Leverage

The term leverage is used a lot in real estate development finance.  It goes back to concepts I’ve discussed in previous blogs, that typical real estate project financing will involve debt because it tends to be cheaper money than equity.  To say that another way, the debit has a lower risk profile and therefore demands less return for its use.

When we describe leverage think about how you might use a lever to move a heavy object or to pull a nail.  You will use less force to achieve the results you’re after. 

photo credit to http://www.dynamicscience.com.au

Using leverage in a real estate development means you’ll use less of your money, or equity, to achieve the same result.  You’ll have additional costs in the form of interest (and fees) so you’ll make less total cash, but the percentage return on the investment increases dramatically.  See picture below and explanation that follows.  I’ve used simple numbers to illustrate the concept. 

The project costs $100, but it costs $105 if you’re going to pay $5 (6.25%) interest for the $80 you’ve borrowed from the bank.  The project revenues are the same.  You’re building the same product so the market sales price (revenues) will not be affected one bit by how the project was financed.  Your total cash return goes down in the bank finance model because you the have the additional costs related to bank borrowing.

But the reason projects use debt is because of the ability to lever that return, to really crank up the % returned on the smaller equity investment.   You give up some dollars, and you give up some control due to the bank’s involvement, but if everything goes well the results are tremendous.

This example is simple but is another way to show how real estate development can generate tremendous returns when done right.  There is a reason for the term real estate mogul and this principle of generating huge returns on a project show how you get to the level of owning professional sports teams.  Commercial and residential real estate development are the same in this regard.  Access to bank debt can make or break your ability to get projects done and the ability to generate impressive returns for you as owner or for your investment partners.

Now, leverage can also turn.  The Great Recession was the result of leverage gone bad.  It’s important to remember that when the project is selling the debt is getting paid off first.  Generally the equity is only returned, and the equity return earned, when the debt is gone.  The capital stack defines how proceeds are distributed.

If the project does not generate enough cash flow to pay the debt, if project sales are delayed and the interest payments exceed what was planned, if the debt is not paid off in the time frame laid out in the loan docs, it’s easy for problems to snowball.  The financial crisis was a result of getting too loose with debt.  When the underlying assets were reduced in value in such a way that the debt was silly relative to what supported it, lots of people and businesses got crushed.

Leverage can be very good, but it can also be very bad.  Use with caution.

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Bank Debt Financing

In the capital stack, having some of your own money, or at least money you can control, the equity, is critical. When you’re looking for land, when you’re planning a project, when you want to put land under contract and need to hire a team of consultants to understand exactly what you’ve got, you’ll need some cash to spend. It’s a given that the first dollars you’ll spend will be equity, creating value and an ownership position in the project you want to develop. After that, most real estate development projects will seek debt financing.

Lenders need to loan money. It’s what they do to earn revenue. Banks are the obvious choice of funding for good reason. Their mission is to loan money. Think back to how George Bailey explained it in It’s a Wonderful Life to his fellow citizens of Bedford Falls. The money doesn’t stay in the bank, it’s loaned to help the local businesses and property owners in the community. Banks lend, but they’re cautious and risk averse. They only need to make a minimal return on their debt investments, but they desperately want to avoid losing a penny.

image credit to http://www.hobbydb.com

If you can get through the bank hurdles, the money is cheap, and the funding can be readily available. But it’s not easy or quick, generally, to establish a lending relationship with a bank. Because real estate is risky, they want to be in a position so that even if the worst happens, they can recover their funds.

You’ll need an environmental study to prove there’s no nuclear waste or major earthquake faults on the site. You’ll need a very detailed land survey so there’s absolute clarity about what is being offered as collateral. You’ll need an appraisal that validates the value of the land. You’ll need a nice sales piece explaining the market and why your project is a can’t lose proposition.

You’ll need attorneys to review the documents the bank wants you to execute. You’ll need proof from all the local government agencies proving you’re allowed to do the project and that they will provide services. You’ll need pretty pictures and maps. You might need to offer up everything else you own as a guarantee. And you’ll have to pay for all of this, including for the bank’s attorneys who draft the documents with a bias against you, to get it done.

Any significant business decisions you make about the project design, construction, and sales will be subject to approval by the bank. But the truth is, it’s worth it for the prime rate money available to pay for 70% to 80% of your total project costs, including the land acquisition.

