Can an architect working for a company which designs hotels and resorts, be able to earn equity in the building project? For example, some developers are building a new independent boutique hotel, can an architectural firm be hired but also part of the deal as investors or recipients of equity in lieu of some fees?
why would you want that? Can’t pay your staff and keep the lights that way. You’ll be waiting years to see a tinkle of dividends in this “investment” at best.
Jan 13, 24 8:45 am ·
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Zorbon the Builder
Why would I want equity in a real estate development project? Well have you seen the latest list of billionaires? Many developers on it, not a single architect.
Anything is possible, especially if you have more money than brains bits it’s a dumb idea for to trade fees for equity. You can’t pay staff with equity.
"Why would I want equity in a real estate development project? Well have you seen the latest list of billionaires? Many developers on it, not a single architect."
The reason is real estate developments typically has payoffs in the 10 year range. A short return on investment is around 3-5 years. These types of developments typically have multiple investors who back the projects so the individual risk (and amount of money) for each person is minimalized.
Just keep in mind that a return on investment isn't a profit. It's when you break even.
FYI: Architects typically have to pay all of the consultants. Those consultant fees typically make up 25% of the total project fee. If you're doing a $10 million project at 7% construction cost . . .
Jan 14, 24 10:51 am ·
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Wood Guy
Chad, I disagree that "a return on investment isn't a profit. It's when you break even." A ROI is neither of those, it's the income you get annually divided by how much you invested.
Good point WG. I meant to say that your typically won't break even for 3-5 years for a fast ROI. An architects portion of a 7% fee investment in such a project would still have such a small ROI it wouldn't be worth it.
Even a 3-5 year "payback" would be very fast, representing roughly a 20-30% ROI. If returns were typically that large, everyone would be investing in real estate. As you noted, 10% seems to be more common, at least in the real estate investing forums/books/podcasts I follow, i.e. around 8 years (including compounding interest) before you would be paid back. After that it's gravy money but who wants to wait 8 years to be fully paid?! I'm sure there are exceptions with higher returns but cap rates of 5-10% seem to be typical.
Yup. The 3-5 years is rather rare and typically involves high demand developments with a limited number of investors who all put up huge amounts of money.
Also, are you interested in the debt you may incur if the business is unsuccessful? Or finding another investor to buy your shares when you need to liquidate for cash?
investing is a whole other business, with its own logic and skills. As an architect your services are a cost to the business. Ironically your financial incentive is at cross purposes to the building owner - the ideal financial outcome is for them to destroy their business paying outrageous architectural fees.
I’m not saying you “want” this. Only that the incentives of owner and consultant are not completely aligned.
The best way to make more money in architectural practice is to get more projects, do them nicely, hire people to expand the office that could still be managed well, and don't complicate this order of business. If you are saying, I love this project so much, I want to do the work pro bono, then you must have some existing financial means to get you and your office going for a couple of years working on a boutique hotel which in itself is a risky business.
Zorbon, I'm sure many developers would be happy to have part of your payment be in the form of an equity stake. But a savvy developer will make sure your stake is small, and you'll have no way of influencing the business decisions that would affect the profit margin. If you're interested in hands-off real estate investing, you might consider joining a syndication or REIT. You'll still have no control but your risk will be spread out and won't complicate your business books.
i imagine there would be significant liability issues if you had ownership in a project you designed which you don't remain actively involved in managing. for example if years later the owner (which is you!) hires another firm for renovations or even just a GC and they screw things up that you should have known to be problematic.
I'm not an expert but I disagree with a lot of these comments. Sounds like a lot of fear from people who have never done this. If a developer is willing to give a decent percentage of equity in a project and you can manage that work flow, I think it's a great opportunity to get into a real estate deal without fronting the cash. You have to do your own research regarding how much cash value your sweat equity is worth and what those potential returns will be but at the end of the end of the day, if you have a piece of a cash-flowing building, that to me is better than a one time fee, especially if you have interest in real estate investment. I once had a professor who was the founder of a large scale architecture firm and he told me "if you want to make real money, be a developer." Thats a whole other discussion but I say, protect yourself with a ton of insurance and if you have to the cojones, then go for it. I am currently working through this but it's a long game, no data to report back at this time.
And you pay your staff and consultants also with equity? No one is commanding fees high enough to warrant a big enough share in dev. It’s a silly idea unless the arch is also the fish in the pond.
Cash flow is the bane of a lot of AEC firms. Put simply, you cash outflow is fairly smooth - wages, overhead, expenses - but your cash inflow may well not be. And while account receivables is a fine accounting entry, it doesn't pay salaries. Small firms frequently find themselves in a bind when they run out of cash to pay employees because clients don't want to pay up.
