Raw Land to Entitled Land to Ground Up Question

[Anonymous]

Let’s say there’s a scenario where a Co-GP level entity (Sponsor + family, friends, and fools’ money) takes 12 months to take a raw land acquisition to entitled land for development. At the end of the 12 month period, a GP/LP partnership is formed to go ground up, which is projected to take 24-months. So in total, the development period from raw land acquisition is 36-months. Let’s assume it’s a 5-year hold in total.

Few questions associated with a scenario like this. I am on the lending side so I’m curious how this would be modeled from an equity perspective.

* When does Month 0 start? For the Co-GP entity, does it start when the raw land is taken down? Does this mean that the GP/LP waterfall would have a different Month 0 start? While the gross profit may be the same to the GP entity between the GP/LP waterfall and Co-GP waterfall, before any fees, would the IRRs be different based on a 60-month IRR calc at the GP/LP entity and a 12mth + 60mth period at the Co-GP entity?

* From what you’ve seen, how do these deals typically get structure? For example, if the Co-GP entity purchased land for $1.0MM, spent $1.0MM entitling, and believes the value to be $5.0MM, how does the GP/LP entity acquire the land? Does the Co-GP entity sell for $5MM and book a net cash gain of $3MM in that period or do they typically roll the $3MM in equity back into the deal? If they book a cash gain, would you model that at Month 12 (when the Co-GP executes the GP/LP partnership) as a distribution to the Co-GP partners? If they only contribute land, rather than cash, I’m assuming you wouldn’t model any share of construction costs to be contributed by the Co-GP, right?

Would love to hear your thoughts on this topic. Perhaps I’ve confused myself a little bit thinking really high level about this.

[Spencer Burton]

Thanks for the questions. Let me do my best to answer them.

1) When does Month 0 start? For the Co-GP entity, does it start when the raw land is taken down? Does this mean that the GP/LP waterfall would have a different Month 0 start? While the gross profit may be the same to the GP entity between the GP/LP waterfall and Co-GP waterfall, before any fees, would the IRRs be different based on a 60-month IRR calc at the GP/LP entity and a 12mth + 60mth period at the Co-GP entity?

Month 0 would generally occur at the GP-LP venture closing. At the property level, any costs to date would be added up and capitalized in time zero (i.e. most often pursuit costs) with the LP typically crediting the GP’s capital account with costs spent to date. If the GP had closed on the land, likewise its capital account would be credited with the value that the GP-LP venture places on the land, which can either be market value or actual cost.

In terms of the second half of the question, you’re right. From the Co-GP perspective, using the the GP-LP venture closing for time zero may throw off time value of money hurdles in the Co-GP waterfall. I have two comments on that.

First, this is one of the reasons Co-GP hurdles usually are simpler and not based on time value of money metrics. You’ll often see a Co-GP structure look something like 8% preferred, non-compounding, with all excess cash flow split 50/50. Then, in your model you’d adjust the ‘Required Return’ for the Co-GP partners in time zero to reflect any accrued preferred return. By the way, many times a Co-GP structure won’t require a preferred return during a period early in the venture in which case even this step would be unnecessary.

[Side bar comment: there’s another more important reason to keep the Co-GP waterfall structure simple, and that’s because the Co-GP investors (“Sponsor + family, friends, and fools’ money”) need you to keep it simple. The saying goes, “people don’t invest in what they don’t understand”. Your aunt May can understand “we’ll split the profit 50/50 at the end”, but she may not understand “90/10 to an 8% IRR, 80/20 to a 12% IRR, and 70/30 thereafter”.]

With that said, if you do have a complex Co-GP waterfall with time value of money hurdles, you would need to run two concurrent models. One to model the LP returns that starts at the GP-LP venture closing, and one to model the Co-GP returns that starts at the Co-GP venture closing. The distributions from the GP-LP model to the Co-GP would then link to the Co-GP model to combine with the contributions from the Co-GP model to accurately model the IRR of the Co-GP partners.

2) From what you’ve seen, how do these deals typically get structure? For example, if the Co-GP entity purchased land for $1.0MM, spent $1.0MM entitling, and believes the value to be $5.0MM, how does the GP/LP entity acquire the land? Does the Co-GP entity sell for $5MM and book a net cash gain of $3MM in that period or do they typically roll the $3MM in equity back into the deal? If they book a cash gain, would you model that at Month 12 (when the Co-GP executes the GP/LP partnership) as a distribution to the Co-GP partners? If they only contribute land, rather than cash, I’m assuming you wouldn’t model any share of construction costs to be contributed by the Co-GP, right?

I partially answered this in question 1, but allow me to elaborate.

Your example is fairly common. The Co-GP purchased the land previous to the GP-LP venture execution and has added significant value to the land through some combination of entitlement/design and/or just simply holding the land for a long time. You’ll often see GPs bring land to a venture that they’ve owned for years (or decades), and thus their cost basis in the land isn’t a fair representation of the value of the land.

In my experience what usually happens is there’s a negotiation over the value of the land. Take your example. The GP has spent $2.0MM to date and asserts that the land is worth $5.0MM. As the LP, I’d need support for that $5.0MM valuation before giving the GP full credit for the land value. But let’s imagine the $5.0MM value can be supported. And further let’s imagine a $50MM total project cost with a 90/10 ownership split. At venture closing, the GP would contribute the land to the venture at a $5.0MM value, and thus would not be required to contribute any further to the venture.

So from a GP-LP modeling perspective, nothing changes. The venture “purchased” the land at $5.0MM and the GP contributed its pro rata share.

From a Co-GP modeling perspective, you’d need to run a concurrent model to appropriately calculate the IRR. And it could get quite complex. But again back to my lecture when I talk about simplifying partnership waterfalls down to cash contributions and distributions. As you model that Co-GP equity waterfall, just focus on what cash contributions were made and when, and what cash distributions were made and when. Ideally you’re building a dynamic model so you can adjust assumptions down the road or use the model on a future deal. But if you get stuck, it’s not the end of the world if the model ends up being static, especially when you’re dealing with once-in-a-career structures.

Happy to answer follow up questions!

[Anonymous]

Appreciate the thorough answer Spencer!

[Author]

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