The difference between a merchant builder and a conventional builder is that a conventional builder finances, builds, and owns a development. This means that the conventional builder receives all of the profit of a venture, but accepts all of the risk to build it.
For a development as large or as complicated as an apartment building, it may not be feasible for any one party to build without assistance. Apartment buildings require a substantial cash down payment to build them, which can range from 20- 30% of the total cost of the project. A developer may not have sufficient equity to invest or be unwilling to take so much risk at the beginning of the project. Alternatively, an investor may have sufficient money, but not the development expertise.
You’ve Got The Money, We’ve Got The Time…
An answer to this problem is for a developer to find a capital partner who wants to share in the development profit and is willing to share a portion of the risk. A developer who enters into such a partnership becomes a merchant builder. A capital investor puts up the money, essentially buying a building in advance (a forward sale). The developing partner then builds the building, and the two cooperate to sell it to an end-buyer (which may be the capital partner or a third party).
There are typically three parties in a merchant builder scenario:
- The developer. He or she finds and entitles the land, and builds the project.
- The capital partner. He or she usually gets involved when the land is under contract and the entitlement work is complete. When the project is fully designed and the building specification is complete.
- The end-buyer. Usually, a long-term apartment owner who wants to own Class-A luxury apartments, but doesn’t have or want the development skills or take the development risk associated. Sometimes the capital partner structures the deal so that he is also the end-buyer.
A Complicated Process
But while bringing in a partner helps to divide the risk, it does complicate the process. Here at SVN Rock Advisors, we have structured many forward sale apartment contracts. This is a complicated process. This means that we have:
- Assisted in the assembly or acquisition of the land the building sits on.
- Completed a feasibility study.
- Sat on the design team.
- Assembled the offering memorandum for the project to be built.
- Assisted with the lease-up.
- And, ultimately brokered the sale of the building.
The Value of Trust
For the merchant apartment building process to work, there has to be trust on both sides. The developer has to know that the capital partner will be there to fund most of the project, and the capital partner has to trust the developer to build the project on time, to specifications and leased-up at the pro forma rate.
How to Structure The Deal: One Example
There is no limit to the number of ways that you can structure a forward sale.
For example: consider a proposed $30 million apartment complex. The initial equity that must be provided before a financial company will loan the remainder is $7.5 million. Of this equity, 90% ($6.75 million) is provided by the capital partner, and 10% ($750,000) comes from the developer. This secures a construction loan of $22.5 million, with the mortgage covenant assigned to the developer.
Let us say that the building takes two years to build and is sold to an end-buyer for $34.5 million, generating a profit of $4.5 million. After paying off the construction loan and taking back the equity, the time comes to divide up the profit.
The first thing to do is to pay the return on the equity the capital partner and the developer have paid into the project. Assuming a preferred return of 10% on the initial equity invested (agreed to at the start of the project), the capital partner is entitled to $675,000 per year, or $1.35 million. The developer also gets a 10% return, translating to $150,000. Thus $1.5 million of the $4.5 million profit is paid out in preferred return. The remaining $3 million can be paid out in a 50/50 split, or $1.5 million each.
Thus, based on an initial investment of $6.75 million from the capital partner and $750,000 from the developer, both parties get that equity back, and the capital partner gains a profit of $2.85 million, and the developer gains a profit of $1.65 million.
Sharing The Risk And Reward
This is just one of many variations on how such profits can be paid.
For example, the capital partner may ask for a 20% Internal Rate of Return on their money (a guaranteed profit of $6 million for every year of construction), allowing the developer to keep the rest. The percentage split could be varied depending on the profit received. There are an infinite number of combinations.
Becoming a merchant builder allows a developer to build bigger projects with far less risk, while still retaining a good return on his or her investment. A capital partner gets a good return on his or her investment with limited risk.