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Deferred Fee plan - Viable?

bjsint

Hi!

I am a newbie developer operating in Los Angeles. I am focusing on High end, spec builds in the 2m-5m range(sale price)

I currently have a couple of options I am entertaining at the moment, all of which involve optioning off-market residential vacant land for under market value, offering the land owner a waterfall structure of deferred payment/equity or as joint venture partner.

This particular tactic a long with some experienced investors is what is allowing me to finance such an undertaking. 

My questions to you guys is first of all how would you structure payment - hourly - up front fee -  % construction costs? 

Im told more often than not fees are based on a % of construction costs? But then what about schematic, and pre development feasibility, is that factored in or done as a separate fee?

My main question is, rather than base the fee on percentage of construction costs, what about as a percentage of profit, much like an equity share? Would this be amenable? That way our incentives are aligned, and we mutual gain from and a value engineered design, and efficient construction process?

If this fee was deferred until the property is sold, it would obviously be slightly higher than if it had been paid up front to account for risk etc, but is this something you guys are likely to participate in? This would help give the project the best chance of being profitable and make way for bigger future developments with more confident investors and loan officers.

What sot of fees would you ask for, and what is your preferred structure?

The houses i hope to build will be around 3500sqft.

Thanks!

Looking forward to hearing your thoughts..

 
Jul 8, 14 2:35 am
Volunteer

How can you pay the architectural fee from "profits" when the fee is one of the things that must be deducted from revenue before you can determine if there are any profits? Reminds me of the scam pulled on writers and actors in LA in the movie biz where they were promised a percentage of the "profits". Seems like after all the other expenses were paid-even on mega-blockbuster movies-there were no "profits" to share. Actors and writers started asking for a guaranteed amount up-front and a percentage of the REVENUE. But you knew that. In a world of near-zero interest rates you can't get financing for your projects?

Jul 8, 14 6:54 am  · 
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Volunteer

So, you are even going to borrow (option) the scrub land from the owner? Is the land even suitable for building or will the civil engineer and geologist also stand in line with the architects for their fee from the "profits"? Ever consider there may be a reason the land is cheap? Built on an earthquake fault? Sliding down the mountain in a slow landslide? And you are going to use "value engineering" which in your case, means "build the sucker as cheaply as possible". Also you are going to use an "efficient construction process"? Why do I have a vision of undocumented workers, working off the books, and unsure of which end of a hammer to grasp, throwing this thing together with the cheapest materials imaginable?

Jul 8, 14 7:32 am  · 
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curtkram

Basically you're asking if the architect would be one of your investors, but provide services instead of money?  So you want to give your architect the same sort of ownership interest that your other investors have?  I don't think that's common, but I'm sure it can be done.

Jul 8, 14 7:37 am  · 
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Appleseed

I've seen similar proposals. I've never seen it work out to everyone's satisfaction. The Trades typically balk, which is pretty understandable. I'd never consider a similar situation w/ a 'newbie developer'.

Jul 8, 14 4:20 pm  · 
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jdparnell1218

If you're new to the construction biz, you should probably stick to the typical means of payment.  Pay your architect.

Jul 8, 14 5:24 pm  · 
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cr8ve

Its not a good idea for the Architect to be a Partner in the deal.  He/she needs to get involved in the accounting of the project and disputes will arise as to how the profit is calculated.  Also, liability-wise its a bad idea!  Insurance companies dont like it.

 

As far as fees go, Architect's fee for a custom home is anywhere between 8% to 15% of construction cost depending on complexity (hillside, etc) ,size and entitlement process.  The more difficult the entitlement process, the higher the percentage.  The percentage will be calculated on an average of $300/sf for a custom spec house (in Southern Calif).  Now, if the developer chooses to, they can agree to pay the Architect on an Hourly basis for the Entitlement Phase (i.e. Feasibility, hearings, commissions, DRB's etc..) and then do the Contract documents on a percentage basis.  This will reduce the percentage somewhat!

Bear in mind that if its a Spec House, the fee maybe in the lower range (8% ) and if the house is really small, the Percentage may be higher !  so , if you decide to do a 1,000 SF home , font expect to pay only $24K as it requires the same amount of work in the building Dept. and probably entitlements!

 

This is the norm in better firms.  There are always guys out there that do it for less and push everyone down with them though!!

Jul 8, 14 6:28 pm  · 
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bjsint

Thanks for your feedback guys. 

