There is an expression that land development is a wealthy man’s game.
Indeed, in our recent meeting with a very seasoned developer (over 30,000 lots before the Recession, now, licking his wounds, down to only 900), he pointed out to the young entrepreneur in attendance that most projects fail because the developer runs out of capital before he gets traction.
This is one reason that successful developers so often need to be visionaries and consummate salespeople. They not only have to convince stakeholders that the vacant land or the unproven mine or the undeveloped port really could be something more, but they have to motivate those stakeholders to act as if it already IS ‘more’.
To the extent that a developer can do that, the more successful the development will be, whether in terms of cheaper cost of capital, project velocity or net returns.
In fact, the more the developer can do this, the less traditional debt or equity he will need, or the better at least his terms will be.
Below is an introduction to 15 creative ways that large real estate and infrastructure developers leverage their projects to generate momentum, raise nontraditional cash, qualify for traditional financing, and turn their vision into reality. The list is interspersed with transactions typically used in infrastructure and other common for real estate development. However, we believe that several of them are underutilized and could be creatively employed more often and in different applications.
How impactful are these strategies? We know one developer who invested only $10,000 by utilizing just two of these strategies and made $35,000,000 by selling to a national homebuilder, and saving substantial within a tax preferred vehicle that his attorney helped him devise.
Forward Sale Funding
Overriding Royalty Interests
Pay upon Completion Contracting
Corporate Bond Funding
Private Transfer Fees
Sales / Leaseback
3rd Party Subordination & Cross-collateralizations
(See previous post for items 1-8)
9. Land-based municipal bonds
Land based Municipal Bonds (LBB) are one of the oldest and more straightforward types of municipal debt being issued by cities and counties throughout the U.S. LBBs finance the construction of public infrastructure and public facilities that benefit private developments. The properties are then subject to a special tax or assessment that is used to secure and retire the bonds. While some jurisdictions may have secondary pledges of other revenues to help repay the LBB debt, many western states, including California, rely on the higher annual property taxes to repay the LBB debt.
The bond’s lien is senior to all real estate loans on the property as they are secured via the property tax lien.
Typically, the value of the property benefiting from the expenditure of the bond proceeds is 300 percent or more than the public debt being recorded against the property. In other words, LBB financings usually carry 25 percent to 33 percent maximum loan to value ratios, although ratios under 20 percent are quite common. Compared to conventional bank real estate loans, LBBs are highly conservative and secure loans.
Land-based municipal bonds are classified into one of two categories, according to the type of funding source the borrower uses to service the cash flows.
10. Private Transfer Fees
Several large developers have structured creative assessments on all resales of their properties over the ensuing 99 years. Considering it as a sort of ‘capital recovery fee’, the developers thereby apportion expenses incurred for permanent improvements among successive owners of the property.
The assessment is 1% of the gross sales price, repaid by future buyers who willingly assume the obligation, much like modern HOA dues and other assessments. Developers can retain the income stream, or offer the income stream to pension funds, endowments, insurance companies and other investors looking for a long term income stream correlated to inflation, while providing project liquidity.
The majority of existing states permit transfer fee covenants where proceeds are delivered to a community association or nonprofit and provide a direct benefit to the property. Because of this limitation and recent restrictions for regulated entities to own mortgages with these fees that do not offer a direct benefit, the strategy remains a niche product. Nevertheless, total present values of these exceed well over $8 billion within the U.S.
11. Sale / Leaseback
In the typical sale-leaseback, a property owner sells real estate used in its business to an unrelated private investor or to an institutional investor. Simultaneously with the sale, the property is leased back to the seller for a mutually agreed-upon time period, usually 20 to 30 years.
The sale-leaseback may include either or both the land and the improvements. Lease payments typically are fixed to provide for amortization of the purchase price over the term of the lease plus a specified return rate on the buyer’s investment.
The typical transaction usually is a triple-net-lease arrangement. Sale-leasebacks often include an option for the seller to renew its lease, and on occasion, repurchase the property.
Raising funds through a sale-leaseback transaction offers property owners a number of important business advantages, including converting equity to cash, as an alternative to conventional financing or the possibility of better financing (e.g. where the buyer has access to better financing than the seller), improves the balance sheet and credit standing, increases tax deductions through rental payments, and others. Although it eliminates future residual value and likely subjects the developer to less flexibility and greater monthly costs, it can be an attractive alternative to raising capital.
12. Third Party Collateralizations and Subordinations
Every investor has their own time horizon, risk tolerances and return expectations. On occasion it is possible to access other collateral, including those of third parties, to finance a development that otherwise would not qualify for financing.
For example, a large owner of dormant or low yielding assets may want to ‘double dip’ by subordinating some of assets, or borrowing against them in exchange for additional upside on the development. In another arrangement, an asset owner may ‘lease’ or ‘rent out’ a portion of his/her assets as a collateral enhancement for the development. The asset owner may be induced to do this based on his/her optimism in the success of the project, or by also receiving collateral from another third party.
Traditional forms of these structures involve letters of credit and guarantees from banks backed by highly rated investors and their deposits, similar to as described above related to forward sales and power purchase agreements. Other more customized, but similar arrangements include, for example the discounted purchase of life insurance pools with actuarially certain longevity ranges, where the death benefits act as ‘principal protection guarantee’ for the investors in the development. Under these strategies, for example, approximately 40% of an investor’s investment funds the insurance pool (which provides a bond like but certain return) and the remaining 60% funding the development. These insurance pools are priced such that even if the development failed completely, the investor would still receive 100% of his/her entire investment from the insurance pool payouts. This transaction is therefore best suited on speculative but potentially high return investments; while the upside may be diluted by the large allotment into the principal protected component of the outlay, the risk of principal is eliminated.
Similar arrangements have been made against commodities, valuables and other resources with the asset owner allowing them to be partially hypothecated with the purchase of additional insurance coverage to protect against developer default.
Subdividing is simply fractionalizing some or all of a property at prices that are greater than the original whole. This strategy can help developers in several ways, including generating needed cash for other phases of a project, enlisting valuable alliances that have equity stakes in the subdivision, maximizing the net yield from the development, among others. It can also be part of a land banking strategy where the developer releases inventory in phases to maximize the overall return over time.
14. Joint Ventures
The term “joint venture” can mean many different things and apply to many different scenarios, but it generally represents a collaboration of resources between two parties. I