“The wise man knows exactly what value should be put upon everything.” — Seneca
Over my 15 years to date of structuring real estate development deals, I’ve screwed up many a deal. I’ve left money on the table. I’ve shouldered too much risk. But luckily, on close to 100 projects I’ve sponsored, I’ve only ever lost money one one. The rest have performed well, and a good many surprisingly well (listen to my story in Episode 57).
What has been the single biggest improvement I’ve made in how I structure my deals? I’ve started thinking of the deal components as separate “Value Buckets.” As a result, I have a much easier job identifying an equitable deal for everyone and easily selling it to my investors.
Value Buckets in a Nutshell
To use value buckets, think of deal structuring as an accountant would. Each deal is a new company in a sense, and that company will have assets, liabilities, and equity that each of the parties to the deal should value at some notion of fair market value. This sounds basic, like a foregone conclusion, but many people miss this point. And when they start thinking of projects through Value Buckets, what seemed like a reasonable deal may no longer be.
Most Common Value Buckets
The developer finds, organizes, and sponsors the deal. He arranges all capital and oversees professionals such as accountants, lawyers, etc. The time, effort, and expertise in this role needs to be considered and compensated, usually as a percentage of back-end profits in the home building business. My company receives 50% of the back-end profits in exchange for this role.
Home builders often plays the role of developer and general contractor in a speculative deal, which is why it’s important to distinguish these. A home builder needs to understand what his profit would be on this project if, hypothetically, it was a simple fee-based project for a client. Why? Because the additional roles the builder is playing in a speculative project, plus the risk, should result in a higher projected income to the builder versus a project for a client.
I establish up front a fee between 7-8% of a deal’s projected sale price, depending on the size and complexity of the project. This fee is paid out to my company with the construction draws from the bank. This fee covers my company’s overhead in the deal but not my general contractor profit, which I defer to the end so that my investors and I are better aligned.
The back-end profits I’m expecting to receive should be enough to account for both my role as general contractor and separately as developer. If the projected profits aren’t sufficient in that sense, I either restructure the deal or pass on it.
The investor may be putting up all the cost of a deal, or if financing is involved, the portion of equity that sits behind the debt in the capital stack. The investor obviously needs to get compensated for the risk they are taking with their investment. Our development projects are far less liquid and less diversified than one can achieve in the stock market, which means we should be paying a premium to investors over typical stock market returns for the added risk profile of our projects.
Beyond that, there are a lot of other factors that determine what a fair return is for your investor. If you are a brand new builder, you represent more risk than someone with decades of experience. You need to be offering a little higher return. Or vice versa.
I structure my deals with investors like this: first, I offer an 8% simple annual preferred return on their investment to account for the opportunity cost of capital. Then, I split profits with them, usually 50/50. This profit split bucket represents their return for the extra risks I mentioned above.
If you notice both with my fee I charge the project and the preferred return I offer investors, I’m structuring the deals such that we try to value and cover our respective costs first, and then profits we split on top of those costs should be a more accurate representation of profitability.
If I see newbies make one mistake, they fail to account for the true cost of their overhead in the deal and they end up having to pay for it with their supposed profit split at the end. I made this mistake for my first several years.
Banks usually get the credit enhancement they need via personal loan guarantees. While this value bucket often gets blurred into others, it’s necessary to break it out for a clean view of the landscape. Some deal sponsors offer additional profits for the people who assume this risk, while some offer flat fees based on the loan amount.
I ask all our partners to guarantee the loans we obtain, including myself. This way we spread the risk. I compensate my investors for this additional risk they assume via higher targeted returns. In other words, most of the projects I sponsor target IRR’s in the low 20% or higher. If I wasn’t asking for loan guarantee support from my investors, I believe the high teens would be a fair return to target for them. And I would accomplish that by shifting the profit splits whatever amount necessary to keep the target returns in that range.
Other Imputed Equity
Sometimes we have a land seller who wants to sell us the land and roll in a portion of the price as investment in the deal. Or we have a broker, architect, or engineer that wants to do the same. This gets messy, so the best way to think about it is to always determine a fair market value for the land or service or whatever is being invested, assuming they would be getting their money up front per usual terms. Then, the amount from that value that they want to defer or invest into the project can be considered and adjusted to reflect for the value they are providing by imputing or “investing” that money into the project. And remember, if they are deferring that amount it should probably receive some return in exchange.
Those are the typical value buckets as I see them. They are just a general framework and can always be amended as necessary. Seeing the individual components of a deal, the assets and liabilities as I mentioned in the beginning, helps create a much clearer baseline from which to structure and negotiate.
What you decide is fair is between you and your investor, but having these value buckets and general reference points of fair market value for each one will take you 90% of the way.