You really like to sell Alex Homozi. You do it in almost every post you make . . .

Ive researched and read a lot of books. Most of those books are filled with un-actionable anecdotal BS. I’m trying to recommend the best action oriented resources that I’ve come across. If it’s free material I will recommend twice as much since I know many architects looking to start their own firm don’t have 5 grand to spend on a seminar. I’m a crab that has made it out of the bucket in a very unconventional route and I’m advocating for the same advice that I’ve found is the most productive. The fact you’re wondering why I’m “shilling” for free is because simply I want other people to succeed. Im in the process of starting a design build firm with offering *gasp* free architectural designs and VR *ungasp* as a freebie for my design-build services. The client doesn’t get the plans until they sign up for construction services, eliminating the need for people using us for free to shop around. Also eliminates competing against internet plans. We charge more for construction services making up for the lack of design fee. But since we charge a bit more for building, we make up for this lack of income. By charging more for construction we can also pay our subs more to get them in on time and to complete their work. This means we build trust, build a path to having to use us, and ultimately getting a custom home on time and in the budget that they agreed upon forehand. Now, if you actually watched any of Alex Hormozi’s stuff you wouldn’t be wondering why I was shilling for free. The fact you’re wondering why I’m shilling is pretty telling you haven’t followed my advice. I’m only trying to help the other crabs out doing what they love. I’d hate for architects to go to levels.fyi and look at the compensation packages for tech companies. Talk about insult to injury.

I never said you're shilling for anyone. The fact that you missed that makes me question a lot of what you've posted on this topic.

Me: post relevant content on said topic. CM: you sure like to mention someone. I suspect you might be paid to post.

Me: it’s free and it’s what I’ve found personally helpful in trying to break the bucket of crabs BS that architecture is caught in. CM: boy you certainly missed the mark on my comment. Chad, you’re literally the person I’m trying to help. Our economy is about to hit the preverbal fan and a whole lot of small businesses are going to go under. The NY Fed says the odds of a recession at 70% (higher than prior the GFC), China’s economy is imploding (but don’t worry that won’t impact us *winky face*) and 53% of small business owners report that there making half or less than what they earned prior to the pandemic. Oh and interest are still below the historic average. I’m providing help and it’s met with skepticism. Fair enough but I’ve escaped the bucket of crabs. I have nothing but the best for you, and the rest of my impoverished peers, in my heart. P.s. I was looking how much architects were offering employees in and around Seattle. With 3-5 years of exp you’re looking at $60k-$75k. This is literally the same salary as 4 years ago. To put this in perspective, master electricians make over $250k (after having their pay docked) and apprentice electricians make half that. This is in bloody Bremerton!

How do you become the client? Where did the money come from? Architects tends to not charge enough and often architects just don't get enough money in salaries or from clients to buy the buildings. Often, they can't afford the places they design for clients. So, how did you get past the market barriers like price ceiling with the 1000 times to many architects and 10x that number of non-licensed architects designing buildings dragging the market to ridiculous low levels that you spend nearly 2-3 full time job worth of time to get a livable professional income for a modest but comfortable living for a family of 3-6 where other occupations makes as much a week as a managing principal may make at most firms in a single year. Some cases, one day's income is more than a firm principal making $250,000 a year salary. Yes, over $100 MILLION a year. How the hell you get to a level of income making million a year or more because that's what you need to even get investors and lenders excited to lend at all for developers. To be a developer, you need something like $1 to $5 Million in starting capital. Under $1 Million and you're laughed at. So how did you get past that crap?

I may have over exaggerated a little but the hurdles or barriers and constraints are real in the essence of the point. There's a gap between revenue for services and the capital and revenue needed to get into land development. Developers are almost always from rich well to do and its kind of a closed door community that put every pressure they can to keep poor and modest income people from the wealthy class and keep a de facto caste system in place. So it is why I was wondering how did you bridge the divide.

The world is awash in money chasing good returns. If you understand how to deliver those returns through creating value, the money will beat a path to your door.

