Because real estate development is risky investors in real estate demand a return commensurate with the risk. You’re happy to buy a government bond supported by the good tax-paying citizens of your community and earn 4% tax free. You’re happy to buy stock in Procter & Gamble (PG) and earn a 2% dividend annually plus expected price appreciation that will net your investment a return greater than inflation….between 6% and 8% on average would be just fine. And you’ll buy that Vanguard index fund which spreads your risk across the performance of the largest U.S. companies and be happy to take your 7% return and go home. If you’re buying riskier junk bonds you expect a promise to pay 8% to 10% interest rates. If you’re funding a new tech startup out of someone’s garage, you’ll expect even more. Residential real estate can be even riskier.
In my experience part of the capital stack is going to include an investor, or the “money partner” in a partnership, that owns the project. There is usually a difference between the operator and the money partner. There are plenty of groups across the country that want to invest money in real estate looking for returns in excess of what the stock or bond market can provide. There are also plenty of groups that enjoy developing land, shaping their community, and creating places for people to live and work. A typical structure pairs a deep-pocketed investor with a local operator who can bring the vision and the hands-on involvement to bring a project to fruition.
The local development group is usually happy to earn a management fee for the time spent working on the project but will also want to share in any upside should they create a profitable project. The investor will want a return that makes the investment worthwhile. Capital stack structures I have seen provide for the investor to earn a defined return (between 10% and 15% ) and get all their invested capital returned before cash generated (from sales or debt) goes anywhere else. The developer will earn their management fee as a capitalized cost related to delivering the project. But after the capital has been paid back, the return has been paid out, and the management fees have been earned is when the capital stack gets interesting.
The profits can be split in many ways, either a standard percentage (maybe 90/10), or can allow for the developer to earn an escalating share of the excess as profits are delivered. The profits will drive up the return for the investor partner and incentivize the developer to manage the costs and drive the revenues. I once had a colleague explain to me that successful developers aren’t in it for the salary (or management fees), they’re in it for that split.
Once a developer can prove to investors they can provide a desirable return on invested dollars the developer can demand better terms for themselves. Again, it all goes back to risk. Delivering a successful real estate project from land to final build-out and sale is complex, can take a long time, and may have to endure up and down cycles in the economy. That is why there must be returns to the parties in the capital stack above and beyond what’s available in other investment products.
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Ed Morgan Real Estate Fundamentals 