Fundamental Skills for Real Estate Development Professionals II – Structuring the Deal to be Profitable (Tennyson Williams) - ULI Fall Meeting 102611

STRUCTURING THE DEAL

Real Estate Development Workshop:
Fundamental Skills for Real Estate Development Professionals II

Structuring the Deal
Wednesday, october 26, 2011
3:00 pm – 4:00 pm

Presented by TENNYSON WILLIAMS

1

Agenda
I. Deal/Project Analytics
– Front Door/Back Door Analysis

II. Deal Structuring To Control The Dirt
– Purchase Agreements, Option Agreements,
ROFRs, Joint Ventures, Seller Financing, Lease-
Purchase Options,

III. Deal Structuring To Attract Equity Capital
– Preferred Returns, Promotes, Waterfall
Distributions, Language & Terms
Structuring The Deal Presented by Tennyson Williams 2

Project Mini-Pipeline
(Project Could be derailed at any point during the process)

Land For
Development Land
Control/Acquisition

File Rezoning Application
Order Environmental/Soils
Start Marketing
Capital raising

Cost Feasible Re-Zoning Feasibility Not
Rents Not Outcome Determined
Realized

Completions,
Profitability

Permits Capital
Raising

HIERARCHY OF PAYOUTS

Profits/Return

Labor/Materials

LAND

Basic Development Profit Formula

Dev Profit =
___ -
NOI
All-In Cost
R

C-O-C =
_____
NOI
(Unlevered)
All-In Cost

I. Deal/Project Analytics
• Back Door Analysis
– Holds pro forma rent constant &
solves for max land cost
necessary to achieve a target
cash-on-cost return

• Front Door Analysis
– Holds development cost constant
& solves for minimum rent
necessary to achieve target cash-
on-cost return


Development Analysis
University Shopping Center
(Atlanta, GA)

• Land size: 3.6 acres zoned C-1 General Retail
• Land Cost: $1,000,000 per acre (There are 43,560 sf in 1 acre)
• Maximum City Allowable FAR = .2958
• Acme General Contractors has submitted a Guaranteed contract proposal for
construction for $76.50psf (hard costs) + $13.50 psf (soft costs) = $90 combined.
• Anchor Tenant’s preferred prototype building size is 14,797 square feet.
• Recent market survey of Tenant Leases suggests the following Structures:
– $8.25 psf NNNN for anchor space (cotenancy restrictions) fixed rent for 25 years
– $20.00 psf NNNN for non-anchor space with 3%/yr inc.
• Local Market Vacancy reports suggest stabilized rate of 7.0% NON-ANCHOR ONLY.
OperExps/psf: Taxes $2.00, Insurance $.25, CAM $3.00, M-Fee $.50
• Investor market appears to support cap rates ranging from 7.5% to 8.0%.

• QUESTIONS : Assuming a sale of the newly completed asset upon reaching 93% occupancy,
(1) Expected development profit range? $936,719 to $1,517,484
(2) Estimated Cash-On-Cost Return (C-O-C) and Spread? 8.96%, 94 To 146 bps
(3) Max land cost assuming a 10% required C-O-C? $776,229 per acre
(4) Required Non-Anchor Rent Constant to earn a 10% C-O-C $22.31 p.s.f.

NP
7

Shopping Center Mini-Case Solution
(1) Profit Range, (2) C-O-C and Cap Rate Spread
• Step 1: Determine Maximum Allowable Building Size
– 43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = (Max Building size)
43,560 s.f. X 3.6 Acres = 156,816 X FAR @ .2958 = 46,386 square feet

