Ample equity is to project construction what grain is to whiskey. Equity can jumpstart a project and satisfy a critical lender financing requirement. But just how much equity, from where, and at what price?
Our hypothetical project is a 120-unit, to-be-constructed apartment complex on land under contract. Our developer has, wisely, formed a new single purpose entity, which we will call SPE, LLC or “SPE”. To complicate the financing but improve equity solicitation, we’ll locate the project in a fictional college town, where former graduates flock and the apartment market stays saturated – call it Oxkville.
Project costs are underestimated at $12 million and the bank-ordered FIRREA appraisal reflects an as-built value of $15,750,000 and stabilized value of $17,250,000.
Computing required equity
CPAs employ more complicated and precise definitions, but for our limited purposes, Minimum Required Equity equals Total Costs less Loan Proceeds. None of the variables are easy to quantify at an early stage.
Estimated total costs tend to move upward as the project ripens. Until a construction contract is inked, the construction bid serves only as a workable estimate. (Think Chinese tariffs.) Depending on the type of construction contract (fixed price, cost plus, management, …), limited allowances and future change orders, the cost estimate can increase even after execution of a construction contract. A pricy wild card may be the local government’s desire to extract developer-paid public improvements (turn lanes, traffic lights, utility enhancements) in exchange for permits and variances. A generous contingency line item is a necessity. To be successful in this business, a developer must contain costs.
For many lenders, the total loan amount is the result of a three-part analysis tied to cost, values, and underwriting. The “supervisory lending limit” applicable to federally insured bank loans for multifamily construction is 80 percent of value (12 CFR 365). The irksome HVCRE rules require upfront equity injection of 15 percent on the “as completed” value of the project (or a higher interest rate may be imposed due to increased bank capital requirements). Finally, based on loan underwriting – an extensive assessment of the market, project, developer and guarantor financial strength – a bank’s credit department might limit the maximum percentage of costs it will advance. These three tests might appear in a loan commitment letter as follows:
Loan Amount: Up to $11 million, but not to exceed the lesser of (i) 80 percent of the total project costs; (ii) 75 percent of the “as stabilized” appraised value; and (iii) 80 percent of the “as complete” value.
Based on our assumptions, the maximum bank loan to SPE will be $9.6 million. SPE must bring at least $2.4 million in cash and/or contributed property to the project, with $2.36 million of that amount to be injected prior to the first loan advance to avoid HVCRE designation.
Sources of equity
In a perfect world, the developer, an owner of SPE, would make a capital contribution to SPE to cover initial costs (land acquisition, soft costs, etc.), which would then be used by SPE to satisfy the equity requirement. But developers, like the general population and our president, are occasionally cash-challenged and highly-leveraged. Any equity shortage will likely be filled by investors.
Investor types run the gamut and include family and friends, well-heeled individuals, equity funds and mezzanine lenders. Any “equity” that resembles debt, including mezzanine loans, creates special underwriting issues for a lender and should be vetted at an early stage.
Once past the bright-colored project presentations replete with heavy foliage, futuristic vehicles, and happy people, pertinent equity investment discussions turn to investment return, timelines, and control. Supply, demand, and acumen rule.
Investment return takes many forms and involves concepts such as preferred return, carried interest, and repurchase rights, all complicated by development fees, management fees, success fees, various caps, required guarantees and different classes of membership. On the facile side, you might have a wealthy investor who brings all the required equity, perhaps delivers a partial or full guaranty in connection with the construction financing, takes an agreed-upon ownership percentage (say 25 percent), receives “first dollar” distributions to achieve an agreed-upon investment return (say 9 percent) for her cash investment, and then shares in distributions (after achieving the preferred return). The sophisticated equity fund has its own complex methodology and plays a mean game of poker. Prepared to be stupefied by the varying structures and agreements.
“Control” is all over the board and might include: (1) a true passive investor with no management or voting rights, (2) contingent or springing rights resulting from failed milestones or missed financial targets, and (3) supermajority voting provisions. “Standard forms” vary widely and wildly. The less-learned party to the negotiation should silently chant the Latin phrase caveat emptor.
After the fact calculations
Due to infinite variables and assumptions, the price of equity is more easily calculated after the fact, perhaps when the project is refinanced or sold. Still, on the front end, the cost of equity loosely follows a sliding scale, increasing as the equity sources moves across the spectrum from friends & family to mezzanine lenders. On a simple deal, the price might be the previously cited 9 percent return through some milestone (such as return of cash equity) and rights to distributions from operations and sale based on agreed ownership, but subject to a repurchase option at a stated return. On a more complex deal, the developer may have paid a hefty preferred return, agreed to shared control, and forfeited a significant share of profits on sale.
With any successful project, third-party equity is invariably more expensive than bank debt. In fact, bank debt can be relatively cheap since the bank has no upside beyond repayment of principal and interest. But even if costly, third-party equity may be the difference between a missed opportunity and a successful project. Any decent fraction of a biscuit may be better than none.
Project development is a Darwinian calling, where only the resourceful thrive. Equity is just one of several challenges, with an inherent conflict between the price (for the developer) and the return (for the investor).
This is not a cookie-cutter business, and all players should negotiate and seek expert advice. And investors vetting those equity opportunities should remember that recycled Shakespeare line from The Merchant of Venice: “All that glisters is not gold.”
» Ben Williams and Molly Jeffcoat Moody are attorneys at Watkins & Eager PLLC and are both recognized by Chambers USA and Best Lawyers in America. Molly was chosen as a Top 10 Finalist in the Mississippi Business Journal’s 2019 Top 50 Under 40 business leaders. Additional information is available at www.watkinseager.com.
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