Bridging the Gap…
Trends In Equity Financing
Real estate development has always been a capital-intensive business. Developers have always attempted to use the capital they have accumulated to fund their overhead and initial project costs. They traditionally seek third party capital from “opportunity funds”, pension fund advisors, life insurance companies and individual investors to execute their development programs. Today, developers face a significant challenge in identifying and accessing consistent sources of capitol for their development programs. The sources they used in the past may be unable to provide the large amounts of capital they require as developers expand their organizations to take advantage of current opportunities. A new breed of real estate investment banker – the Real Estate Merchant Banker – is addressing this situation. Today’s real Estate Merchant Banker may invest its own capitol in a transaction and/or act as an intermediary for developers to access institutional equity capital.
Who Is Closing on Transactions?
In today’s market there are both public and private sector investors. Each sector has its own challenges in accessing capitol for new projects and opportunities or to address lingering legacy issues . Small, mid-size and large private investors have many opportunities they may not be able to take advantage of because they have a limited amount of capital and must let some opportunities fall by the wayside due to the lack of seed capital for new projects.
Many public development companies operate as REITS and must distribute most of the earnings they would otherwise use for new project development to shareholders. Both public and private firms have the infrastructure of talent and goodwill with real estate users to generate opportunities, but they require steady streams of dollars to take advantage of the opportunities they identify.
What are the Equity Sources Seeking?
The sources of equity require a high yield on their dollars and after the real estate market crash – they are seeking steady, predictable ash flow.
In the earlier phases of the current real estate cycle the potential equity sources for developers purchased loans at a discount from the government, or perhaps ventured with “asset managers” to work out troubled assets. These were the high yield opportunities in the real estate economy over the last couple of years.
The highest yields going forward will be in the in the repositioning of troubled assets and the development of new properties – as they are needed by the market.
Today, capital sources requiring the highest yields seek to generate relationships with experienced developers with strong track records, good reputations and the ability to source new opportunities and perform the value creation function.
What are Some Problems in Matching Equity Sources with Investors/Developers?
It is not easy matching the investor/developer with the right capital source. Most of the institutional capital sources seek to deploy large amounts of cash, typically $20 million or more per transaction while most transactions require far fewer dollars.
Most institutional sources have investment horizons of two to three years while many opportunities may take four or five years to realize their full value. Many institutional sources will not assume assemblage, land use or lease-up risk…keys to the early stages of a development or repositioning transaction.
Some investors/developers want to accumulate a portfolio of assets for long term appreciation and/or to provide a source of continuing fees to fund their firm’s infrastructure. Matching the developer goals with the right investor is difficult and continues to require fine-tuning as the relationship evolves over time.
Which Source Plays What Role?
Individual investors – call them real estate venture capitalist – now work with developers to assemble land, change the site’s allowable uses, prepare it for development and provide funds for pre development leasing programs. This phase may take one or two years. The venture capitalist’s involvement on the project’s front end allows the developer to present a shorter investment horizon to the institutional source. The venture capitalist may also put up deposits for the developer on a number of sites allowing the developer to generate a pipeline of deals to create the critical mass the institutional investor seeks. Once a critical mass of project(s) is (are) to the point where the risk has been reduced to the level the institutional sources feel comfortable the assuming developer should take out the venture capitalist with an institutional source.
What Does Today’s Equity Cost the Developer?
The institutional investors typically seek IRRs greater than 20% with the amount over 20% being the portion of the deal that goes to the development partner. The venture capitalist takes a greater risk than the institutional investor and generally seeks returns greater than the institutions. The investors may participate in profits as a partner or take a fixed rate of return structured as a loan. The returns and structures are as varied as the transactions. As a rule of thumb, return on cost of a commercial project should be greater than 7.5% to attract the interest of institution equity sources.
How Does a Developer Access This Capital?
A new breed of real estate investment banker – the real Estate Merchant Banker – has cropped up to provide money in the early on for new developments. These real estate entrepreneurs have the in-house funds to act as the venture capitalists and the contacts to access outside venture capitalists and institutional sources with speed and credibility.
Our firm acts in this capacity. For more information – e mail me at jim@friedonbusiness.com or call me at 305-773-6300.