I think it's important to consider the scale of these projects. A massive multimillion-dollar project with substantial professional fees for a small % of equity ownership might not be the best. I'm working on a small 6 unit project. The drawings are manageable. I am essentially running the show and received a sizable % of the equity in the building to do so. If you have an interest in real estate investing and can find a good opportunity, it could work. Maybe you partner with a home builder and get % of profits and you're responsible for all the documents, permits, construction oversight etc. I think there are a ton of unique circumstances to make this work.
What is your stake in the project? What's your ROI? I as because: Assuming the 6 unit project costs $10,000 your typical arch fee would be around $335k with about $112k going to consultants. If traded all your arch fee for a stake in the project that's a 3.35% of the profits and losses.
There's not an arch firm in the world that can charge the amount of money you need to get into these projects as a minority partner, so fee in lieu to get in a development is a unicorn that I personally killed when I left school. Save money, and invest it like a man.
That's what I was thinking JLC-1. I just wanted to see MDH-ARCH try and 'enplane' to the rest of use mere morons how it works for him.
I like how MDH said to partner with a home building to get a % of the profits. Most home builders get 10-15% profit per unit. Unless you're taking at least half of that it's not worth your time as an architect to do this type of work.
kids, It can be done in Ultra High End SFR, mostly in resort towns, but you have to wear a lot of hats and have enough money to hold on for 3 or 4 years - it's basically design -built where you buy an empty lot and build a spec house for 8M and sell it for 15M, you get about 3M after paying everybody. I have not met a developer willing to give a 3% stake on anything.
I don't claim to have this figured out at all, I just don't think the idea should be shot down if you don't have experience in doing it. James Petty wrote a book "Architect & developer" he goes into a lot more detail of how this can be done and explains how architects can use their sweat equity to get some skin in the game. As a young person who has an interest in expanding their career beyond running a typical practice, there are other options out there. Jonathan Segal also talks about using sweat equity as well, He calls them "Johny Bucks". People do this type of thing all the time. I'm not saying it's easy or that I have it figured out, just that whoever reads this and is curious should do some more research and give it a try.
You read one book, don't understand it, yet think it can be done?
You're also ignoring people here with 20 + years of experience who have seen firms attempt this and are telling you why it doesn't work.
FYI - the book by Petty - it's not about trading your architectural fees for equity in a development. It's about an architect partnering with a developer and buying into the development with cash money. Basically you buy in, and because you're partnered with the developer you get a few more % of ownership of investment in addition to your architectural fee.
So... this is something I have personal, direct experience with, both as an architect and also as a developer. The majority of the comments in this thread are off base and show a very poor understanding of how our industry works as a business. However, a few of the comments are on target, foremost among them being the issue of cash flow management. Swapping fee for equity means you delay receipt of cash in return for your work. If you don't have other sources of cash to cover ongoing overhead expenses (mainly payroll and rent), you will go bankrupt in the interim from insolvency. Not coincidentally, this is a major failure mode for real estate development companies too. Even if they have very healthy balance sheets (lots of valuable assets), poor cash management can force them into insolvency fairly easily.
Another big issue not mentioned here is that most real estate developers do not want an architect as an equity partner. You have to do a lot of extra work to convince them you belong at the table and won't be a liability. Architects' (usually well-deserved) reputations for being very bad at business decision making means that there is a very strong bias against having them as business partners in real estate projects.
Now, in my case, I already had a track record for successfully completing my own RE dev projects before I ever had a conversation with a client about a fee-for-equity swap, and I was in a position to speak about the advantages, disadvantages, and deal terms very knowledgeably. In general, fee-for-equity swaps are really only going to be attractive to smaller developers who themselves are carefully controlling cash outlays. Architect fees are typically paid out-of-pocket by developers prior to project financing, which means architect fees are literally cash equity for them already. This is also why architects often have to fight over pennies, while downstream project participants get larger leeway and returns.
Anyway, I'm happy to answer questions about doing design-development if you want to know more.
So do you forgo your architectural fee to have that money be used to purchase equity in a development? Say your 7% fee on a $10 million development?
Jan 15, 24 1:44 pm ·
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gwharton
In the case where it is a negotiation with a client for fee-for-equity, it's usually a discussion about the balance of fee vs. cash investment (they always want you to have skin in the game, and lenders will insist on it), plus fee scope and participation rights. Much more commonly, fee-for-equity swaps are something which makes a lot of sense if you as the architect are the deal sponsor (GP) rather than an investor participant (LP). I do them on every project I do as a developer, since it reduces the amount of cash I personally have to put into the deal up front while giving me extra leverage on payout downstream (which also has a waterfall incentive structure to me as GP/sponsor).
Again, fee-for-equity with a client-subordinate position is really only something which you would see for small-scale projects where the client is really husbanding cash outlays up front.
Jan 15, 24 1:51 pm ·
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gwharton
Another advantage of doing fee-for-equity as a GP/Sponsor is that you can set your fee at whatever level you can get your LP investors and lenders to agree is reasonably plausible. There are certain arms-length limits to that, but it's another way to get equity leverage into your own projects.
