Equity For Commercial Development Projects
In my important training article entitled, How Commercial Construction Loans Are Underwritten, I make the point that the vast majority of all commercial construction loans are made by banks. I also make the important point that the bank will usually require the developer to cover at least 20% of the total cost of the project. If the proposed project is a business property, like a hotel, the bank may require that the developer cover at least 30% of the total cost. Please note the words, “at least”. In many cases the bank may require even more equity from the developer.
So where does this equity come from? Where can a developer get more equity? This is the subject that we will cover in great detail today. This article should be helpful for commercial real estate developers, mortgage bankers, and commercial brokers (commercial real estate salesmen) involved in the sale or purchase of land destined for multifamily or commercial development or for residential subdivision or residential condominium development.
A commercial property developer can provide or find equity in a number of ways:
1. Equity in the Land
2. Prepaid Costs
3. Reg D Offerings
4. Joint Venture Partners
We will discuss each of the categories in more detail below:
1. Equity in the Land:
Every developer since Adam and Eve has made the argument to his banker that although he purchased the land just two months ago for $350,000, it is worth $1 million today because he got a really good deal. Ha-ha! Nice try. Such an argument usually will not work. The general rule in construction lending is that the land is only worth what the developer actually paid for it. Therefore if you paid $350,000 for the land, and the seller carried back a $200,000 first mortgage or contract of sale, the bank will only you give you credit for your $150,000 down payment.
However, there are some exceptions and some legitimate arguments that may succeed with your banker:
- You optioned or purchased the property many months earlier, and then you got the property rezoned to a more valuable use; e.g., you got the land rezoned from agricultural to a 120-lot residential subdivision. When you have gotten the property rezoned like this, but before you have started any horizontal improvements (streets, gutters, utilities, etc.), these potential homesites are known as paper lots.
- You successfully purchased and assembled a number of adjoining lots into a larger, more valuable parcel. This is called assemblage. For example, four tiny 1946-era rental homes lined a busy commercial strip (thoroughfare). Each had a different owner. You successfully bought all four homes, knocked them down, and created a very desirable site for a law office and parking lot, which is now worth far more the sum of the cost of each of the four dilapidated homes.
- There has been a significant economic event since your purchase that affects the area. For example, after you bought the land, Wal-Mart erected a new store 500 feet away. Your retail lot is now shadow-anchored by Wal-Mart; i.e., your property is not in the same shopping center as Wal-Mart but it nearly next door. It will greatly benefit from the increased traffic count.
- You bought the land many years ago, and real estate nearby has appreciated markedly since then.
2. Prepaid Costs:
Anything the developer has paid towards architectural fees, engineering fees, legal fees associated with getting the property rezoned, governmental fees (plan check fees, sewer hook-up fees, etc.), and toxic report fees will all be counted by the bank towards the developer’s contribution to the total cost of the project. What the bank will not usually accept, however, is the developer’s land carry cost; i.e., any interest payments the developer has made on his land loan. Using our example from above, you will recall that the developer paid $350,000 for the land and put $150,000 down. His $150,000 down payment will certainly count as a cost contribution, but not the $30,000 he paid in monthly interest payments to carry the land for 15 months while his building plans were prepared.
Remember: The general rule is that the bank wants the developer to bring the land to the table free-and-clear. In real life, this often does not happen; but the land should be pretty much free-and-clear of any mortgages. Now, of course, if the developer has a big pile of cash that he can bring to the closing table, that certainly will work in place of free and clear land.
3. Reg D Offerings:
But what does a developer do when the sum of his downpayment and his prepaid costs falls far short of the required 20% of the total cost of the project?
Many small to mid-sized commercial real estate developers will raise money from family, friends, business acquaintances, and nearby wealthy folks. The developer will hire someone to prepare a Reg D Private Placement Offering, which consists of (1) a Private Placement Memorandum (PPM), which is like a prospectus that describes the improvements to be constructed, the projected cost, the projected income, and the projected expenses, along with the risks; (2) the proposed Operating Agreement of the new limited liability company (LLC); and (3) a Subscription Agreement, which is a legally binding promise on the part of an investor to take a certain share of the offering.
Who prepares the Private Placement Offering? Private placement’s are securities, and if they are prepared improperly, the developer could get sued, or even end up in jail, if the project fails. It is therefore very important that the developer not try to prepare these legal documents himself. Well-heeled developers will hire a securities attorney. The typical cost of a PPM is between $25,000 to $35,000. To find a qualified securities attorney in your area, simply go to Google and type in, “Reg D offerings [your state].”
JOBS Act: In the past the SEC was very strict about Reg D offerings. The issuer was not allowed to publicly advertise. The issuer was limited to presenting his offering to family, friends, and people with whom he had a prior business relationship. At the bottom of the Great Recession, Congress passed a very important and beneficial change to the securities laws known as the JOBS Act. JOBS stands for Jump-start Our Business Start-ups. Under the JOBS Act a developer is now allowed to publicly advertise his offering (certain advertisements have to be pre-approved) to strangers, as long as every investor in his offering is accredited. You actually have to verify it. Be sure to ask your securities attorney about the JOBS Act.
But what does a developer do if he cannot afford to pay some attorney $25,000 to $35,000 for a Reg D Private Placement Offering? There are a number of companies online, not associated with a law firm, that sell templates that a developer can use to prepare his own Reg D offering documents. The cost is between $6,000 and $12,000. There is considerable legal risk here, but hey, life is not without risk. You can find such companies on Google by typing, “Reg D PPM preparation.” I did a quick search today and found one. I don’t know these guys from Adam, but if you scan their site, it will give you an idea of the type of service that I’m talking about.
4. Joint Ventures:
There are institutions who will actually joint venture with developers and supply up to 90% of the required equity. This kind of equity money is called joint venture capital or venture equity. Here are some cold, hard realities about joint venture capital:
- Institutional joint venture (JV) investors seldom want to invest less than $3 million to $5 million, and that is just the equity portion. This means that the total project costs usually needs to be well north of $12,000,000.
- Your Curriculum Vitae (CV) has to be very, very impressive. You must have successfully built a number of similar projects. A curriculum vitae or CV, in this context, is like a resume, and it contains a list of all of the properties that a developer has built.
- You will also need a large net worth to qualify for a JV, a net worth earned from successful real estate development. I have jokingly told my sons, when training them on the subject of JV's, that, “The only guy who qualifies for a joint venture is a guy wealthy enough to build the property for all cash.” No doubt that saying is unfairly restrictive, but it is closer to the truth than what most people think.
- If you are very wealthy and very experienced, you will find your joint venture partner, not by applying directly, but rather by applying to one of the top twenty commercial mortgage bankers in the country, companies like Holiday, Fenoglio and Fowler , George Elkins Company, or George Smith Partners. Neither C-Loans, Inc. or Blackburne & Sons is associated with any of these firms.
Unless you are very wealthy, focus your attention on issuing a Reg D Offering. Because of the JOBS Act, raising equity for commercial developments is far easier than you might think. The investment world is awash in capital.