There are other options. The hard money guys who are happy if you fail so they can take the project. The mezzanine debt lenders who may take your company if you fail. So, banks, despite the time and complexity they bring to the process, are a critical source of funding for almost every real estate development you see. Also, equity returns can be increased on a percentage basis with leverage. I’ll break the concept down and demonstrate that simply in a future blog post. 

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Debt can be good, unless Mr. Potter wants to wipe you out. Be careful.
image credit to theatlantic.com

 

The Capital Stack (Part 2)

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.

image credit to http://www.propertymetrics.com

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The Capital Stack (Part 1)

You’ve got a project you think makes sense. It makes sense for your team, for the community, for the ultimate end users (the buyers), and your financial model says it will generate positive cash flow in an amount that justifies the investment.  The next step is to figure out how to pay for it.

Just like real estate developers are always looking for the next deal, they’re also always looking for funds.  Only large and well-established real estate companies (think Trammell Crow in office or Toll Brothers in housing) have enough cash within their organization to start and finish projects with their own money.  The typical developer will have just enough cash to prove to others they have some skin in the game and they think the project is good.

The capital stack defines how the project will get paid for and how the parties that invest in the project will share in the financials rewards (or losses). 

If you have a mortgage on your house, you have a capital stack.  You likely had to come up with some portion of the purchase price to buy your home.  That was the equity and that was your way to prove you believe in the value of the house.  You own it, but if you have a mortgage then there is a bank that also has a stake and is part of the stack.

Banks are not in the business of owning houses for long periods of time and trying to make money when they sell five or ten years down the line.  They are in the business of lending money and collecting interest payments on that money.  They’re part of the capital stack required to fund your home, but each party has their own purpose, their own defined financial rewards and risks, and their own protection.

You own your house and your name is on the grant deed recorded with the County, but the bank has a deed of trust recorded on the property that says they can take it from you if you don’t perform.  They want you to pay interest and pay them back the principal over time.  If both parties act as agreed, you end up owning your house and the bank makes decent interest on their loan.

The real estate development business operates under the same principles.  The owner is usually going to put up the first money to buy the land and start the development.  Then you hope to have a bank fund the balance of the project.  However, real estate development is different from a residence because the owner is likely to be a partnership, perhaps an LLC with multiple members, each with different responsibilities and obligations.  Those owners must have an agreement about who is going to fund the upfront dollars and who is going to get money back after any debt is paid off.  The capital stack is often defined in a partnership or operating agreement.

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Real Estate Development Accounting

A young auditor from a Big Four accounting firm once told me that real estate accounting is the easiest kind.  It was the only kind of accounting I knew so I took him at his word.  After many years of experience, I think he was right.  But accounting may be the only aspect of real estate development that is easy.

For real estate development accounting you try to capitalize everything.  To capitalize something means to convert your cash to another hard asset on the balance sheet versus having it be expensed and go against your bottom line.  This is for a couple of reasons.  First, the end all, be all of accounting principles is the matching principle.  Match your expenses with your revenues.  But what do you do when you spend money for 18 months to build some townhomes and then sell each unit in a day?  Real estate requires you incur all your costs up front, over a relatively long time frame, and then sell the finished product (not just put under contract, but close escrow with the title company) in a day.  Spend $400,000 evenly over the course of a year, sell and collect $500,000 in revenue in one day.  The numbers are for example purposes, but you get the idea.  Imagine the scale and time frames and dollars spent when building Manhattan’s massive residential skyscrapers or Florida’s sprawling master-planned golf communities.

Put all the costs in one pot and then try to match up the cost when you sell the finished product.  In real estate development it’s impossible to match where every shingle went, where every electrician pulled a wire, where every unit of concrete was poured, so you pool all the costs and then allocate them relative to the revenue you expect to make overall for the project(s) for which the costs were incurred.

Phasing helps make this simpler.  You can at least usually track the costs of a phase based on contracts.  But how about that main road that’s going to access multiple phases. You’ll have to come up with some sort of reasonable allocation to spread those costs into the cost pools of each phase the road is going to serve.

There are some complexities, but like the industry itself, real estate development accounting can be a little like the wild west.  In order to match those costs with future sales you must start with the assumption that you know the finished product will sell a year from now and have some idea of how much it will sell for.

The second biggest thing you’re likely to ever buy rolls off an assembly line in a day.  The house, the office building, the tower takes years of costs to produce.   And the accountant can lump them all together and make estimates about very large transactions that should happen in the future, sometimes years out.

But I think the auditor was right, real estate accounting is easy.  That’s good, because nothing else about real estate development is.