Despite recent announcements of huge single-family projects in far, far North Dallas and foreclosures of downtown office buildings, it seems that most of the focus for commercial real estate continues to be related to infill projects closer to downtown. The difficulty with these projects is either a lack of sites or a rather wide bid/ask spread in pricing. As a result, buyers and developers are required to be more creative in structuring their acquisitions in a manner that bridges that spread or otherwise entices the seller to sell. Here are some recent approaches that have been successful:
• Providing the seller with a piece of the deal. Although payment of a back-end carried interest is not guaranteed and is clearly subordinate to the first-lien financing, the prospect of some development upside can often provide a carrot to a reluctant seller who feels that his land is being undervalued. The additional value can be rolled into the deal as deemed equity (albeit, the lender might not give you credit for all that equity value in determining the loan-to-value ratio) that accrues a preferred return and has a sharing ratio similar to all the other equity in the deal.
In certain cases where the seller may be asking for too much in the eyes of the project equity, the project equity provider may require that a portion of that deemed equity be recovered in a subordinate tranche in the waterfall or come out of the developer’s promote. In years past, this same problem could have been solved with a subordinate mezzanine note to the seller. However, in today’s market, it seems that construction loans are hard enough to find, and trying to add a mezz loan into the capital stack could be a non-starter.
In addition, although the seller’s piece is most often a back-end carried interest, we have seen deals recently where, in addition to contributing its land to the developer, the seller agreed to provide certain of the development services—for example, handling pursuit of certain entitlements—in exchange for a portion of the development fee.
• Sellers and developers are constantly battling over the time needed to appropriately conduct due diligence on the project, design the project, and obtain entitlements. And the developer typically will not have the capital in place to acquire the property pending completion of the pre-development period. We were recently involved in a deal where the developer agreed to close and solved the capital issue by obtaining seller financing for the bulk of the purchase price. This approach works best when the seller has confidence in the developer’s ability to close into a construction loan, or if the developer makes a more substantial down payment.
As a consequence, if everything works right, the seller gets a market or above-market return on its seller financing when the developer closes into the construction loan, and worst case they foreclose (or negotiate an up-front deed in lieu) and keep the downpayment. A nervous seller can also get a carve-out guaranty, which makes the loan recourse in the event of a bankruptcy filing.
• In certain cases, the seller just doesn’t want to or cannot sell the property, or the land cost is so expensive that the developer cannot make it work in its capital stack. In those instances, a long-term ground lease can sometimes accomplish the goal of keeping title in the hands of the seller but giving the developer the opportunity to proceed with its development project, or can markedly reduce the up-front costs of the acquisition.
Ground leases raise other issues from a financing perspective, and in a tight financing market can significantly limit the number of lenders willing to consider the project. But it is an “arrow for the quiver” that can be useful in the right circumstances.
• Sometimes a seller is willing to sell, but they have an operating business and don’t have the time or expertise or inclination necessary to find a new site for their company. A client recently solved that problem by agreeing to acquire a nearby site and swapping the new site, and some cash, for the existing site with the seller, and entered into a short term lease with the seller for the existing site to give the seller time to build a replacement facility on the new site.
We considered building a new facility on that site for the seller but ultimately concluded that we didn’t want to get into the build-to-suit business and left those obligations with the seller.
Although complicated in terms of the risks associated with acquiring a separate site and building a facility for an unrelated third party, this structure allowed the buyer to acquire a key tract of land for a fair price and allowed the seller to take advantage of the “equity” in its existing site to significantly upgrade its facility without really having to come out of pocket.
Rick Kopf is a founding partner and shareholder at Munsch Hardt Kopf & Harr PC. Contact him at firstname.lastname@example.org.