2009: What’s A Developer To Do?
With development activity at a standstill, how can developers alter their business to ready themselves for a changing climate?
Scott A. Fisher, Esq.

Over the last several months, I have been talking with many developers to try to assess what to anticipate for 2009. As 2009 begins, the good news is there is clearly a consensus. The bad news is that the consensus doesn’t bode well for the short term.

It will come as no surprise to anyone that, except for finishing deals that are already underway and financed, development activity has come to a virtual halt. There is no demand for product from tenants or buyers and, notwithstanding the efforts of the federal government; lenders do not appear to have either the capital or the inclination to lend. Shell-shocked investors are interested in preservation versus investment of capital. It is also extremely difficult to accurately value existing product or estimate what a project under development will be worth when completed. Accordingly, even if there was new equity or debt interested in real estate development, the uncertainty presented by the markets would make that investment difficult, if not unwise.

Given the foregoing, what is it that developers intend to do in the foreseeable future?

In the immediate short term, many developers and their principals are focusing their efforts on fixing problems emanating from existing deals. That process is being hindered by a lending community that isn’t sure how it wants to or should proceed with addressing its problem loans. The result to date, except in obviously unsalvageable situations such as land loans to residential single-home developers, is that lenders generally are extending loans while trying to figure out their internal end-game. This is relevant because the long term strategy of virtually every developer with whom I have spoken is to cease being developers and apply their experience and expertise to take advantage of the acquisition opportunities that history says inevitably arise out of this type of downturn. Many, if not most, of those opportunities will arise when lenders begin to aggressively resolve their problem loans or when those lenders simply elect to sell problem loans or foreclosed properties at a meaningful discount.

In order to be poised to pounce when the opportunities appear, developers are considering forming real estate funds with strategies that will allow those funds to pursue the acquisition of available properties and/or debt. Developers are trying to identify the best potential sources of capital for those funds and revising their company resumes to reflect relevant experience and expertise. The difficulty is that, at this juncture, the markets are not settled enough for potential equity sources to assess the damage they have or will sustain as a result of the current downturn. It is, therefore, not clear whether and to what extent traditional sources of equity such as high wealth individuals, insurance companies, pension funds and real estate funds will be ready, willing, or able to jump back into the real estate market. We also do not yet know what returns investors will demand in order to commit new capital to real estate. On the one hand, we can expect investors to seek a high risk premium; on the other hand, we are still in a period of historically low interest rates and low returns on alternative investments. The developers that successfully emerge from this downturn will be those that can anticipate the requirements of potential capital and identify and attract capital commitments in this market.

To successfully form funds and attract capital, developers will need to understand the structure and returns historically offered to equity investors in syndicated real estate funds. They will need to be prepared to propose terms that will attract capital in today’s market. During the last cycle, real estate funds were structured so that the fund sponsors were compensated with a 1 to 2 percent annual fee on committed capital, plus a promoted interest (in the range of 20 percent) subordinated to a preferred return (8 to 12 percent) on the investors’ money. The sponsor’s upside was dependent upon its ability to invest in projects that generated returns that first provided the investors with their scheduled preferred return and then returned the investors’ capital. When coupled with a capital contribution by the sponsors, the interests of the sponsor and the investors were strongly aligned.

When structuring funds going forward, developers/sponsors will need to look hard at each of the economic elements of their contemplated fund to see how they might competitively improve their ability to attract capital. They will need to ask the following questions:

1)  Is there an alternative to the 1 to 2 percent annual fee structure?

For example, if a developer operates at lower overhead or has alternative sources of fees to pay overhead, it may offer to reduce, subordinate, and/or defer its asset management fee or substitute acquisition, disposition or financing fees that are tied to success rather than the amount of the committed capital.

2)  What is an appropriate return in the projected market?

In the recent past, preferred returns moved down as the market became more heated. The question is, given historically low treasury rates, will preferred returns need to move up from 8 to 10 percent in order to attract capital in a more risk-adverse environment? Similarly, will investors demand an investment strategy that seeks to generate a 20 percent or greater IRR and, if so, is that level of return realistic in a low leverage environment?

3)  How will the sponsors’ carried or promoted interests be calculated? 

This number will, by necessity, be tied to the conclusions reached with regard to the fees paid to the sponsors and the amount of the preferred return payable to investors. Ultimately, investors may increasingly demand waterfalls that increase the sponsor’s interest incrementally as the investors reach agreed upon IRR hurdles.

4)  How much “skin” is the developer/sponsor willing to put “in the game”? 

Developers should anticipate that their investors will require that the promoters invest a meaningful amount (calculated as a percentage of the overall investment or a minimum dollar amount) side by side with the investors.

Even if a developer can successfully answer the foregoing questions, it will need to determine whether it is prepared or suited to operate as a fund sponsor. Specifically, the developer will need to evaluate its sources of capital and the willingness of its principals to go through the legal and practical process of raising the capital. That process involves the preparation of offering documents and identifying and soliciting potential sources of capital. Many developers, which have historically raised capital on a deal by deal basis, may find it more challenging to convince investors to commit to a “blind fund” where the specific projects have not yet been identified. Those developers may need to be more patient and wait until the market allows them the time to put a project under contract and then seek to raise capital.

Developers will also need to evaluate their ability to maintain an organization capable of operating a real estate fund. During the downturn, development fees and development activity will inevitably dissipate and, as they decline, so will the willingness of developers to maintain the level of staffing necessary to ultimately operate a real estate fund. A key element of attracting capital will certainly be the depth and experience of a company’s staff. A developer intent on forming a fund will need to maintain a quality staff or take advantage of a less competitive employment market to attract employees with the right skill sets to roll out and operate a fund.

Finally, even if a developer can successfully form a fund or position itself to attract capital on a deal-by-deal basis, the developer will need to use 2009 to attempt to identify and build relationships with potential deal sources. Those sources may include lenders who will be taking back properties or looking to sell loans, loan servicers who are charged with handling problem or matured CMBS loans, developers or existing funds with troubled portfolios looking to sell assets at a discount, property managers who have familiarity with and early knowledge of available assets they manage, and brokers who are likely to have access to the initial wave of opportunistic properties. For many developers this process is a simply matter of maintaining and expanding long-standing relationships during the downturn. Others will need to identify and establish new relationships.

In conclusion, although development has come to virtual halt and the prospects for developers in 2009 seem bleak, many developers are using their “down” time to formulate a strategy for creating future deal flow and attracting and deploying capital. Those developers that are able to formulate and implement that strategy will be in the best position to successfully navigate through and eventually emerge from this downturn.

Scott Fisher is a partner with Atlanta-based law firm Arnall Golden Gregory LLP. He can be reached by email at scott.fisher@agg.com.

©2009 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.