So you have venture capitalists/investors. Of course, you would need to know them. Real estate investors/VCs but okay. So in a way, they are your client of a sort. So you use their money and goal of getting good returns. I can see where you are using your architectural background for creating value. Of course, you need to argue that value to monetary value not just "feel good" value that is likely to be non-compelling for many investors that could not give a shit about. However, you don't have to go with every investor and find those who do actually care about value that is more than just collecting more on return than they invested. They all will care about that, though. Otherwise, they wouldn't be in business as investors. It is a business and business 101 rule #1 is a business or venture is to generate wealth. To produce more money than spent. Aside from that, there can be other values. Now, in my locality, money doesn't exactly come beating its way to the area. Too small of population is my guess. Being significantly less than 1,000 people per square mile in the county-wide area, significantly less than 2,500 per square mile of municipality area. There is considerably less money in places below those persons per sq.mi. (County and City respectively). While the City is minimally dense enough, the county is a bit low considering the area. Both factors are in the consideration factors so they are looking at market potential and scale in and throughout their pro forma analysis. Other factors like incoming vs outgoing population trend and more. So, yeah. It's more than a single factor, of course. So, not claiming a single factor.

RE deals these days (i.e. post-downturn) are put together using a wide variety of capital sources on both the equity and debt sides of the equation. Typical LP investors are looking for an internal rate of return which offsets their opportunity costs and meets their risk adjusted return target. That is going to vary depending on their strategy (merchant build, value-add, core, etc.), but it's never going to be less than 10 percent IRR. It's not too difficult to deliver that with a well-conceived project, but it does require thinking about our work beyond the extremely narrow boundaries architects are accustomed too.

It always makes me kind of wonder what other architects are doing, if not working with their clients on pro-formas. It seems crazy that one wouldn't want to better understand how your clients' businesses work, so you can provide value for them. At least for us, it's a huge and essential part of our own business.

Thank you for the response, gwharton. I also look forward to reading your your other threads.

Going back to discussing sources of equity and finance in putting together RE deals, here is a rough conceptual breakdown of the equity structure for a small-ish apartment project I've been putting together for a couple of years...

This is a fairly complex example despite the small project size because the landowner was coming into the project as a limited partner, using their land as equity in the deal, and a second general partner was coming in to self-perform on construction, since my own design-development org did not have that capacity. Since the construction GP would also use their balance sheet to help guarantee the construction loan, their share is consequently pretty big.

And you'll see woven through that the incorporation of fee-for-equity trades to reduce cash commitments, as well as a waterfall promote structure for return to equity on the back end. Waterfall promotes are very, very common now in the post-downturn RE investment world.

One thing most architects utterly fail to grasp about real estate development finance is that the architect's fee is counted as equity for the developer and has to be paid out of their own money. That means, in a project with a 70% finance ratio, ever dollar paid to architects is worth roughly three to five times more to the developer than dollars paid to contractors. This may help you understand why clients get so uptight about design fees relative to other expenses.

gwharton, what is a "waterfall promote structure"?

I LOL at "most architects utterly fail to grasp about real estate development finance" -- it's not just true; it's laughable to expect we have ANY understanding of these strategies/constructs/concepts. I think I can safely say most, if not all, get ZERO education or experience in development. Finance ratios? This may seem basic to you, but it's another language if you never see the pro formas ever...we just see the client insisting on a lower fee without any suggestion that we take any equity for the risk of producing a liability-inducing set of docs

Yes, the jargon can get fairly confusing without digressing into a graduate-level seminar on modern investment finance (BORING). Finance ratios and "capital stack" are references to how the money for a deal is put together. The "total stack" is all the capital (money) necessary to complete a project (e.g. the total cost of the thing all-in, including all fees, construction, interest, and whatever). The components of that capital stack fall into two broad categories: borrowed money (lending) and invested money or assets (equity). The percentage of each relative to the total cost is a ratio: the Lending Ratio and the Equity Ratio. The lending ratio is also a measure of what's called "leverage" in investment finance (using borrowed money to "lever" or multiply the effect of invested money on the outcome) Developers work very hard to balance these two things to maximize profit potential and minimize risk. Too much leverage (borrowed money relative to invested money) dramatically increases the effect of value swings of an investment, and thus also risk. If you buy a $100 share of stock with $10 of your own money and $90 of borrowed money, and the share price drops 10% to $90, you have just lost all of your own money. A bigger drop than that you can lose more than your own investment. Maybe a lot more if your leverage ratio is very high.

For that reason, lenders are also very careful about balancing their exposure to risk by lending you money for your project. In a typical real estate investment deal, the lenders will typically have maximum amounts of lending they will do relative to the value or cost of your proposed project. They typically look at it three ways in your pro-forma: Loan-to-Cost (LTC), Loan-to-Value (LTV), and Debt Service Coverage Ratio (DSCR). They analyze your pro-forma all three ways, and typically you will only be able to borrow as much as the lowest of the three methods yields. For example, a project which costs $10 million is projected to be worth $15 million on completion, with a stabilized annual rental income of $600,000 (or $50,000 per month). An LTC Ratio of 70/30 says you can't borrow more than $7 million. An LTV Ratio of 60/40 says you can't borrow more than $9 million. And a DSCR analysis of the required loan payments at a 7% interest rate with a 20-year amortization says you can't afford to pay for borrowing more than $5.38 million if the DSCR limit is 1.2. So, that means you can't borrow more than $5.38 million to pay for your $10 million project as it is currently proposed. That's a lending ratio of 54%, which means you have to put up 46% equity (or $4.62 million) in equity investment to pull it off.

