MCA was recently retained by a sophisticated client to arrange a construction loan and secure a joint-venture equity partner for a very large project in North Texas. The project cost exceeded $100,000,000 and the capital structure was complex, with multiple providers, including a public bond component. The timing of the project required that the committed capital fund a portion of its investment before the majority of the predevelopment work was completed, with a ground breaking estimated to be 6 to 8 months after the committed capital “closed” on the project.
The Pre-Development Stage, or the early stage of a project, centers around due diligence, research, confirming entitlements and permitting. As such, investing at this stage carries the greatest and most varied risks, because there are many unknowns. Market analysis and feasibility studies can assist with potential project viability. Other risks include site plans, development plans, and building plans, permitting, project costs and in rare cases, arranging construction financing. It is not typical for a joint venture equity partner to close in advance of a construction loan commitment so that is why I slot construction financing as a rare instance.
Since the pre-development stage is the riskiest, pre-development costs are usually financed by the project sponsor or if the project is large enough, the joint-venture equity partner that might get taken out by the construction loan. Investments made during this stage, therefore, provide for higher returns than those made during the later stages. One important note for equity investors is that obtaining construction financing from a bank or other lender is a very rigorous process, and if a developer already has a construction loan arranged, it usually means that a number of major hurdles have been cleared.
Perhaps the greatest impediments to capital formation during pre-development are zoning/permitting and project cost verification. Zoning and permitting can be a cause for delays in ground breaking. The building permit application process is relatively speedy compared to the land use process because it is supposed to be based on objective criteria. For this reason, it is less likely to delay fundraising.
The last milestone in the pre-development stage is the confirmation from a reputable General Contractor of the project hard costs. This concept can cause for a real show stopper during a joint-venture equity agreement negotiation. The joint-venture equity does not want to take risk that the project cost is higher than what the developer proforma suggests. The project cost directly affects the project profit. Joint-venture equity does not want to be surprised during pre-development, when the project they thought they had committed to might actually cost significantly more. In most cases, the General Contractor cannot accurately cost a project until a full set of Schematic Design plans are completed. This endeavor can be costly depending on the project size. Therein lies the conundrum: how does the joint venture equity recoup its investment into the predevelopment stage if the project cost exceeds a level of viability?
That question is usually followed by a swift answer….the equity doesn’t jump into the deal until the sponsor is able to provide assurances that the project cost is as outlined in the investment brochure/business plan.
Based on the feedback from institutional equity investors in the marketplace, MCA was able to determine which investors were willing to accept pre-development risk and who was not. Setting aside the pre-development aspect, the project had extremely favorable above-market returns and economic metrics. After sourcing approximately 75 sources of capital, the majority of the capital prospects would not consider investing in a deal prior to the issuance of a Guaranteed Maximum Price Contract (“GMAX” or “GMP”) from a reputable general contractor. Simply stated, the majority of the joint venture equity available in the market was willing to bet on the deal outcome as well as market conditions; however, they were not willing to bet that the sponsor’s costs were accurate absent of the GMAX contract. When a reputable contractor with a strong balance sheet guaranties construction costs not to exceed a pre-agreed upon amount, it is essentially a credit enhancement to the project and can, in most cases, mitigate the potential for cost-overruns (save for change orders).
MCA was successful in identifying several candidates that, via various different forms of “structure” on the joint venture, were able to stomach the pre-development risks. However, those equity providers generally priced in the pre-development risks in the equity waterfall returns and required a higher IRR or Equity Multiple threshold before the sponsor could earn their promoted interest.
Developers should know that in order to negotiate the most favorable terms from the joint venture equity market, the pre-development risks need to be eliminated and/or covered by the sponsor. Putting the joint venture equity in a position to fund at the construction loan closing and ground breaking of the construction, will yield the best economic deal toward the sponsor as well as increase the appeal to prospective joint venture equity providers to the project.
The author, Todd McNeill, is a Director and Principal in the Dallas office of Metropolitan Capital Advisors. Todd can be easily reached at firstname.lastname@example.org