Jan 15, 24 1:53 pm ·
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gwharton
On the returns side, many of the commenters here seem to not really understand how real estate development finance works. Investor equity returns (regardless of seniority) are paid in tranches depending on the original deal terms, usually with preferred returns to LP participants to around the 10% IRR level, and then scaling into incentive distributions above that at specific performance levels (e.g. 15%, 20%, etc.). This is the "waterfall" model the industry adopted widely after the Downturn made 90/10 LTC lending deals impossible and developers had to start coming up with lots more equity up front.
Aren't you still looking a small amount of buy in unless you're raising your fee substantially? IE: for a $10 million project you'd only be getting around $350k in equity. That doesn't seem like very much very much.
Aren't you also still looking at a 8-10 year time frame before you break even at a 10% ROI?
Jan 15, 24 2:12 pm ·
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gwharton
Again, it depends on the terms of the deal structure. You have to think about your position in the entire capital stack, what the leverage is, and what the payout terms are. For a $10mm project, around $7mm of that is going to be borrowed money. So if my fee is $350K and I trade it one-to-one for equity, I am now a 11.67% owner of the final project ($350K as a percentage of $3mm total equity share). Does that make sense?
On the ROI side, this is always discussed in terms of IRR, not direct return. IRR is the inverse of compound interest. Your internal rate of return for any financial decision is the implied annual compound rate of return for a series of cash investments and payouts over time. So if I invest $350K of fee to own 11.67% of equity returns at sale, and target a 10% IRR as minimum performance, that means the project would need to be worth $620K (before tax) or so back to me in six years (six-year return is typical for a merchant-build deal pro-forma, but it could be any period of time at all). That means the value of the whole completed project in six years needs to be $17.7 million ($620K divided by my 11.67% share then divided by 30% total equity).
Jan 15, 24 2:26 pm ·
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gwharton
What your IRR target is for the investment is completely dependent on opportunity cost and risk. You could take that money as cash fee now and invest it at whatever "risk-free" level you can find (call it 5% IRR). That's your opportunity cost. Deferring the receipt of that payment for six years and locking the value up in a real estate project is more risky, so you need to be compensated for taking the risk. By how much depends on how risky the decision is. Most GP merchant developers I know (including me) will not even consider getting into a deal as a sponsor unless it can reasonably give me at least 20% IRR cash-on-cash. LP investors require less return, because they are taking less risk. Lenders take the least return (interest on the loan) because their risk is comparatively very low.
Jan 15, 24 2:30 pm ·
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gwharton
There's obviously a lot more to it than this, but I hope it communicates some of the basic issues associated with participating in a real estate project on the equity side. Debt leverage ratios have a gigantic impact on potential risk and return for any fee swap. In the example above, $350K of fee is worth 11.67% of a $10mm project at 70/30 LTC lending. At 60/40 LTC, that same fee only buys 8.75% ownership. But at 80/20, it's suddenly 17.5% ownership! However, you don't just own that share of the project and it's returns. You also own that share of all its liabilities too. And if you are going to try and do this as a GP/Sponsor, the lender is going to want to know if you have a big enough balance sheet to cover those liabilities if the whole thing goes sideways.
I knew it was possible and complicated. I didn't realize how complicated.
In addition the basic cash flow component still stands. You can't pay your firms operating costs this quarter with income two years from now. I mean you 'can' but we won't get into that . . .
Our firm has been approached with offers like this from developers. Because of the risk, and the 'unique' demands of the developer we decided to pass. Keep in mind our firm typically keeps 9(ish) months of operating costs in the bank at all times.
Yes, absolutely. Cash is King. The number one failure mode for most businesses is not having enough to cover expenses. Real estate is no different.
Jan 15, 24 3:03 pm ·
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gwharton
Also, as a closing note here, even for architects who have zero interest getting involved in real estate deals as equity participants, you will gain a LOT more leverage on fee negotiations if you understand more about the business model on your client's side which is paying you. It continues to shock me how few architects actually understand the business accounting surrounding their fee agreements from their clients' perspective. For developer projects (i.e. private, for-profit work), your fee is coming out of the client's early cash equity nearly 100% of the time, and is often fully at-risk capital on top of that (unrecoverable if the project goes sideways). That cash is very valuable to them, more so than borrowed dollars paid to a general contractor for instance. If you can deliver proportionately high value to them at the early projects stages you are working in, and can work out ways to reduce the cash impacts on their P&L of paying you, you get a lot more leverage to increase fees.
Cash is king. I work for a large GC that has internal development capabilities, fee developer, merchant developer, and P3 lead. Your comment about client's actual cash vs. borrowed cash made me think of another option... which is to defer a portion of the design fee to financial close. That will allow the A/E firm to realize some cash flow month to month, and balance how much capital the developer is paying prior to financial close. You would have to write into the contract a clause about being paid in full even if the deal falls apart and financial close never happens.