So, unless you have $4.62 million under your couch cushions, you're going to need to come up with the remainder of the required capital some other way. There are basically two ways to do this. First is to find a second or even third lender to let you borrow even more money. Second is to get other people to invest their own money in your project as equity.

Second- and third-lien loans have a lot more risk to the lenders (the first-lien lenders gets paid before they do if the project goes sideways), so they are not going to lend you as much money, and the terms are going to be much less advantageous. You'll pay a lot more in interest, for one thing. So generally a developer is going to start looking for equity partners at this point.

So, here I am, a developer needing $4.62 million to move forward with my project. Let's say I have $462,000 (or 10% of that amount) available to invest in the deal. That leaves $4,158,000 I have to raise elsewhere. There are lots of different ways I can do that. The most straightforward is to find an investor who is willing to put up the remainder of the cash. That would be a 90/10 equity split. It's my deal and I'm doing all the work, so I am considered the Sponsor (or General Partner, which is a holdover from the days when these deals were done as partnerships rather than LLCs). I run the project and am responsible for its success or failure. In addition to my investment and equity ownership, I probably also get paid a developer's fee out of the project cost for my efforts. My investor is just looking for a good return on their money and wants to be insulated from some of the developer's risk as well as not having to put lots of direct work into making the investment work out. So the Investor (or Limited Partner) owns a majority share of the project in return for a Preferred Return on the back end (they get paid preferentially before the higher level profits are distributed). The specifics of how that works can be complex, and are unique to every project and equity structure relationship.

If I can't find an investor to put up all that money in one shot, I may have to bring in multiple investors as LPs. Some potential investors may want a larger role and share of the deal, bringing them on as co-Sponsors (or co-GPs). That means I am giving up more power over the project, but there might be a good reason to do that.

As part of negotiating that whole deal to put together the project equity stack, there needs to be a defined arrangement for paying all the equity partners at the end of the project. How that's done depends on what the overall investment time horizon and purpose is, as well as the various participants' risk exposure, value-add, and investment requirements. The deal structure for a long-term hold (build the project then continue to own and operate it for income over a period of years) is going to look very different from a "Merchant Build" (build the project, get its income stablized, then sell it).

Since the Downturn, when lending ratios dropped much lower (it became impossible to borrow a very large portion of the total project cost) and the equity requirements went way up. the way equity investors and sponsors get paid as part of a deal has become much more complex. One thing which has become much more common in that period is a "Promote" style of investment return more like what is commonly seen in the Wall Street private equity world. This is commonly called the "waterfall" because of the way it's typically calculated. At project sale and close-out, all the money goes into a single pool. The lender gets paid back in full first. Whatever's left over get's distributed among the equity partners according to the Promote Structure is it was defined in the original investment agreements. The money flows out of that pool first into the Preferred Return pool, which is usually distributed to the equity partners "pari passu" (passing directly through according to whatever their ownership share is) until a specified level of return IRR is reached. After that, whatever is left flows into the next distribution pool, where there is usually some kind of incentive payment to the project sponsors on top of their equity share. There may be several different levels of this incentive return, each at a higher level of return performance (IRR) than the previous. The point of this is to incentivize the project Sponsor to deliver high value and profit by giving them a proportionately larger share of higher returns. This continues until all the money is distributed and the partnership (LLC) dissolved.

Here's a visual example of a relatively complex waterfall promote structure for a multifamily development project:

Note that the top-end share of returns to Sponsor is much larger than their actual equity share (10%) here.

The last point on all this is that architects are brought into the project, do all our work, and get paid our fees BEFORE the financing for the project is in place. That's why I emphasized above that architects need to understand better how and when we are getting paid, and what that means in the context of our clients' business models. Every dollar we get paid usually has to come out of the equity stack unless we have some other sort of deferred payment agreement in place.

This is a very complete and easy to digest explanation of how deals are put together. As you and I have discussed in other threads, most architects lack this level of understanding. I am saving this for future use!

Thank you gwharton for posting all that -- very helpful to at least see the vectors involved with getting the project to pencil