@Volunteer. It may seem unconventional, but it has been done before and is most definitely not a scam. In the scenario I am looking at, even conservatively the architect would earn a lot more than if they had just ben paid un upfront fee. There are many ways to structure the payment, I am mostly concerned about pre-development - as soon as construction starts, the architect could absolutely get paid at that time and then perhaps a balloon payment at the end to cover what wasn't paid during pre-development and then some. If you were just going to be snarky and insult me, why bother even replying and hijacking my forum? I am planning on building a house worth possibly $5m, you think I would risk building a crappy house, with undocumented workers who wouldn't be covered under insurance?? I have no idea why you took such a low opinion of me I was just asking an honest question. As a developer, I defer all my fees until then end as well, so I have the potential to get screwed as much as anyone, plus I've already spent months longer on the project than anyone else, and i would personally have money in the deal too.

I am honestly not trying to screw over an architect over, I am fully aware they are the most important component to building an amazing house that will command a price of $5m. In high end residential, the design is what can make the difference between a $4m and a $5m house.

I have just read lots of posts of architects either complaining about the money developers make, or wanting to be developers themselves. The model(s) I was suggesting was a way of bridging that gap, yes there is potential risk (but thats why developers/investors make the most money) - as least you are just risking time and opportunity cost, not actual money. Plus the actual upside is huge. PLUS you would have a preferred equity so the architect would get paid a minimum FIRST, so before the investors or me. So its incredibly unlikely they wouldn't get paid. As I said or there's the option of contractually just deferring a pre negotiated payment, which can be legal guaranteed by a lien on the property or by some other way. So then theres no risk, or no more than usual you  just get paid more 10 months later.

The benefit for the developer is that its less money to raise pre-development which is the hardest time to get money, which also means less holding cost, and higher margins on the back end, even if the equity split is smaller or more spread around - which I had thought might be fairer.

Also I wasn't asking your opinion on the land. Even though i mentioned I have some plots in mind, this is a hypothetical question at this stage. Of course due diligence is thoroughly conducted in all potential land parcels.

@Curtkram Yes either that or a pre negotiated fee. Or both. Say a minimum fee which gets paid first before investors, me etc, then a equity split along with everyone else. As I said the main savings is in predevelopment, so figuring out exactly what can be built, and preliminary schematic design, which can then be used in the investors package.

@Appleseed For what reasons do you think it never works out to everyones satisfaction? Unless the project was poorly developed from the beginning and nobody makes money, which would be unfortunate. Theres definitely a risk but thats why the upside can be so profitable. But lets take two scenarios where a project is successful but structures differently:

1)one is done where the architect is paid normally at say $80,000

2)and the other where they got paid $2000 as a sort of 'earnest money' for the pre development stuff and then get the remaining $78000 once the project is sold. the 78000 is also treated like equity, the project made 20% profit, so the architect also gets an extra $15600 for a total of $95600. 

Would this still not be a good scenario for an architect, or is the extra amount just not worth it?

@jdparnell1218 I myself am new but this project would also be partnered with a more seasoned developer. The investors are also other developers and real estate hard money lenders, and the only way to get their money is to give them a rock solid development deal. And it would be even better for the architect as they would get paid first.

Thanks guys!

Jul 8, 14 6:34 pm  · 
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bjsint

@Cr8ve

Thanks for your insight. I wrote my last post before yours had posted!

My only concern is in aligning everyones incentives. During the construction phase, the architect is partly responsible for making sure the GC/builders are doing everything right, and in a timely manner. However the architect benefits when the GC is sloppy, or slow or when he chooses a more expensive option with no added design value. Changes orders need to minimized but then the architect benefits when they are not.

I absolutely trust architects, but one has to really stay on top on contractors/GC's who again - are incentivized run the costs up as much they can. Basing payment on profits as opposed to costs just seems like a more sensible way to have everyone on the same page.

I still don't see why architects wouldn't partner in the deal for potentially a lot more upside. You say it would work because Architects are involved with accounting - so are developers, and hence my points above, about aligning incentives. From my stand point as a developer the only reason I can see it not happening very often is because it is not worth it for the developers side, especially if the project goes very well - it would be cheaper just to pay the normal fee.  The only reason I am suggesting it is because it makes it a little easier to get the project off the ground and as a new developer this is more important than back end equity for me at this time.

Jul 8, 14 8:01 pm  · 
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I can't believe anyone is taking this seriously. Does he even read what he writes?

As a developer, I defer all my fees until then end as well, so I have the potential to get screwed as much as anyone, plus I've already spent months longer on the project than anyone else, and i would personally have money in the deal too.

Jul 8, 14 11:36 pm  · 
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gruen
Frikkin developers w their skin in the game. As a certain mr Jaffe would say price of everything...
Jul 8, 14 11:39 pm  · 
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x-jla

At least he's thinking about design.  Most developers around here don't ever use architects.  They almost always skip the entire design fee and hire a contractor who slaps together a thoughtless "free design". 

Jul 9, 14 1:42 am  · 
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Volunteer

When the buildings deteriorate because of shoddy construction and the fly-by-night substitution of specified materials can the architects be sued even though they were never paid? Will defending themselves in court be fun?

