When do developers earn their profits?
Risk and the timing of returns
The Question
Many people seem to think that a real estate developer earns a big, fat profit not long after receiving their approvals, and long before the completion, lease-up, and sale of a project. But how and when do developers really earn their profits?
The Three Ways to Make Money In Real Estate
There are three ways to make money in real estate: ordinary income (cash flows or rents), appreciation (in value, realized at time of sale), and tax benefits. These three different types of return, however, are realized at different times, emphasizing the concepts of risk and the timing of returns, so let’s take a closer look at each. But before we do, let’s first define what “profit” means.
In a real estate development deal, the “profit” pays the developer’s overhead, which includes payroll and staff costs, rent, insurance, and other operating expenses typical to running any business. Profit also covers the “pursuit costs” from failed projects. For example, it may cost $250,000 to get to the point where your entitlements are not approved, or you pull the plug on a project for some other reason. These are sunk costs, and profits from successful deals must be used to cover these losses. After all these costs are covered, any surplus income is profit.
Ordinary Income: Assume you plan to develop or acquire a real estate asset—an apartment building, office building, warehouse, or retail center. If you develop, it can take several years to go from inception through planning, design, entitlements, construction, and sellout or lease-up. Whether you develop or purchase an existing asset, you plan to sell it after ten years. You expect to borrow 70% of the purchase price from the bank, and pay the remaining 30% of the development cost or purchase price with investor equity—your cash and the cash of three other friends. Your share will amount to 2%-3% of the total. Every month, you will collect rents from the tenants, and after covering operating costs and accounting for vacancy and bad debt, you will be left with Net Operating Income, or NOI. From the NOI, you must cover your debt service payment to the bank: the mortgage. Whatever is left over after paying the mortgage is the “profit,” which you will distribute as a preferred rate of return, for example, 10% of invested equity, to your other three investors. Whatever is left after paying your investors is yours to keep and is taxable as ordinary income at 37%, similar to your paycheck. (More about taxes below.)
Appreciation: If you are successful, the building will increase in value over time, or “appreciate.” When you sell it after ten years, you will use the sales proceeds to pay off the mortgage balance and to pay two taxes: First, you will pay a one-time capital gains tax of 15% on the increase in value from when you bought the building to when you sold it. For example, if you bought the building for $10 million and sold it for $15 million, then you will pay a 15% tax on the $5 million gain. You will also pay a 25% depreciation recapture tax (below). Whatever is left after paying off the mortgage, capital gains, and depreciation recapture taxes is yours to keep and/or to distribute amongst your investors.
Tax Benefits: The US tax code incentivizes people to invest in real estate by allowing them to “depreciate” a building. Using “straight line depreciation,” every month you are allowed to charge off a portion of the value of the building as if it were a cost, until the building reaches a value of zero (27.5 years for rental apartments and 39 years for non-residential properties, including commercial office, retail, and warehouse). For example, if you bought an apartment building worth $10 million, using straight-line depreciation, you can expense $10,000,000/27.5 years/12 months=$30,303 per month, as if you spent or used up that amount of the building each month. Depreciation allows you to show a “paper loss,” which reduces both your taxable income and your ordinary income tax bill. However, at the time of sale, you must pay a one-time 25% depreciation recapture tax on all the depreciation you have claimed over those ten years. Depreciation is an incentive because it allows you to keep more income every month by shifting a portion of ordinary income (taxed at 37%) to a lower rate (25%), and allows you to pay it all off at the time of sale from the sales proceeds. After paying off the mortgage, capital gains tax, and depreciation recapture, you and your three equity partners will share the remaining profit.