Suffice to say, that to a developer, each project dollar is not worth the same... you have to understand what is actual equity and what is borrowed.
Excellent point. If payment of a portion of the fee can be deferred until the client gets construction financing, that reduces client cash outlay up front and shifts some of the cash flow into the leveraged portion of the project finances. As an architect, you can propose this as part of your contract. If you do so, however, you are assuming some risk, so be sure to get paid for it: the deferred portion of the fee should be higher than scale, and maybe even include a performance bonus/penalty structure to make it even more attractive. These are all things which speak to the client's needs and business model, and provide both options and value if done right.
Jan 16, 24 12:46 pm ·
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betonbrut
Indeed. Back to some of your original insights... architects need to better understand how the client is structuring the financing to better understand how they might provide value to the developer.
You don't speak to your clients about how they're financing their projects?!? I thought that was a basic question as it may impact the project delivery method.
Read what gwharton actually wrote. You'll see that what I've written is correct - except for my mis-typing the ROI with WoodGuy. You're still going to need a lot of start up capital to make a fee or equity payment to work. Unless gwharton says otherwise it's realistic for a break even timeframe with an ROI of 10% is still around 8-20 years.
Also there still isn't any insurance you can buy to mitigate your risk with this type of investment. Your contract could help but it will never lower the risk.
Jan 15, 24 2:19 pm ·
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Wood Guy
If that's what you got out of everything said before gwharton put a lot of lingo to basically the same thing everyone else said, I wish you well in your endeavors.
Jan 15, 24 3:41 pm ·
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gwharton
Wood Guy: go re-read what I wrote. Other than reiterating the importance of cash flow management, I was specifically NOT re-hashing the other comments, but correcting them.
There is a high(er) level of risk with this type of 'investment'.
It's a complicated process that relies heavily on contracts.
There is no insurance that will protect you from this risk.
MDH-ARCH doesn't understand this process very well.
Are all incorrect?
Jan 15, 24 3:56 pm ·
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monosierra
It really depends on one's risk appetite - and almost by definition, one's financial buffer. Y'all raise valid points. Perhaps an entrepreneurial architect with an eye for real estate and solid financial backing of his/her own can indeed find a good investment in a real estate collaboration with a trusted partner.
Interim cash flow issues? No problem - we have a year-ful of emergency funding courtesy of other businesses. Complicated capital stack? We got it - the architect is just as financially savvy as his or her developer partner.
I do think it takes a special set of skills and resources to succeed (or even to persuade a real estate partner to agree to another equity partner). Most architects are probably unqualified though.
A couple of success stories I've came across both involved considerable funding from family and friends - one architect's wealthy in-laws financed his real estate endeavors while another enjoyed the backing of a developer friend.
There are cash flow issues with it because of deferred returns.
It is a different kind of risk, not necessarily higher risk. Architects take on all kinds of risks as consultants which they don't understand and don't get paid for. This is at least one way to get paid for the risks.
It's different but not necessarily more complicated than standard contracts.
There isn't "insurance" to cover the risk, but insurance doesn't cover a lot of risk in fee-for-service either. On the other hand, it's easier to hedge risk as an equity participant than a contract consultant. A lot easier, actually.
MDH-ARCH was asking about it from a position of unfamiliarity, but didn't make any unwarranted assumptions about it, so meh.
GH, you certainly added a lot of detail--so much, and so many abbreviations, that I find it almost impossible to follow. But what I get out of it is that cash-on-cash returns are roughly what others and I noted above.
Oh, I see that you disagree about the desire for architects as equity partners. I said many would probably be in favor, and you say they aren't. You know more than I do there. But "many" is not very specific.
Jan 15, 24 4:52 pm ·
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Wood Guy
^ that came out more negative than I intended. I appreciate you sharing your expertise.
You would need to be willing to put in an equity stake into the project, either your time for a very small percent, or real money and backing. It's definitely possible, there are all sorts of clever business models that architects for the most part do not participate in. But some do!
Some do. I've been at firms that have. It can work. In my opinion it's more complicated than standard arch contracts but if you have some experience with it then it's OK. You still typically need to put up a lot of your own money into the development.
We typically don't do it as part of our professional fees but many of the developers we work with always reach out to see if we are interested, personally or as a company, to invest in a project, monetarily. There is usually a minimum of $75,000 investment and the return is about 10% for 3 years unless they sell the project once built. Few years back some of our investments were astronomical in returns as the ownerships sold some of the properties for a huge profit.
Yup - it can work. You're almost always going to need to buy in with actual money and not just do a fee for equity buy in. I've seen it done with both though.
