commercial centers you'll see single owners more often because it's so important for the property management to be unified, etc, but there is a huge amount of service-retail on the bottom of residential/office buildings that's sold off stata title.. for a 3m sq ft development comprised of 60% residential and various other property types, you might have 300k sq ft strata title retail... and that retail space often sells quickly and at excellent margin. Some of that has to do with government restriction on individual apartment purchases for investment reasons (you can't buy a 3rd home in China right now if you already own two, essentially), some of it has to do with rising consumer spending and the advantages of holding retail within residential projects in China (there's a ton of traffic/congestion, so people don't travel far to buy things when they've got a shop downstairs)
One thing to note on here, as well, is that the equity will cost substantially more to do a development deal. For example, if you can get a const. loan at 5% from a bank, life co, etc., this will generally only cover around 50-65% of the costs. Most developers can't handle the remaining 50-35% in equity, so they go out to these equity guys above to fill the gap. This money will cost a lot more and be a lot riskier... 7-12% pref rates.
This is important to remember if you are trying to eventually model your own developments. ESPECIALLY if you are trying to start your own firm in the future and will be going to these company's as a complete unknown.
In real estate, I think distinctions in IRR targets are more pronounced across investor group rather than by property type. You have core investors (REITs, pensions, lifecos) that are looking for stable, fully-leased properties in high-barrier markets with minimal deferred maintenance or capital needs. Historically, these investors have sought returns in the 6-12%, but since real estate is often thought of as an alternative to fixed income, a low interest rate environment like what we have today pushes down on that return expectation.
Value-add and opportunistic investors (I will kind of lump them together, since the distinctions are not really well defined) look for higher return opportunities. Historically one would say a value-add investor wanted 12-16% (low teens), and an opportunistic investor wanted high teens and twenties. As core returns have gotten compressed, though, most would say higher return strategy targets have as well.
Private equity funds that pursue higher return strategies are flexible and usually play in whatever sector they think will hit their hurdle, but REITs and core investors will often specialize in a given sector so you can sometimes see a difference in their target returns. Generally speaking, apartments are seen as the least risky asset with the lowest return target, and hotels have the highest expected returns. People debate where industrial, office, and retail shake out relative to each other. Some say malls are more resilient to downturns because the in-line tenants are smaller; others say the credit quality of the tenants is weaker and the mall model is dying. For what it's worth, Green Street Research today suggests that the implied target IRR for core mall investments is 7.7% today, strip centers are at 7.2%, and office is at 6.5%.
100% agree. I've seen REPE investing in emerging markets has a hurdle rate of >20%, but some pension fund manager told me that they are happy with 8% which nearly made my jaw drop. Now I know why. Again, applaud for your awesome posts!
Remember, target returns are ex-ante, its what you need to demonstrate to get people to write you a cheque. what actually materialises can be materially different.
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