Real estate developers are navigating through a uniquely challenging capital environment. Last week, in this blog piece, we explored access to debt resources for ground-up construction projects, and covered several strategies to win financing even as the debt markets tighten.
While it’s reassuring to remember that even in the most challenging market, there’s funding available for experienced developers with quality projects, looking only at debt resources neglects an important tool: equity partnerships. Unlike the banking sector, private equity firms are thriving.
At the end of 2022, S&P Global estimated that private equity companies held some $2 trillion in dry powder searching for a place to land. The figure conveys a 21% increase over the previous year, illustrating the growing strength of the private equity market even as the debt sector has tumbled.
“This is a great opportunity for private equity funds with good local [development] partners,” said Ed Chazen, senior lecturer at Boston College Carroll School of Management, in a recent interview with Northspyre. Developers have an opportunity to tap into this liquidity through an equity partnership. A partnership is another option at a developer’s disposal to fight through market challenges and secure new projects.
Liquidity Is King
In a down cycle, equity is powerful. Well-capitalized investors and developers have the ability to wait through market volatility and take advantage of distressed assets. In a high-interest rate environment like we have today, well-capitalized investors can operate outside of the debt markets in the short term. It’s a significant advantage, and there are plenty of examples of the ways that liquidity has offset market strife.
Earlier this year, a highly liquid market helped to stabilize the banking sector when Silicon Valley Bank and three others were taken over by regulators. John Jordan, a portfolio manager and research analyst at Janus Henderson Investors, said that a well-capitalized banking sector helped to weather the SVB storm without setting off a widespread crisis.
Stability through a downturn is one reason why large real estate developers forgo debt coverage. “Real estate companies crash and sink during financial storms because of their debt. When a downturn hits — just when you need to replace your debt most — you cannot replace it,” said John Kilroy, Jr., the CEO of office development company Kilroy Realty Corp. in an interview with NAIOP. The firm self-funds acquisitions and holds no short-term debt. Chazen notes that this is a common practice among real estate investment trusts (REITs), which typically only place 35% leverage onto an asset and usually have three times the interest payment in cash reserves as a standard.
Developers with a strong balance sheet and access to liquidity will not only survive the current market crunch but will also be able to take advantage of opportunities and market distress.
Benefits of Private Equity Partnerships
While it’s true that liquidity increases stability, in practice, most developers can’t operate like a REIT. That is, few private or family developers have the ability to self-fund projects or maintain large cash reserves. Debt is a standard element of the capital stack, with most developers leveraging more than half of the total cost of a project. Private equity partnerships are an opportunity to backfill the capital stack and limit exposure to debt, mimicking the REIT strategy while also increasing internal liquidity. The strategy has tremendous benefits in a tightening debt market with rising capital costs.
“Investors that buy bigger property on their own or in a partnership are not going to get in financial trouble,” says Chazen about the benefits of a private equity partnership. Developers can pursue partnerships before or after the start of a project, even when a project has fallen into distress. “It really rescues a property from imminent default,” he explains.
Augmenting capital access through a private equity partnership is only one benefit. Partnerships can also expand a developer’s network and surface new opportunities. Developers will also share in the risk and responsibilities of a construction project, enhancing overall stability. As a result, private equity partnerships have historically produced higher returns, second only to stocks, and have greater resiliency during a down cycle.
Steering the Relationship
A private equity partnership is a good option to work around a complex and challenging capital market, but it isn’t necessarily a good fit for every developer. To start, a partnership, by definition, means shared ownership. Developers must relinquish autonomy, both in concept and in financial management, to secure a private equity partnership. “It's complicated,” says Chazen. “The property owner [or developer] may be unwilling to give up control, but they will have to.”
Private equity partnerships also mean shared profits. Developers share in the risk as well as the rewards. So, although these partnerships produce outsized profits, developers will likely see reduced returns.
In addition, private equity firms are exposed to the same economic challenges as any other investment stakeholder. Although the private equity market is flush at the moment, researchers anticipate momentum will slow due to “inflation and macroeconomic challenges” that will likely “blunt private equity performance.” Because private equity companies raise capital through individual investors, reduced returns could hamper future fundraising efforts, leaving firms with less dry powder to place in development projects.
In other scenarios, equity capital could reposition investments to risk-averse assets. S&P Global expects private equity’s market share to fall from 28.3% of assets under management to 25.3% of assets under management by 2027. If equity fundraising falls, developers will not only find fewer opportunities to pursue a partnership but will also experience increased risk and involvement inside of an equity partnership.
Securing the right capital is only one piece of a robust strategy that developers should use to navigate market turbulence. Investing in automation and robotic intelligence tools that create efficiencies and reduce costs should also be a part of the equation. Platforms like Northspyre help developers shave budgets down 6%, reduce overages by 66%, and alleviate as much as 80% of administrative tasks. By pursuing new capital sources and leveraging technology to create operational efficiencies, developers will find deals that work.
In a challenging market, developers must look for alternative strategies to offset risk without stalling business activity. Private equity partnerships are one option to secure capital for a ground-up construction either in place of or in addition to debt. There is currently an abundance of private equity circulating in the market. Now is the time to strike.
Download the Maximizing Returns: A Real Estate Developer’s Recession Guide to discover how you can secure the right projects despite market uncertainty.
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Real Estate Development