Risk and the Timing of Returns
The returns to a real estate asset come at different times, from monthly ordinary income to a one-time gain on sale, and include tax benefits that affect both. When developers and investors talk about return on investment, or ROI, they mean the sum of all of those returns over the ten-year ownership period, and more specifically, the after-tax Internal Rate of Return, or IRR, which is the average rate of return over the hold period. More importantly, during the hold or ownership period, most of the cash flow will go to the bank and your investors before you, the developer, receive anything; the final profit will not be known and realized until the time of sale; and the final sale price is, at best, an educated guess when you first buy the property. Indeed, profit in real estate development is not as simple as it looks, as it must cover costs the public does not know about; is influenced by investors and lenders the public never sees; is largely earned at the time of sale, which can be years or even decades away; and is dependent upon a big bundle of assumptions that must play out over time. So, let’s look a little more closely at profit from the developer’s perspective, by considering three other ways to think about it:
Profit margin is not completely up to the developer: The developer may be the only person community members see or meet, but behind the scenes are numerous investors who expect a minimum return for their risk. The bank also wants to see a healthy profit on your proforma, because they want you to be motivated to complete the project successfully and not just walk away when the going gets tough. Indeed, both the bank and your investors want you to have some of your own cash invested and a strong profit motive, or, as Warren Buffett famously said, they want you to “have some skin in the game.” And finally, if there are any government subsidies, such as Tax Increment Financing (TIF), in the deal, then there will be strings attached and additional performance requirements. All of these interested parties—investors, lenders, and, in some cases, governments—will play a role in reviewing and shaping the developer’s pro forma—including the developer’s profit—before they agree to fund the project.
Profit is not guaranteed: A pro forma is based on a series of assumptions about how different variables will change over time, whether it’s a new development project or the apartment building you plan to sell after ten years. A lot can change, too, including the economy, financial markets, interest rates, inflation, material and labor costs, market conditions, demand for your product type, local, state, and national politics, local ordinances such as inclusive zoning and rent stabilization, and cap rates, which affect value at the time of sale. For example, commercial office buildings with high vacancy rates have lost value over the past several years, reducing tax revenues and forcing cities to increase taxes on other property types. At the same time, insurance rates have skyrocketed, due in part to an increasing number of natural disasters. Profit margin is an assumption, based on a whole pile of other assumptions, all of which reflect variables like these, that will change over the five, ten, or fifteen years from inception through completion of a project.
The developer’s profit is not fully realized until the end: In the case of that building you plan to own for ten years, every month the lender will be repaid first (that’s why it’s called a “first mortgage”), and the investors will earn a preferred return from the remaining cash flows. Although you have invested your time and expertise in putting the deal together, you have invested the least amount of cash, so you are in third place. But while you may earn a smaller return every month, you expect to earn a large profit from the appreciation of the asset: the increase in value realized at the time of sale. Increase in value is based in part on rent growth over the ownership period, so the more the rents and Net Operating Income grow every year over the ownership period, the higher the value at the time of sale and the larger your profit (as long as cap rates don’t go up, but that’s a subject for a future post). In other words, the lenders and investors who have contributed the lion’s share of capital to the project earn their interest and returns every month—sooner, more regularly, and more predictably. The developer, who has invested less cash, earns a greater share of their profit at the time of sale—a higher risk, because it comes at the end, but a potentially higher reward. The most important thing to understand is that the longer an investment is held, the less predictable its outcome, and the riskier it becomes. Or, as one saying amongst developers goes, “you make all your profit when you sell the last four units.”
The Lesson
To summarize, the three ways to make money in real estate are through ordinary income, appreciation (gain on sale), and tax benefits. But things are not as simple as they appear when we talk about profit. There are more people involved in determining profit—and who that profit really belongs to—and, in addition to risk and reward, the timing of the returns plays a role. Along the way, the bank will be repaid, and the investors will earn their returns, but the developer will earn a large share of their profits at the time of sale, and no one can predict what conditions will be like five, ten, or fifteen years into the future. And while most people think developers are all wildly successful and rich, many developers who started delivering completed condominium units after the beginning of the great financial crisis, in late 2007, not only did not earn a profit, but lost everything. As an example of how it can go wrong, the former leader of a large, well-known, long-running family-owned development firm in Chicago that was wiped out said to me in 2010, “We are not a development company anymore.”
Investment decisions should be made on the basis of the most probable compounding of after-tax net worth with minimum risk.
- Warren Buffett, former CEO of Berkshire Hathaway, also known as “The Oracle of Omaha.”
Not even the “safest” investment is without some risk and some element of speculation.
- Bernard Baruch, American Financier and Statesman
And last but not least, I want to thank my colleague and friend, Murray Kornberg, for reviewing and commenting on multiple drafts of this essay. Any errors are mine alone.