cart-before-horse-cartoon

I do a lot of teaching and coaching of small developers through the Incremental Development Alliance (IncDev). In the course of that effort I meet folks who are really interested in Alternative community based models for owning buildings.  These include Benefit Corporations, Co-operatives (Co-ops), Low-profit Limited Liability Companies (L3C's), or Cohousing

.  I think I understand and appreciate the reasons why these arrangements are attractive to people looking to build community, but I want to offer some advice on the mechanics of using these structures in a development project.

These are all structures for owning real estate that have alternative methods for governance and distribution of profits that are alternatives to the more typical tools for owning income producing real estate, the partnership or 

Limited Liability Company (LLC)

 .  Before you get fancy with alternative ownership structures, focus upon the basics by standing up an enterprise that will be doing the work of the developer; finding the site, testing various designs and financing approaches, building . leasing and operating the building or buildings.  The Operating Company can be the operating partner, operating co-op member, managing LLC or L3C member, or Benefit Corp. manager. All of these various ownership structures are set up to do the job of describing how capital will be raised for the project and how profits will be distributed. It is the role of the Operating Partner to raise the capital, build/rebuild and operate the buildings profitability so that there is cash flow to distribute among the owners regardless of what ownership model is used, or the mission of the enterprise.

Before you get fancy with alternative ownership structures build a straightforward simple project with straightforward and simple ownership structure, an operating partner and a capital partner under a typical LLC that is limited to just one project as the owner. (a Project-Specific LLC).  You build this structure with an ordinary LLC Operating Agreement.  Under the Operating Agreement, the Operating Partner and the Capital Partner both know who is supposed to do the work (the Operating Partner), who is supposed to put in the capital needed (the Capital Partner), how important decisions will be made, how and when the capital partner will get their original investment back, and how revenue beyond the repayment of principal will be distributed between the capital partner and the operating partner.

The basic deal structure is a good starting point for folks that want to eventually set up other more elaborate alternative forms of ownership. It will help the small developer to  become good at doing the work of the operating partner -an essential role that is required in every one of the alternative ownership structures mentioned above.

In any of these structures people putting up the money in large or small amounts are going to ask a very legitimate series of questions:

• Who is in charge of this thing?
• Do they know what they are doing?
• How do decisions get made?
• How does the project make money?
• When do we get our initial investment back?

The horse that goes before the cart is knowing how to do the work of the operating partner. Do that on a small project. It’s like learning how to drive in an empty parking lot before you attempt to drive on local streets or on a freeway. Once you have some of those basic operating skills, then you can look at alternative ownership structures consistent with your mission. The operating partner is the crucial resource,

not the money

.

Raising money from a couple of individuals and operating under a straightforward project-specific LLC is easier and less complicated than Crowd Funding, REIT formation, starting a co-op, L3C, or Benefit Corporation. Walk before you try to run (attempt to fly).

 

I commented on a friend's Facebook thread in which he lamented the lame podium building getting built on his street. Somebody posted a comment that "It's all about maximizing the developer's profit" to explain why the building was not great.

I gotta say, that's really over-simplifying what it takes to get a building constructed in Portland.  There is a pretty good chance that trying to build a building will result in the developer losing money if they are not on top of things. I guess Not Losing Money may be the same as Maximizing Profit, but there is a lot more to the work. If you lose money often enough you become a former developer.

Most developers are minimizing risks and maximizing returns within the current crop of constraints which include local, state, and federal regulations, local approval processes, skilled construction labor shortages, and a number of can only be described as short sighted bad habits. Over the life a a project it is too easy for design to end up as the superficial consideration -kinda like deciding how a cake will be frosted. All of the other things (that will blow up your project if you don't pay attention) are about the cake. Attention to urban design and place making should be part of the cake because they can add a lot of value and solve some gnarly problems. The developers that get that employ urban design as a tool with great flexibility and utility. For the rest, well, that design stuff is just frosting.

While we can beat up developers for being unaware of the power of design to manage risk, let's bear in mind that there is plenty of cluelessness to go around.  Some of the problem with how buildings are currently conceived and delivered be found in the unfortunate culture and habits of the design community. Most planners, urban designers, and architects are satisfied with remaining uninformed and unskilled when it comes to developer math and operations.  In the end they don't have much of a common vocabulary to communicate with their clients (which is unfortunate.)

The bar for decent infill is pretty low these days -even in a place that likes to consider itself forward thinking and progressive like Portland.  It is very hard to build trust with local folks who have seen a lot of lousy buildings go up recently. If you do succeed in building something  something decent, you can start to carve out a place for yourself in the neighborhood. No matter how good your built work is, chances are good you will still be treated with contempt if your chosen line of work is to be a developer. Other people get paid at their job, but getting paid to make buildings happen is somehow something sleazy in the minds of some.  Development work is considered a vocation reserved for individuals of low character. Your buildings will have to speak for your character after you are dead. In the mean time, most folks will just think you are an asshole.  That does not mean that you can consider yourself some sort of community builder/martyr.  It's an everyday thing.  Humans prejudge strangers based upon fear, myth, or by their direct experience of some recent bad building put up by somebody that you resemble.

I live in Portland Oregon.  Moved here last December.

Last year Oregon's legislature removed a prohibition on Inclusionary Zoning (IZ) which now allows cities to require a percentage of Affordable Housing units in new buildings of 20 units or more.  The Portland City Council unanimously voted to put an IZ ordinance in place.  Recently I have had a number of folks from around the country and from Portland ask me what I think about IZ.  I have had a hard time coming up with a response that does not shut down the conversation. I get really exorcised over this topic.  To be blunt, IZ makes me nuts and I tend to go off on the people who innocently ask me about it.  Clearly, I need to craft a more grownup response.

I respect the motivation behind wanting to see more affordable housing get delivered. I am appalled by the naive methods being employed toward that very positive goal.  I get frustrated with smart and sincere people who are serious about the delivery of housing if I think they have not made a serious effort to understand the basics of how housing gets delivered.  Maybe that information has not been available to them if they are not in the business.  It's not reasonable to hold people accountable for information they don't have, so let's start by laying out the basics of how a building makes money and how people decide if they want to construct a building in a given location.

If you can't get the rent, you shouldn't build the building.  The rental income for a building needs to cover the Total Project Cost.  This includes cost of buying the site, , paying the impact fees, designing, bidding, financing, building and leasing the building.  The rental income also needs to allow for some of the units not paying rent from time to time because nobody is living in them (Vacancy).  Finally, the rental income needs to be able to cover the building's Operating Expenses which include property taxes, insurance, property management, maintenance, water, sewer and trash, and replacements reserves of $300-$500 per unit set aside each year.

In addition to covering these costs, a building need to make a profit to justify why someone is going to put up 20% - 40% of the cash need to make the building happen.  Whoever puts that money up (and signs a guaranty to repay the construction loan that will provide the rest)  has other things they can do with that money and they can reasonably expect to get paid something for the risk they are taking in undertaking a construction project.  A construction project has more risk than a savings account, treasury bond or mutual fund, so money put into a real estate project has to pay a higher return than alternative investments with lower risk.  A workable rule of thumb is that $1 in monthly rent can typically support $100 in Total Project Costs and yield a reasonable return of 10-12% on the cash you put in the building.

What happens if 20% of the units in a building don't pay their way because the rent you can charge has been limited by the IZ Ordinance?  The assumption is that you will have to convince the potential tenants for the other 80% of the market rate units to pay higher rent, or find a way to  reduce the Total Project Cost.  Reducing Total Project Costs will come down to convincing the person selling you the site that you need to pay less for it.

In Part II we can walk through the math on how this works on a example building.