Jul 9, 14 6:51 am  · 
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Who cares? The developers and the money are long gone.

Classic NYC development scenario:

Developers buy property with as little down as possible and mortgage it for max value with interest-only ballon note.

Developers put as little as possible of the borrowed money into development, keeping as much as possible as profit.

Developers condo/coop and sell out for max price, passing underlying interest-only ballon note that paid for everything along to buyers, who wake up some years later when the balloon payment of tens/hundreds of millions is due.

By which time the developers have repeated the process 4-5 times. The vampires I know in the business won't even touch a project if they can't take at least 30% margin under the most pessimistic projections. 

Jul 9, 14 8:46 am  · 
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Non Sequitur

Sounds like a scam. I bet the OP is the type to wear rubber bands with holograms on his wrists... to promote good profit health of-course.

Jul 9, 14 8:51 am  · 
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curtkram

/

Jul 9, 14 9:09 am  · 
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curtkram

for the kids that don't know what wimpy is going to propose:

Jul 9, 14 9:12 am  · 
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Wilma Buttfit

If something happened and there was a liability instead of a profit, would the architect be liable for some of the losses? Just wondering out loud. 

Jul 9, 14 9:16 am  · 
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Volunteer

Variation on this theme in the North Carolina mountains. Developers put in a massive well-landscaped gate with pretty flowers off the main road and maybe complete nine holes of the name-brand golf course and the clubhouse, which doubles as the sales office, of course. Then they bringing the marks with promises of luxury living. When they begin to clear the lots on the mountains they have sold for hundreds of thousands of dollars and start to build roads the unstable terrain starts sliding down the mountain. Oops. Bankruptcy for the developer who escapes back to Florida with the lot owners money to plan the next scam. The owners are left with worthless property.

Jul 9, 14 10:07 am  · 
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mightyaa

I've heard of these situations.  They weren't uncommon in the boom of the 80's with speculative development.  I'm rusty on it since we don't do this and actually bought another firm who lost their butts on a couple of these deals; They weren't built...

The basic scenario was taking stock options of what I assume is a LLC or some other investment group doing the development.  That's what is negotiated is how much of that stock.  So then the architecture firm is part of the investment group.  It's just that instead of a check, the value of their work is paid in stock options at discounted rates.  It goes on the book as an corporate asset.  From the architect standpoint, it has to be looked at as an investment.  Buy in low, sell high.  You might lose your butt or you might have something worth a lot down the line.  And when you are investing like that, you need to look closely at who's running it and the data because you can loose your ass.

The risk is you do the work up front before there's a product to sell. Lots of things can go wrong like an economy slump, over building thus over valuation, site issues, planning issues, acts of God and so forth.  The architect's employees still want their paychecks for some reason, so you are out of pocket without a check coming in to cover those cost.  That chews into the reserves.   So there are usually only two types of firms; The single proprietor who can skip paychecks if need be.... and the larger firm with enough other work that the monthly bills can be covered out of the profit margin on those other projects.

Jul 9, 14 10:34 am  · 
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My father once took a small share in a celebrity restaurant he designed as the final fee payment. Years later there was a cash call and all the partners had to make a cash contribution to keep the place afloat. The cash was more than the final payment would have been. Some years later I inherited his interest and was bought out for around 10% of what he had in it.

This Hamptons celebrity spot was open for 15 years, and on the books did 1.5m a year - every single year despite rapid growth of the area - pretty much breaking even.  Who knows how much cash was drained out by the manager and majority partners along the way.

Bottom line, if you want to swim with sharks ...

Jul 9, 14 12:58 pm  · 
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bjsint

@Miles Jaffe

You seem to know a lot of horrible stories, and unethical developers. Thanks for giving me the benefit of the doubt. We all have anecdotes for good developers and bad developers, telling horror stories wasn't the aim of this thread. I could tell you just as many positive stories where people would have wished they'd taken an equity share. For an example, a spec residential; $600,000 equity investment for 2.2m loan of total costs. Sold for $3.8m. After all sales and fiance cost, net profit was 1.2m. So the investors doubled their money. Had the architect got $100,000 in equity rather as a fee. they would have made twice as much. 

Im sure you'll pick a part this scenario, my intentions, and integrity, but that is besides the point. The purpose of this thread was to find out the hypothetical pros and cons of what i proposed and how it could be negotiated. Many people defer fees(for a price) in many different areas of work. Just a simple 'the developer could be a scam artist or the project could go under' would have sufficed. 

@Non Sequitur. If I was planning a scam do you really think i would be on an architects forum getting advice? 

Since posting on this forum I've actually found a couple of examples of deals being structured the way i suggested, by architects on other blogs. So it's nice to know Im not completely crazy.