If you are thinking "I want to get rich quick too" that's not the way. Our role ( equity value (5-8 %) based off of fees to design the project ) is a minor percentage of the overall investment providing only a faction of the profit to us in return and lots of risk factors that you aren't in control of. Unless of course you felt, like Trump that you have a brand that speaks for itself and are owed much more go for it.
Jan 16, 24 7:22 pm ·
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Architects Gaining Equity in Construction Projects?
Can an architect working for a company which designs hotels and resorts, be able to earn equity in the building project? For example, some developers are building a new independent boutique hotel, can an architectural firm be hired but also part of the deal as investors or recipients of equity in lieu of some fees?
why would you want that? Can’t pay your staff and keep the lights that way. You’ll be waiting years to see a tinkle of dividends in this “investment” at best.
Why would I want equity in a real estate development project? Well have you seen the latest list of billionaires? Many developers on it, not a single architect.
How much cash do you have on hand to contribute and how long are you willing to wait before you see any return?
Well I don't mean me specifically. I am applying to arch school atm. I was asking if this was a possibly within the field.
Anything is possible, especially if you have more money than brains bits it’s a dumb idea for to trade fees for equity. You can’t pay staff with equity.
Zorbon the Builder wrote:
"Why would I want equity in a real estate development project? Well have you seen the latest list of billionaires? Many developers on it, not a single architect."
The reason is real estate developments typically has payoffs in the 10 year range. A short return on investment is around 3-5 years. These types of developments typically have multiple investors who back the projects so the individual risk (and amount of money) for each person is minimalized.
Just keep in mind that a return on investment isn't a profit. It's when you break even.
FYI: Architects typically have to pay all of the consultants. Those consultant fees typically make up 25% of the total project fee. If you're doing a $10 million project at 7% construction cost . . .
Chad, I disagree that "a return on investment isn't a profit. It's when you break even." A ROI is neither of those, it's the income you get annually divided by how much you invested.
Good point WG. I meant to say that your typically won't break even for 3-5 years for a fast ROI. An architects portion of a 7% fee investment in such a project would still have such a small ROI it wouldn't be worth it.
Even a 3-5 year "payback" would be very fast, representing roughly a 20-30% ROI. If returns were typically that large, everyone would be investing in real estate. As you noted, 10% seems to be more common, at least in the real estate investing forums/books/podcasts I follow, i.e. around 8 years (including compounding interest) before you would be paid back. After that it's gravy money but who wants to wait 8 years to be fully paid?! I'm sure there are exceptions with higher returns but cap rates of 5-10% seem to be typical.
Yup. The 3-5 years is rather rare and typically involves high demand developments with a limited number of investors who all put up huge amounts of money.
Also, are you interested in the debt you may incur if the business is unsuccessful? Or finding another investor to buy your shares when you need to liquidate for cash?
investing is a whole other business, with its own logic and skills. As an architect your services are a cost to the business. Ironically your financial incentive is at cross purposes to the building owner - the ideal financial outcome is for them to destroy their business paying outrageous architectural fees.
I’m not saying you “want” this. Only that the incentives of owner and consultant are not completely aligned.
there can be a conflict of interest if you invest in projects you're hired to work on. that can especially turn troublesome with public projects.
The best way to make more money in architectural practice is to get more projects, do them nicely, hire people to expand the office that could still be managed well, and don't complicate this order of business.
If you are saying, I love this project so much, I want to do the work pro bono, then you must have some existing financial means to get you and your office going for a couple of years working on a boutique hotel which in itself is a risky business.
Zorbon, I'm sure many developers would be happy to have part of your payment be in the form of an equity stake. But a savvy developer will make sure your stake is small, and you'll have no way of influencing the business decisions that would affect the profit margin. If you're interested in hands-off real estate investing, you might consider joining a syndication or REIT. You'll still have no control but your risk will be spread out and won't complicate your business books.
i imagine there would be significant liability issues if you had ownership in a project you designed which you don't remain actively involved in managing. for example if years later the owner (which is you!) hires another firm for renovations or even just a GC and they screw things up that you should have known to be problematic.
I'm not an expert but I disagree with a lot of these comments. Sounds like a lot of fear from people who have never done this. If a developer is willing to give a decent percentage of equity in a project and you can manage that work flow, I think it's a great opportunity to get into a real estate deal without fronting the cash. You have to do your own research regarding how much cash value your sweat equity is worth and what those potential returns will be but at the end of the end of the day, if you have a piece of a cash-flowing building, that to me is better than a one time fee, especially if you have interest in real estate investment. I once had a professor who was the founder of a large scale architecture firm and he told me "if you want to make real money, be a developer." Thats a whole other discussion but I say, protect yourself with a ton of insurance and if you have to the cojones, then go for it. I am currently working through this but it's a long game, no data to report back at this time.
And you pay your staff and consultants also with equity? No one is commanding fees high enough to warrant a big enough share in dev. It’s a silly idea unless the arch is also the fish in the pond.
