The Need for Patient Equity

Capital sources willing to take a long-term view on their investments may have an opportunity to win over developers in today's real estate financing market. Here's why, according to Avison Young Principal Jay Maddox.

Despite increasingly jittery financial markets, tons of capital both domestic and foreign is aimed squarely at U.S. commercial real estate. In particular, it is aimed at projects that have short-term upside potential via value-added business plans or ground-up development.

The Developer’s Dilemma

The private equity funds allocating capital to such projects have promised their investors double-digit returns. Consequently, developers face pressure from investors that is decidedly short term and IRR driven, placing an artificial “sell-by-date” of typically no more than five years for the developer to work its magic and deliver the high returns that investors demand. The grim reality is that the longer it takes to complete the project, the fewer scraps of profit will remain for the developer because the investor’s return meter is always running. To many, it feels like the goal posts just keep getting further and further away.

Interestingly, this short-term investment strategy is also prevalent in the corporate world. Venture capital and hedge funds raise enormous amounts of capital for start-up, emerging growth, and turnaround situations with the express goal of positioning the target company for an IPO, corporate acquisition or other liquidity event within a few years. This creates an artificial incentive to drive short-term profits at the expense of taking a longer-term view and building a great, profitable company.

The Equity Disconnect

Impatient capital is pervasive, and developers often feel like there is no alternative. Short-term bridge and construction lenders have lined up to support this short-term investment strategy, creating an artificial capital markets-driven pressure to sell properties at what may be far from the optimal time. To be sure, the cost of this capital is getting cheaper because of the competition for good deals, but it is still very expensive, and the short-term investment horizon pressures remain.

Despite the abundance of capital, many developers would prefer not to sign up for this ticking time bomb form of equity. The truth is that it is extremely difficult for a developer to control a great piece of real estate at a reasonable cost basis, then develop or reposition the property optimally. (The old adage is true: in real estate, you make your money on the buy.) And because of intense competition, especially in gateway markets, it is becoming increasingly difficult to acquire these opportunities at an attractive cost basis. Worse, once the value has been created, there is immediate pressure for investors to realize their return. Unless the property can be refinanced at a level sufficient to repay the investor plus its returns, the developer is faced with having to sell the property and either redeploy the profits in another project or pay significant taxes. So once again, the developer has to find another great deal, when in fact the preferred course would be to hold the property for the long term.

What Developers Really Want

An increasing number of developers reaching out to me yearn for more patient, flexible capital sources who can both invest in a project at an early stage, and stay for seven to 10 years or more, earning very reasonable but not necessarily astronomical returns. Unfortunately, in today’s market there are only a few such equity investors. This apparent disconnect represents a potential opportunity for new market entrants willing to take a longer-term view, provided they can align themselves with strong operators and quality projects. Developers who wish to tap into these capital sources, which can be difficult to identify, would be well served to work with strong professionals that have deep connections in the capital markets.