Real estate development projects can offer lucrative investment opportunities, but they also come with unique challenges and risks. In a recent episode of the Passive Investing from Left Field podcast, host Jim Pfeifer interviewed Andrew Brewer, founder and managing partner of Iron Gall Investments and Distance 3 Development, to gain valuable insights into investing in ground-up real estate development deals as a passive investor or limited partner (LP). With his extensive experience in development projects across various asset classes, Andrew shared practical advice on vetting operators, evaluating deals, and structuring investments for successful outcomes.
Vetting the Operator: Experience and Aligned Incentives
One of the most critical aspects of investing in development deals is thoroughly vetting the operator or sponsor. Andrew emphasizes the importance of examining the operator’s track record by inquiring about their past projects, both those they have sponsored themselves and those they have been involved with in other capacities. Investors should also consider the operator’s educational background and professional experience, as these factors can shed light on their qualifications and preparedness for undertaking development projects.
In addition to assessing the operator’s experience, Andrew recommends understanding how they are compensated. He prefers a compensation model where the operator doesn’t receive substantial fees upfront; instead, their payment is tied to the project’s success. This approach ensures that the operator’s interests are aligned with those of the passive investors, as they only get paid if the project generates returns.
Andrew’s preference is to structure deals where he doesn’t take any development fees during the project. Instead, he receives a share of the profits once the project is completed and the investors have received their preferred return and capital back. This model incentivizes the operator to work diligently to ensure the project’s success, as their compensation depends on delivering positive outcomes for the investors.
Evaluating Partners and Subcontractors
In development deals, the operator typically works with various partners and subcontractors, such as architects, engineers, contractors, and consultants. Andrew advises investors to inquire about the qualifications and reputations of these partners, as their performance can significantly impact the project’s outcome.
He recommends working with larger, well-established firms with sufficient resources and backup personnel, as opposed to smaller, one-person operations. Larger firms can provide continuity and mitigate the risk of delays or setbacks due to unforeseen circumstances affecting individual subcontractors. For instance, if a key engineer or architect faces an unexpected situation, a larger firm can seamlessly transition the project to another qualified professional, ensuring minimal disruption.
Andrew cites examples of reputable firms he has worked with, such as WGI and Pape Dawson, which investors can easily research online to validate their reputations and business standing.
Analyzing the Deal and Project Timeline
When evaluating a specific development deal, investors should thoroughly understand the status of the land, including zoning, entitlements, and access to utilities. Andrew emphasizes the importance of a realistic project timeline that accounts for potential delays and includes contingency buffers.
He explains that every project he has worked on has experienced delays, often due to factors beyond the operator’s control, such as city approval processes, council meetings, or additional rounds of comments from regulatory bodies. To mitigate this risk, Andrew recommends building a substantial contingency timeline, typically doubling the estimated timeline under ideal conditions.
For example, if a multifamily development project in Texas is expected to take 12-14 months for entitlements under perfect circumstances, Andrew would set a two-year timeline to account for potential delays. This approach ensures that the investor returns are calculated based on the contingency timeline, providing a more realistic and conservative estimate.
In addition to the timeline, Andrew also recommends including contingency buffers in the project budget. Unforeseen expenses are common in development projects, and having a financial cushion helps mitigate the impact of cost overruns on investor returns.
Higher Return Potential, Higher Risk
Due to the increased risks associated with development deals, Andrew typically targets a higher internal rate of return (IRR) for these projects compared to value-add cash flow deals. For development deals, he aims for an IRR of 20-23% for passive investors, while for cash flow deals, he targets an IRR of 16-20%.
The higher potential returns compensate for the additional risks involved, such as entitlement challenges, construction delays, and market fluctuations that can impact the viability of the completed project. By setting appropriate return expectations, investors can make informed decisions about whether the risk-return profile aligns with their investment goals and risk tolerance.
Exiting in Phases: Mitigating Risk and Providing Liquidity
Andrew suggests structuring development deals in phases, with planned exit points for investors. This approach allows investors to realize returns and potentially reinvest in subsequent phases or exit the deal altogether if desired. It also incentivizes the operator to perform well in each phase to secure capital for the next phase.
By breaking down a larger development project into smaller phases, such as land acquisition and entitlement, construction, and stabilization, investors can mitigate risk and gain liquidity at predetermined intervals. For example, after the land acquisition and entitlement phase, investors may have the opportunity to receive a portion of their investment back or reinvest in the construction phase.
This phased approach addresses several challenges associated with development deals. First, it provides investors with pre-planned exit points, allowing them to align their investment horizons with their personal goals and circumstances. If an investor’s financial situation changes or they become uncomfortable with the development risk, they can exit the deal at the end of a phase without being locked in for the entire project duration.
Additionally, phased exits incentivize the operator to perform well in each phase, as they need to secure capital from existing or new investors for subsequent phases. This alignment of interests further mitigates risk for passive investors.
Investing in real estate development deals can offer attractive returns but also involves unique risks compared to cash flow investments. Andrew Brewer’s insights from his extensive experience as a developer and operator provide valuable guidance for passive investors navigating the complexities of these deals.
By thoroughly vetting the operator’s track record, experience, and compensation structure, evaluating the qualifications of partners and subcontractors, conducting thorough due diligence on the project timeline and budget, and structuring investments with appropriate exit strategies, investors can make informed decisions and potentially diversify their real estate portfolios with development opportunities.
Ultimately, successful development investing requires a deep understanding of the risks involved and a partnership with an experienced, well-aligned operator who prioritizes investor interests and transparently communicates the project’s challenges and milestones.
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This article is for educational purposes only and is not to be relied upon as the basis for entering into any transaction or advisory relationship or making any investment decision. All investments involve the risk of loss, including the loss of principal. Past performance, and any performance results reflected in this article, is not an indication of future results.