The equity argument seems to be an unlikely scenario which the more i think about it, isn't a great option for the developer either. But what about focussing the discussion on deferring the architects fee - not even until the end of the project, just until the loan comes through and construction starts. So basically we are talking the pre-development stage. Plus a 20% mark up for the hassle?

Thanks everyone else for their helpful posts :)

Jul 9, 14 2:37 pm  · 
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Keep thinking that developers are in business to make you money and you'll do just fine.  

Jul 9, 14 5:44 pm  · 
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gruen
Basically you dangle the prospect of higher profits to distract from the fact that you are dead broke and don't want to pay us regardless. I can spot this type of client a mile off, they always want an unrealistic deal and promise something in the future - I suspect the future thing sucks as much as the thing today.
Jul 9, 14 7:24 pm  · 
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Volunteer

The OP asked for opinions. The consensus is that it is a horrible idea; a fact he refuses to acknowledge. The whole idea of buIlding 5 million dollar homes on undervalued scrub land, that nevertheless is buildable, in good school districts (which buyers of 5 million dollar homes will demand), and already has municipal services installed, is just a little much to begin with. It goes downhill, rapidly, from there.

Jul 9, 14 7:42 pm  · 
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Nobody buying a $5m house is sending their kids to public school.

Jul 9, 14 7:52 pm  · 
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quizzical

During my career I've worked both in real estate development and as a practicing architect. I appreciate the cash flow difficulties associated with getting a new development project going. I also appreciate why architects are skeptical about deals such as that proposed by the OP.

In my experience, the most reasonable way for the parties to balance "feasibility phase" risk is for the architect to work hourly -- at a reduced hourly rate -- while project feasibility is being explored. The reduced hourly rate can be pretty low -- and does not necessarily need to include any profit or full overhead. However, it should at least cover the architect's variable expenses -- such as labor and related personnel benefits. The architect invoices monthly and the developer pays quickly - otherwise the architect stops work.

If the project dies, the developer has no further obligation to the architect - beyond paying any outstanding invoices for services provided during the feasibility phase. However, if the project does move forward the architect is guaranteed the work, at a reasonable and previously negotiated fee. And, all hourly work provided during the feasibility phase is converted to the architect's normal hourly rate -- the "make up" amount is funded out of the first draw.

The advantages of this approach should be obvious. The architect is participating actively in helping to make the project feasible, but isn't totally speculating his time. And, the developer has minimal cost exposure related to the architect's services if the project dies. Both parties benefit / neither party suffers undue economic burden.

Generally, this approach works well only if the architect and the developer have worked together previously and a high degree of mutual trust / respect already exists. Each party is taking some limited risk and both stand to benefit if the project goes forward -- but nobody's getting a free ride.

Jul 9, 14 8:01 pm  · 
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Volunteer

Maybe not, but no one is going to buy a house where the local schools resemble something from the south side of Chicago either. And they had rather their kids not get assaulted, killed, or raped by the crips and bloods enroute to Miss Mortimers Finishing School.

Jul 9, 14 8:05 pm  · 
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bjsint

@Volunteer. Did I refuse to acknowledge that its a horrible idea?? Pretty sure I agreed an equity stake was now off the table but still wanted to continue the discussion on a PARTLY deferred fee out of interest... Also, stop assuming your own facts. Any real setae investor knows you make money when you buy the house/land at the beginning, its called built in equity - I never said I got the plot for dirt cheap I just said I got it under market value, or to put it another way, under RETAIL value which is what every single real estate investor does, whether they are flippers, or land developers. So one of the main aspects of being a good developer/investor is having the resources to find those deals and get them under contract fast. It doesn't mean the land is worthless by any means just because I got a good deal on it. 

I should have probably mentioned the surrounding houses are between $3m -15m. The position alone commands a presume price, along with a well designed house from a great architect 5m, wouldn't be difficult at all. The plot of land is in the Hollywood Hills, almost entirely flat, the gentleman who owned it inherited it and just wanted to get rid of it because he couldn't afford the property taxes. It's a great spot.

Anyway its safe to say I've received my answers, thanks to all the helpfully ones. Didn't expect so much hostility for asking an honest question without everyone assuming I'm trying to pull a fast one, question my integrity and bash property developers.

Jul 9, 14 8:08 pm  · 
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bjsint

@quizzical

Thank you so much for your detailed response. This is the type of structure that would be very workable for us at the moment as long as a good architect would agree to it, which from this thread i can see might be difficult. This is exactly the kind of no nonsense advice I was seeking when I started this thread.

I was thinking of a small 'earnest' retainer for the pre development stage at a % of what it might usually cost, the difference to be paid when the project goes forward. But I like the reduced rate scenario you proposed better.

Thank you!

Jul 9, 14 8:16 pm  · 
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