Today’s real estate developers often rely on “other people’s money” for projects both large and small. But is that always the best approach? In a 2017 ULI Fall Meeting presentation titled “No Partners, No Problems,” ULI governor and trustee John McNellis offered attendees tips on the risks and rewards of working with financial partners versus tapping one’s own bank account.
McNellis is the author of Making It in Real Estate: Starting as a Developer, published by ULI last year, and the cofounder of McNellis Partners. Specializing in community retail, the McNellis firm funds all its own projects. But McNellis sees the value and disadvantages of both approaches.
“You should do your first deal all on your own,” he advised. “But as soon as you can afford outside operational help, hire it or ‘rent’ it.” He recommends the flexibility of using consultants, at least at first, and hiring full-time staff when the company is on solid ground. “Key employees are more expensive than consultants if you fail, but far cheaper in the long run if you truly succeed.”
Selecting financial partners is trickier than finding the right operational collaborators, McNellis continued. “We all start with financial partners,” he said. “If you are born rich, your first partners are your family. Or your friends may step in. Everyone starts out with partners, but do you stick with them?”
The advantages of working with long-term financial partners include enhanced deal flow, prestige, and risk mitigation. The partner’s investment usually covers 90 percent of a project’s equity under a nonrecourse agreement, allowing developers to participate in very large projects with a relatively small monetary commitment. For example, for a $10 million project with $6 million in debt and $4 million in equity, the financial partner contributes $3.6 million while the developer puts up just $400,000. Both partners profit if the project sells at a higher price than it cost to develop.
If that happens, the developer now has several million dollars and faces another dilemma. “Do you do one deal on your own or make ten deals with financial partners?” McNellis asked. Ten deals would generate a much greater total payday, but it’s not as simple as it might look.
“Both approaches work, and both can fail,” he explained. “Great deals are hard to find, and finding ten in a row is nearly impossible. Pushing the deal quota intensifies risk.” Developers can become subject to investors’ criteria. For example, a stock market downturn could cause a pension fund to sell a project prematurely to avoid overallocation in real estate. Or another investor may pass up a great selling opportunity to avoid the consequences of a spike in earnings.
“Essentially, it’s more of a lifestyle issue,” McNellis said. “You can end up doing ten times the work, with serious overhead and reduced profit share.” Other risks include partnership conflicts, good-faith differences of opinion, a change in an investor’s long-term strategy, and unanticipated events. In short, McNellis concluded, “Even the best partners can kill you.”
So how should developers choose which road to follow? “It’s not selfish to ask, what do I get out of it?” he said. The guiding principle, he said, is NTM—net to me.