Step 2: Determine Total Project Development Cost
– Land Cost 3.6 acres X $1,000,000 = $3,600,000
– Construction Cost @ $90 psf (hard & soft) X 46,386 square feet = $4,174,756
– ALL IN DEVELOPMENT COST $7,774,756
Step 3: Determine NOI
– Anchor Tenant @ $8.25psf on 14,797 sf (31.9%) = $122,077 NNNN
– Non Anchor Space @ $20.00psf on 31,589sf Less 7% Vac = $587,555 NNNN
– Less Non-Reimburseables due to vacancy = ($12,714)
NOI 696,918
Step 4: Determine Value Range
– NOI / Cap Rate $696,918 / .075 = $ 9,292,240
– NOI / Cap Rate $696,918 / .080 = $ 8,711,475
Step 5: Determine Development Profit Range
– Profit = Stabilized Value – All In Project Costs
– $9,292,240 – $7,774,756 = $1,517,484 (19.52% straight profit)
– $8,711,475 – $7,774,756 = $ 936,719 (12.05% straight profit)
Step 6: Determine Development Profit % Range (Including Land Cost)
– 1,517,484 / 7,774,756 = 19.52%
– 936,711 / 7,774,756 = 12.05%
– Cash–On–Cost = Stabilized NOI / Total Project Cost $696,918 / $7,774,756 = 8.96%
(Spread = Cash on Cost – Market Cap Rate) 8.96 – 7.50 = 146bps, 8.96 – 8.00 = 94 bps
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(3) Solve For Max Land Cost Given Required C-O-C

– Land Cost 3.6 acres X TBD = TBD
– TOTAL PROJECT DEVELOPMENT COST (Excluding Land) $4,174,756
Step 3: Determine NOI
– Anchor Tenant @ $8.25psf on 14,797 sf (31.9%) = $122,077 NNNN
– Non Anchor Space @ $20.00psf on 31,589sf Less 7% Vac = $587,555 NNNN
– Less Non-reimburseables due to vacancy = ($12,714)
NOI $ 696,918

Step 4: Determine Maximum Total Project Cost (including land @ 10% C-O-C)
– NOI / Desired C-O-C $696,918 / .10 = $6,969,180

Step 5: Determine Maximum Land Cost
– Maximum Total Project Cost (including land) less Construction Cost
– $6,969,180 - $4,174,756 = $2,794,424 ($776,229 per acre)

9

(4) Solve For Rent Constant on Non Anchor Space

– Land Cost 3.6 acres X $1,000,000 per acre = $3,600,000
– TOTAL PROJECT DEVELOPMENT COST (Including Land) $7,774,756

Step 3: Determine NOI @ 10% C-O-C
– Total Project Development Cost X 10% C-O-C = $777,476 NNNN
– Less Anchor Space Rent @ $8.25psf = ($122,077) NNNN
$655,399

Step 4: GROSS-UP NON ANCHOR RENT BY 1 – Vacancy Rate
– Non-Anchor NNNN NOI / .93 = $704,730 / 31,589 sf = $22.31psf

10

II. DEAL STRUCTURING
TO CONTROL THE DIRT

Deal Structuring To Control Dirt
THE TOOLS
1. Option Contract
2. Right of First Refusal (ROFR)
3. Lease/Option
4. Seller Financing
5. Joint Venturing
6. A & D Loans


1. Option Contracts
Options work as a hedge against not being able to
assemble all the land needed or obtain necessary:
– Entitlements, – Investor commitments,
– Growth plan amendment, or
– Rezoning, – Institutional commitment
– Environmental analyses, for development
financing

Structuring The Deal Presented by Tennyson Williams
13

HOW AN OPTION WORKS
• Seller unconditionally agrees to sell to Buyer
– Seller can take back-up contract(s)
• Buyer pays consideration ($) to Seller
– Amount is negotiable
• Buyer has to exercise option (go hard on the
contract) within a specified period of time
– Time period is negotiable
• Seller has notax consequences until option is
exercised or expires

14

BUYER’S GOALS:
–Minimize option
money, maximize
option period
–Control property
against other
potential buyers

15

STRATEGY:
–Works best in a Buyer’s market;
–May have to pay taxes, mortgage
and other carrying charges
–Seller defers taxes until option is
exercised or expires

16

TACTICAL CONSIDERATIONS:
– Apply some or all of the option money
to the purchase price (works toward
equity portion for future loans)
– Make the option payments in
installments (retain use of the funds
for longer periods)
– Tie purchase to enhanced
entitlements or zoning

17

TACTICS (continued):

− The ultimate purchase price may be
contingent on changes to
− Allows buyer to control the land for
little initial consideration

18

Rolling Options:
– Allow development of contiguous parcels
incrementally
– Initial take-down may be for signage, access,
sales/leasing center, models
1,000 Acres

