Making it in Real Estate (Part Seven): Fickle Shades of Green
“Friendship is constant in all other things save in the office and affairs of love.”
Shakespeare had it right. And money is less constant than love. Even if your project is profitable, the money that loved you when you first put together your deal can grow distant, even hostile, over the course of the investment. And if things do go wrong, the principal advantage a partnership has over a marriage—ironclad dissolution rights—can cause a developer a world of grief. In short, a dollar-denominated relationship is one of those wrong places to go looking for love.
Instead of love, seek understanding; seek money that listens. While capital is seldom a great listener—money talks—one type of capital available to real estate is distinctly harder of hearing than the other.
Almost everyone starts with family & friends’ money. Also known as country club money, this is your preferred form of outside equity. You will get the best economic deal from your friends, you will have more control over your project and, typically, you will be more difficult to dethrone should your deal sputter.
The F&F profit-sharing formula hasn’t changed since the Paleocene era: from the project’s cash flow, the equity gets a preferred return a few percent higher than treasury bills (say about 5 percent today) and, once that’s paid, any remaining cash is split 50-50 between money and developer. If the project entails less work, risk or return than a ground-up development—e.g. a simple lease-up on an empty building—then the split might be 80 to the equity, 20 to the developer. When the project is sold or refinanced, the proceeds are first used to bring the preferred return current, then to repay the equity in full and then any remaining proceeds are divided 50-50 (or 80-20 in the simpler deals).
Assuming you want outside partners (whether you should is a future column), F&F is the way you to start and what you should stick with as long as you can. F&F investors are, by definition, your friends and they—in the beginning at least—will listen to your explanations about why you missed your performance benchmarks. They may even be mildly sympathetic. And because they will be neither real estate professionals nor have the rights in your partnership agreement professionals would insist upon, they will likely have little choice but to ride out the bad times with you. Even if the love is gone. (If you want to go to heaven, never accept money from anyone unless you are certain he can readily afford the loss of his investment; far too many guys will raid their kids’ college funds for a risky venture just to act like hitters.)
The chief drawback of F&F money is obvious: Unless you picked your parents and college roommates based on their balance sheets, this is at best a quarter tank of gas and, when you empty-pocket the last of your friends, you will be running on fumes about the time you need to fund your next big deal.
In contrast, the other equity’s proven reserves are beyond measurement. Institutional money flows from multiple headwaters and—as long as you don’t need it—is always readily available. It costs more than F&F money and is basically deaf. Called hot money for good reason, it will burn a serious hole in your deal—if not you—if you fail to deliver on time. How? Through the unholy miracle of compound interest. Rather than the simple interest of say 5 percent asked by F&F investors, institutional money demands a compounded annual return as high as 15-20 percent before you share in any profits. Known as the internal rate of return (the IRR), this formula adds the cash flow the equity receives each year to its share of sales proceeds and then calculates the rate of interest on the total thus paid. If that return fails to exceed the equity’s minimum required yield, you receive nothing. This, by the way, is a common result for developers in institutional joint ventures. (For more on the IRR, see Lies, Damn Lies and the IRR in The Registry’s September 2011 issue).
If you can build, lease and sell your project on-budget and on-time, you should do well with institutional money. But a delay of even a year or two or a significant cost overrun may mean your partner gets a 14 percent return instead of the 15 percent it required and you get an expensive life-lesson.
And if things do go poorly with your project and you start begging for relief, your institutional partner’s attitude may remind you of Tommy Lee Jones in The Fugitive. Moments before he leaps into the abyss from atop an enormous dam, a desperate Harrison Ford swears, “I’m innocent.” Ready to gun him down, US Marshall Tommy Lee replies, “I don’t care.”
Instead of love, look for money that listens. You want the best economic deal you can get from your money partner, but you also want someone with patience and understanding, someone who is content to be your partner even when the fan gets clogged.
John E. McNellis is a Principal at McNellis Partners in Palo Alto, Calif.