^biggest fish.
MDH-ARCH HISTORY wrote:
"I'm not an expert but I disagree with a lot of these comments."
If you're not experienced in this then why should we listen to you?
"Thats a whole other discussion but I say, protect yourself with a ton of insurance and if you have to the cojones, then go for it. "
There is no such thing as insurance that protects development investors from loss. Did you mean a contract?
"I am currently working through this but it's a long game, no data to report back at this time."
This tells me that you're not making any money, don't expect to for a long time, and don't have any reasonable projections that you ever will.
Cash flow is the bane of a lot of AEC firms. Put simply, you cash outflow is fairly smooth - wages, overhead, expenses - but your cash inflow may well not be. And while account receivables is a fine accounting entry, it doesn't pay salaries. Small firms frequently find themselves in a bind when they run out of cash to pay employees because clients don't want to pay up.
I think it's important to consider the scale of these projects. A massive multimillion-dollar project with substantial professional fees for a small % of equity ownership might not be the best. I'm working on a small 6 unit project. The drawings are manageable. I am essentially running the show and received a sizable % of the equity in the building to do so. If you have an interest in real estate investing and can find a good opportunity, it could work. Maybe you partner with a home builder and get % of profits and you're responsible for all the documents, permits, construction oversight etc. I think there are a ton of unique circumstances to make this work.
What is your stake in the project? What's your ROI? I as because: Assuming the 6 unit project costs $10,000 your typical arch fee would be around $335k with about $112k going to consultants. If traded all your arch fee for a stake in the project that's a 3.35% of the profits and losses.
There's not an arch firm in the world that can charge the amount of money you need to get into these projects as a minority partner, so fee in lieu to get in a development is a unicorn that I personally killed when I left school. Save money, and invest it like a man.
That's what I was thinking JLC-1. I just wanted to see MDH-ARCH try and 'enplane' to the rest of use mere morons how it works for him.
I like how MDH said to partner with a home building to get a % of the profits. Most home builders get 10-15% profit per unit. Unless you're taking at least half of that it's not worth your time as an architect to do this type of work.
kids, It can be done in Ultra High End SFR, mostly in resort towns, but you have to wear a lot of hats and have enough money to hold on for 3 or 4 years - it's basically design -built where you buy an empty lot and build a spec house for 8M and sell it for 15M, you get about 3M after paying everybody. I have not met a developer willing to give a 3% stake on anything.
I don't claim to have this figured out at all, I just don't think the idea should be shot down if you don't have experience in doing it. James Petty wrote a book "Architect & developer" he goes into a lot more detail of how this can be done and explains how architects can use their sweat equity to get some skin in the game. As a young person who has an interest in expanding their career beyond running a typical practice, there are other options out there. Jonathan Segal also talks about using sweat equity as well, He calls them "Johny Bucks". People do this type of thing all the time. I'm not saying it's easy or that I have it figured out, just that whoever reads this and is curious should do some more research and give it a try.
You read one book, don't understand it, yet think it can be done?
You're also ignoring people here with 20 + years of experience who have seen firms attempt this and are telling you why it doesn't work.
FYI - the book by Petty - it's not about trading your architectural fees for equity in a development. It's about an architect partnering with a developer and buying into the development with cash money. Basically you buy in, and because you're partnered with the developer you get a few more % of ownership of investment in addition to your architectural fee.
So... this is something I have personal, direct experience with, both as an architect and also as a developer. The majority of the comments in this thread are off base and show a very poor understanding of how our industry works as a business. However, a few of the comments are on target, foremost among them being the issue of cash flow management. Swapping fee for equity means you delay receipt of cash in return for your work. If you don't have other sources of cash to cover ongoing overhead expenses (mainly payroll and rent), you will go bankrupt in the interim from insolvency. Not coincidentally, this is a major failure mode for real estate development companies too. Even if they have very healthy balance sheets (lots of valuable assets), poor cash management can force them into insolvency fairly easily.
Another big issue not mentioned here is that most real estate developers do not want an architect as an equity partner. You have to do a lot of extra work to convince them you belong at the table and won't be a liability. Architects' (usually well-deserved) reputations for being very bad at business decision making means that there is a very strong bias against having them as business partners in real estate projects.
Now, in my case, I already had a track record for successfully completing my own RE dev projects before I ever had a conversation with a client about a fee-for-equity swap, and I was in a position to speak about the advantages, disadvantages, and deal terms very knowledgeably. In general, fee-for-equity swaps are really only going to be attractive to smaller developers who themselves are carefully controlling cash outlays. Architect fees are typically paid out-of-pocket by developers prior to project financing, which means architect fees are literally cash equity for them already. This is also why architects often have to fight over pennies, while downstream project participants get larger leeway and returns.
Anyway, I'm happy to answer questions about doing design-development if you want to know more.