Phase One Phase Two Phase Phase Phase
Three Four Five
2010 2012
2014 2016 2018

street

19

1. b. Right Of First Refusal
NEXT BEST THING TO AN OPTION

How It Works:
– Does not entitle the holder of the right to force the
other party to sell or lease the asset.
– If and when the other party decides to sell or lease
the asset to any third party, the holder of the right
of first refusal can require the asset to be sold or
leased to him or her for the same price and terms
that the owner is willing to accept from the third
party.
– Doesn’t tie the land up; seller can still try to market
the property

20

2. Lease with Option to Purchase
How It Works:
 Buyer leases the property from Seller for a
specified period of time at an agreed upon
rent
 Lease contains a right of Buyer to exercise
an option to purchase the leased property
 Best to have the price and terms spelled
out in the lease or attached as a proposed
contract

21

BUYER’S GOALS:
 Minimize invested capital/maximize leasehold period
 Control property against other potential buyers
 Gain use of the property
 24/7 Access
 Post signs advertising the coming project
 Assemble all the land needed, or
 Obtain necessary: entitlements, plan amendment,
rezoning, environmental analyses, investor commitments,
or institutional commitment for development financing

22

STRATEGY:
–Works best in a Buyer’s market (no
demand);
• Seller earns income from the property
until lease expires or the option is
exercised
–Exercise of option must occur by
determinable specific date

23

–Annual rent can be based on a
percentage of the land’s market
value
–Pay taxes, mortgage and other
carrying charges
–Tie purchase to enhanced
–Some of the lease payments may be
applied toward the purchase price
(negotiable)
24

3. Seller Financing
a/k/a Purchase Money Mortgages

• Generally involves the seller’s level of
sophistication (more is better) as well
as his or her financial circumstances,
plus the current market situation
• Down payments typically range from
10% to 30% of the purchase price

25

GOALS:
Acquire land:
• With minimal equity upfront
• Avoid institutional lenders
• Avoid additional investors
• Better mortgage terms
• Less cost involved

26

STRATEGY:
– Minimize down payment
– Minimize interest rate
– Maximize term
– Get releases

27

TACTICAL CONSIDERATIONS
– Under current tax law sellers, but not dealers (as
defined in the tax code), of real property generally
can structure the purchase money mortgage as an
installment transaction for tax purposes, allowing
them to defer income taxes until each mortgage
payment is received.

– Always try to get the seller to agree to subordinate to
the development loan(s); otherwise, the purchase
money mortgage will have to be paid off so that the
construction and permanent lenders can have first
liens

28

4. Joint Ventures
• Usually a type of partnership with a
single specific purpose in mind for
example:
Partner A = Landowner
Partner B = Developer
Partner C (maybe) = Investor
(Capital Partner)

29

How It Works:
– Seller contributes the land in exchange for
an equity interest equal to the agreed upon
value of the land vis-à-vis the overall value
of the project
– Seller’s interest equates to an interest in
profits
– Seller agrees to subordinate title to a
construction loan
– Developer provides equity and/or sweat
equity, knowledge and experience, and
does the grunt work
30

Sample Structuring:
1. landowner receives equity land value
2. landowner receives a preferred return (cumulative or
noncumulative) on the equity value of the land
3. developer receives agreed upon amount or percentage
compensation (in lieu of or in addition to developer fees
received during the construction and leasing periods)
4. landowner and developer split balance per an agreed upon
formula for priorities and percentages
5. a 3-tiered structure may be used if third party equity
investors are involved

31

BUYER’S GOALS:
–Avoidance of equity investment
in the land
–Optimize developer’s equity for
other uses, such as entitlement,
planning, and construction
–Boost Equity Yield

32

Tips For Joint Ventures
• Plan aheadfor partnership
disputes
• Be prepared for dissolution
of the venture use buy-sell
• Don’t put yourself in a
position to lose control of
the venture
• Have a viable backup plan


5. Land Acquisition Loans
• Generally institutional lenders loan
only to their strongest and best
customers who have fully entitled
land and other assets or sources
from which to repay the loan

34

CAVEAT: Institutional lenders generally say they will
finance “up to 50%” of the acquisition price of
unimproved land if at all, but the actual loan-to-value
may be less depending on:
1. The lender’s risk tolerance
2. The lender’s determination of the actual value
versus the contract price
3. The extent of the borrower’s equity contribution
4. The borrower’s relationship with the lender
5. The borrower’s financial strength and credit
history
6. The borrower’s level of experience with the
planned development
7. Estimated time before take-out will occur
8. Conditions in the market

