Why do developers get "promotes"? How do they get "buried"?
Assume you're looking to invest a lot of $. Development sounds fun, but you only know enough to be dangerous. You need to hire someone with expertise.
What's a good way to pay your developer?
You could just pay them a fixed fee. But what good is that? Your developer could blow the budget, fail to generate value, and still get paid. You want alignment.
What about profit sharing?
If you invest $100 and the project generates $200, you'd probably be willing to share the $100 of profit. But you'd probably want to get some credit for your investment. Maybe you'd want 10% per year on your investment.
We call this 10% a "preferred return" in JV speak.
---- SIMPLE EXAMPLE ("BASE CASE") ----
Cost = $100
Sale proceeds = $200
Profits = $100
Hold period = 3 years
Project IRR = 26%
10% preferred return = $33 = (100 * 1.1 ^3) - 100
Profits over pref = $67
Developer's promote (assume 50% of profit) = $33
----- BASE CASE + 1 YEAR -----
What if it takes a little longer to deliver the $100 profit?
Cost = $100
Sale proceeds = $200
Profits = $100
Hold period = 4 years
Project IRR = 19%
Preferred return at 10% = $46 = (100 * 1.1 ^4) - 100
Profits over pref = $54
Developer's promote (assume 50% of profit) = $27
----- BASE CASE + 2 YEARS -----
What if it takes even longer to deliver the $100 profit?
Cost = $100
Sale proceeds = $200
Profits = $100
Hold period = 5 years
Project IRR = 15%
Preferred return at 10% = $61 = (100 * 1.1 ^5) - 100
Profits over pref = $39
Developer's promote (assume 50% of profit) = $19
----- BASE CASE + 2 YEARS AND LESS PROFIT -----
What if it takes even longer and there's less profit?
Cost = $100
Sale proceeds = $150
Profits = $50
Hold period = 5 years
Project IRR = 8%
Preferred return at 10% = $61 = (100 * 1.1 ^5) - 100
Profits over pref = -$11
Developer's promote (assume 50% of profit) = $0
BURIED BEHIND THE PREF
The $0 developer profit in the last scenario is referred to as being "buried behind a pref." The project's IRR fell below the preferred return, which means the implied cost of equity wiped out the developer's profit sharing.
A FEW TAKEAWAYS
- Timing matters. Extending the hold period by a year or two meaningfully dropped the project IRR and the developer's promote.
- Developers tend to want to walk away when they get buried.
- The balance of power in a partnership shifts when a developer gets buried.
- Developers can get buried even when a project is profitable.
WHEN DO DEVELOPERS GET BURIED?
1. When too much supply causes rents and/or occupancy to fall.
2. When costs escalate meaningfully.
3. When it takes longer to complete and stabilize the project.
4. When equity return requirements (cap rates) increase.
5. When interest rates spike. (<--- uh oh)
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