So do you forgo your architectural fee to have that money be used to purchase equity in a development? Say your 7% fee on a $10 million development?
In the case where it is a negotiation with a client for fee-for-equity, it's usually a discussion about the balance of fee vs. cash investment (they always want you to have skin in the game, and lenders will insist on it), plus fee scope and participation rights. Much more commonly, fee-for-equity swaps are something which makes a lot of sense if you as the architect are the deal sponsor (GP) rather than an investor participant (LP). I do them on every project I do as a developer, since it reduces the amount of cash I personally have to put into the deal up front while giving me extra leverage on payout downstream (which also has a waterfall incentive structure to me as GP/sponsor).
Again, fee-for-equity with a client-subordinate position is really only something which you would see for small-scale projects where the client is really husbanding cash outlays up front.
Another advantage of doing fee-for-equity as a GP/Sponsor is that you can set your fee at whatever level you can get your LP investors and lenders to agree is reasonably plausible. There are certain arms-length limits to that, but it's another way to get equity leverage into your own projects.
On the returns side, many of the commenters here seem to not really understand how real estate development finance works. Investor equity returns (regardless of seniority) are paid in tranches depending on the original deal terms, usually with preferred returns to LP participants to around the 10% IRR level, and then scaling into incentive distributions above that at specific performance levels (e.g. 15%, 20%, etc.). This is the "waterfall" model the industry adopted widely after the Downturn made 90/10 LTC lending deals impossible and developers had to start coming up with lots more equity up front.
For fee-for-equity:
Aren't you still looking a small amount of buy in unless you're raising your fee substantially? IE: for a $10 million project you'd only be getting around $350k in equity. That doesn't seem like very much very much.
Aren't you also still looking at a 8-10 year time frame before you break even at a 10% ROI?
Again, it depends on the terms of the deal structure. You have to think about your position in the entire capital stack, what the leverage is, and what the payout terms are. For a $10mm project, around $7mm of that is going to be borrowed money. So if my fee is $350K and I trade it one-to-one for equity, I am now a 11.67% owner of the final project ($350K as a percentage of $3mm total equity share). Does that make sense?
On the ROI side, this is always discussed in terms of IRR, not direct return. IRR is the inverse of compound interest. Your internal rate of return for any financial decision is the implied annual compound rate of return for a series of cash investments and payouts over time. So if I invest $350K of fee to own 11.67% of equity returns at sale, and target a 10% IRR as minimum performance, that means the project would need to be worth $620K (before tax) or so back to me in six years (six-year return is typical for a merchant-build deal pro-forma, but it could be any period of time at all). That means the value of the whole completed project in six years needs to be $17.7 million ($620K divided by my 11.67% share then divided by 30% total equity).
What your IRR target is for the investment is completely dependent on opportunity cost and risk. You could take that money as cash fee now and invest it at whatever "risk-free" level you can find (call it 5% IRR). That's your opportunity cost. Deferring the receipt of that payment for six years and locking the value up in a real estate project is more risky, so you need to be compensated for taking the risk. By how much depends on how risky the decision is. Most GP merchant developers I know (including me) will not even consider getting into a deal as a sponsor unless it can reasonably give me at least 20% IRR cash-on-cash. LP investors require less return, because they are taking less risk. Lenders take the least return (interest on the loan) because their risk is comparatively very low.
There's obviously a lot more to it than this, but I hope it communicates some of the basic issues associated with participating in a real estate project on the equity side. Debt leverage ratios have a gigantic impact on potential risk and return for any fee swap. In the example above, $350K of fee is worth 11.67% of a $10mm project at 70/30 LTC lending. At 60/40 LTC, that same fee only buys 8.75% ownership. But at 80/20, it's suddenly 17.5% ownership! However, you don't just own that share of the project and it's returns. You also own that share of all its liabilities too. And if you are going to try and do this as a GP/Sponsor, the lender is going to want to know if you have a big enough balance sheet to cover those liabilities if the whole thing goes sideways.
Thanks gwharton!
I knew it was possible and complicated. I didn't realize how complicated.
In addition the basic cash flow component still stands. You can't pay your firms operating costs this quarter with income two years from now. I mean you 'can' but we won't get into that . . .
Our firm has been approached with offers like this from developers. Because of the risk, and the 'unique' demands of the developer we decided to pass. Keep in mind our firm typically keeps 9(ish) months of operating costs in the bank at all times.
Yes, absolutely. Cash is King. The number one failure mode for most businesses is not having enough to cover expenses. Real estate is no different.