35


–Expect to provide personal guarantees
to adjust for the absence of an income
stream produced by the land
–Consider using a revolving line of credit
–Use builders’ precommitments,
presales, preleasing, agricultural leases

36

III. Deal Structuring
To Attract Capital

37

The Cost of Equity Vs. Debt

Generally, the cost of equity is considered
to range between 4% and 8% above the
effective cost of debt

38

BUYER’S GOALS:
–Obtain capital for acquisition,
planning, and entitlement of land
–Maintain control of the enterprise
–Identify a compatible partner or
partners who can provide or raise
equity

39

STRATEGIES:
– Don’t give away the farm up front – if your
projections are off, you lose
– Carefully balance all participants’ risks and
rewards
– Retain control and be clear about it
– Prepare from the beginning for the
possibility of dissolution of the venture –
use buy-sell agreements “you cut, I choose”
– Communicate frequently and clearly with
the investors

40

The major areas requiring careful
consideration and negotiation skills for
distributing cash flows include:
1. Preferred returns on equity invested
2. Priorities of payback of equity invested
versus sweat equity
3. How any remaining balance will be split,
if at all
4. Developer fees/Management fees

41

Distributions of Cash Flow from Operations
• Pari Passu – the developer receives a % of
the distributable cash proportionate to the %
of his equity contribution
• Preferred Return (“Pref”) – initial distribution
of cash flow to investors in a specified %
before any other distribution
• Promote – distribution of the remaining cash
to the developer in an amount
disproportionate to his actual % of equity
invested (as an incentive)
42

Distribution of Cash Flow from Sale

• After payment of expenses of sale and repayment of debt
• Then distributed to all parties in the amount of their initial
capital investment
• The balance is distributed in predetermined proportions
(50/50; 60/40, etc.)
• Exception: IRR Preference, an investor’s specified IRR must
be achieved before the balance is distributed
• IRR Lookback – if an investor was to receive a specified IRR
and it isn’t achieved in the final distribution, then the
proportions of other investors are adjusted to cover it

43

Distributions – Example slide 1
Outside investors put up 90% of the equity
and developer puts up 10%.
Project is 3 years in development stage, then
produces cash flow for 5 years of
operations.
Property is sold at the end of the 5th year of
operations.

44

Distributions – Example slide 2
1. Annual cash flow is distributed to outside investors
until a specified hurdle return (c.f., 9%) is received
(the “pref”);
2. Then the developer may receive a
disproportionately larger share (than his 10%) of any
additional distributions (the “promote”);
3. All remaining money may then go to the investors;
4. At sale, the net proceeds after repayment of debt
may go first to the outside investors to repay their
invested capital, then to repay the developer’s
capital, then be divided in a specified split.
45

Sample Structuring (“waterfall”):
1. all cash goes to investors until they have
received return of equity in full
2. cash then goes to investors until they have
received their priority return on equity
(cumulative or noncumulative)
3. next cash goes to developer until agreed
amount of percentage is reached (perhaps
in addition to developer fees paid during
operations)
4. the balance is divided according to
negotiated split

46

Developer & Management Fees

• Developer’s fees for overseeing the
development of the project; typically
3%-4% of hard and soft costs
• Management fees for overseeing day-
to-day management of the project:
typically 3%-4% of effective gross
income (adjusted gross income)

47

The investment vehicle can be can be a:
–Partnership,
–Limited partnership,
–LLC, or
–Corporation (C or S)

48

A Word About Syndications:
–Syndicators, promoters, or sponsors
raise capital from investors and
charge fees and/or may retain an
interest in the venture
–Complex tax and securities laws are
involved
• Violation of the securities laws
carries severe penalties

49

• Some Institutional Investment Entities:
– REITs

– Pension Funds

– Insurance Companies

– Venture Capitalists

– Opportunity Funds

50

Example:
– XYZ, an opportunity fund, is actively
seeking investments in joint ventures
with current owners and developers.
1. The developer monetizes part of the
asset value of entitled raw land, or
2. Acquires a financial partner for
acquisition and development
financing.

51

Q&A

52

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