Also, as a closing note here, even for architects who have zero interest getting involved in real estate deals as equity participants, you will gain a LOT more leverage on fee negotiations if you understand more about the business model on your client's side which is paying you. It continues to shock me how few architects actually understand the business accounting surrounding their fee agreements from their clients' perspective. For developer projects (i.e. private, for-profit work), your fee is coming out of the client's early cash equity nearly 100% of the time, and is often fully at-risk capital on top of that (unrecoverable if the project goes sideways). That cash is very valuable to them, more so than borrowed dollars paid to a general contractor for instance. If you can deliver proportionately high value to them at the early projects stages you are working in, and can work out ways to reduce the cash impacts on their P&L of paying you, you get a lot more leverage to increase fees.
Cash is king. I work for a large GC that has internal development capabilities, fee developer, merchant developer, and P3 lead. Your comment about client's actual cash vs. borrowed cash made me think of another option... which is to defer a portion of the design fee to financial close. That will allow the A/E firm to realize some cash flow month to month, and balance how much capital the developer is paying prior to financial close. You would have to write into the contract a clause about being paid in full even if the deal falls apart and financial close never happens.
Suffice to say, that to a developer, each project dollar is not worth the same... you have to understand what is actual equity and what is borrowed.
Excellent point. If payment of a portion of the fee can be deferred until the client gets construction financing, that reduces client cash outlay up front and shifts some of the cash flow into the leveraged portion of the project finances. As an architect, you can propose this as part of your contract. If you do so, however, you are assuming some risk, so be sure to get paid for it: the deferred portion of the fee should be higher than scale, and maybe even include a performance bonus/penalty structure to make it even more attractive. These are all things which speak to the client's needs and business model, and provide both options and value if done right.
Indeed. Back to some of your original insights... architects need to better understand how the client is structuring the financing to better understand how they might provide value to the developer.
You don't speak to your clients about how they're financing their projects?!? I thought that was a basic question as it may impact the project delivery method.
Thanks for shedding some light on this, interested to hear more!
Clearly, Chad just has a negative bias on the subject.
Not at all.
Read what gwharton actually wrote. You'll see that what I've written is correct - except for my mis-typing the ROI with WoodGuy. You're still going to need a lot of start up capital to make a fee or equity payment to work. Unless gwharton says otherwise it's realistic for a break even timeframe with an ROI of 10% is still around 8-20 years.
Also there still isn't any insurance you can buy to mitigate your risk with this type of investment. Your contract could help but it will never lower the risk.
If that's what you got out of everything said before gwharton put a lot of lingo to basically the same thing everyone else said, I wish you well in your endeavors.
Wood Guy: go re-read what I wrote. Other than reiterating the importance of cash flow management, I was specifically NOT re-hashing the other comments, but correcting them.
qwharton - so the comments that:
Are all incorrect?
It really depends on one's risk appetite - and almost by definition, one's financial buffer. Y'all raise valid points. Perhaps an entrepreneurial architect with an eye for real estate and solid financial backing of his/her own can indeed find a good investment in a real estate collaboration with a trusted partner.
Interim cash flow issues? No problem - we have a year-ful of emergency funding courtesy of other businesses. Complicated capital stack? We got it - the architect is just as financially savvy as his or her developer partner.
I do think it takes a special set of skills and resources to succeed (or even to persuade a real estate partner to agree to another equity partner). Most architects are probably unqualified though.
A couple of success stories I've came across both involved considerable funding from family and friends - one architect's wealthy in-laws financed his real estate endeavors while another enjoyed the backing of a developer friend.
GH, you certainly added a lot of detail--so much, and so many abbreviations, that I find it almost impossible to follow. But what I get out of it is that cash-on-cash returns are roughly what others and I noted above.
Oh, I see that you disagree about the desire for architects as equity partners. I said many would probably be in favor, and you say they aren't. You know more than I do there. But "many" is not very specific.
^ that came out more negative than I intended. I appreciate you sharing your expertise.
You would need to be willing to put in an equity stake into the project, either your time for a very small percent, or real money and backing. It's definitely possible, there are all sorts of clever business models that architects for the most part do not participate in. But some do!
https://amzn.to/3O18O7J
Some do. I've been at firms that have. It can work. In my opinion it's more complicated than standard arch contracts but if you have some experience with it then it's OK. You still typically need to put up a lot of your own money into the development.
We typically don't do it as part of our professional fees but many of the developers we work with always reach out to see if we are interested, personally or as a company, to invest in a project, monetarily. There is usually a minimum of $75,000 investment and the return is about 10% for 3 years unless they sell the project once built. Few years back some of our investments were astronomical in returns as the ownerships sold some of the properties for a huge profit.
Yup - it can work. You're almost always going to need to buy in with actual money and not just do a fee for equity buy in. I've seen it done with both though.
If you are thinking "I want to get rich quick too" that's not the way. Our role ( equity value (5-8 %) based off of fees to design the project ) is a minor percentage of the overall investment providing only a faction of the profit to us in return and lots of risk factors that you aren't in control of. Unless of course you felt, like Trump that you have a brand that speaks for itself and are owed much more go for it.
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