The Guru Is In

Pity the Misunderstood Developer

By David A. Smith
January 29, 2021 5 min read

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I’m just a soul whose intentions are good.

Over a long career of observing developers at close range, I’ve evolved an understanding of how they think and act, and, as a result, find myself with an unexpected sympathy for them. Though the algorithmic model that follows may seem reductive, time and again it’s been critical to making good deals happen and succeed. Consider it the wisdom of experience.

Just as a hen is only an egg’s way of making another egg, to a developer a property is a developer’s way of making enough money to do another property. Their field of action always constrained by capital and liquidity, developers (large or small, for-profit or nonprofit ) all operate according to a simple value function: maximize the reward-to-risk ratio.

Reward has three elements:

• Net development cash extracted. Money captured in cash by completion and stabilization. That’s not what they book, much less what they pro-forma, but instead what they actually extricate from the deal. Only when capital is safely extracted can it be redeployed into hunting the next deal.
• Controllable positions’ capitalized annuity value. Development results in control and that creates potential for future revenue streams. Though Deferred Development Fee sounds like cash, in fact it’s a chimera, realized only to the extent of future cash flow. DDF is merely a slice of that cash flow, as are all other below-the-line fees: incentive management fee, asset management fee or grandiloquent circumlocutory fee. Above the line, legitimate profit earned on any ordinary and necessary service provided by an identity-of-interest (IoI) entity, such as a capable property management company, is an annuity and valued as such.
• Impact value. It drives all developers, though what is impact is in the individual eye of each developer: visible monument, mission motivation, business reputation, platform scale, fundraising mojo, capital-raising mojo and plaudits all factor in. Why do you think industry awards are so eternally popular?

Resources risked. Development means risking key organizational resources, which come in four main varieties:

• Time spent. Measured by both actual calendar time (beginning to end of the high-risk period) and by senior executive bandwidth devoted (with principal executives’ bandwidth counting much more). Time is the ultimate equity, because it is always irrevocably invested, and returns are never certain.
• Maximum capital exposure. To a developer, capital exposure means only the developer’s money at risk. Developers respect Other People’s Money but they obsess incessantly about their own.
• Gauntlet risks run. For a developer, time is measured in three intervals:

1. Ideation through site control. Though cash outlays are small, the investments of time and senior executive bandwidth consumed are massive;
2. Site control through financial closing. The capital exposure interval, which begins by writing big checks to secure the site, and ends only when Other People’s Money arrives in large chunks, typically recouping a significant portion of the developer’s capital exposure;
3. Financial closing through stabilization. Construction, leaseup and initial operations. Most of these risks are laid off on the general contractor, not the developer.

That second interval, site control through financial closing, is the gauntlet. That’s when the developer’s capital obsession peaks.

• Risks retained indefinitely. Like parenthood, development is an initiative that begins with the best of intentions and powerful feelings, with no guaranteed end date, and emotional anxiety throughout. Even after the property is stabilized and the visible or contractual financial risks abate or expire, invisible ones endure. Litigation (including latent defects), poor management or maintenance, after-the-fact claims of excess profiteering, bad publicity and all the new asymmetric reputational risks associated with social media – all of them land on the developer’s stoop.

What separates every developer from any general contractor, any architect, any lender, any equity investor, and most especially from any government body, is continually taking risk. Many in our industry believe that somehow every problem can be analyzed to the point where risk is quantified and contained. In the world of development, often it cannot. Someone has to take those risks: open-ended risks; unquantifiable risks; unique risks; hard-to-control risks; unexpected risks; unfair risks. Taking risk is a business fundamental: “the business we’ve chosen,” to quote Hyman Roth. Risk becomes the developer’s constant companion, and an embedded mindset. What separates successful developers—the fair from the good, the good from the great—is their ability to choose which risks to take when, and how to react when risk profiles suddenly change.

Knowing this, how can you get developers to do what you want? Help them maximize their Reward-to-

Resource ratio:

Reward = N + C + I

Resources = T + M + G + R

• Reward = Net development receipts + Controllable positions value + Impact value
• Resources = Time spent + Maximum capital exposure + Gauntlet risks run + Risks retained indefinitely.

Want affordable housing to be cheaper? Reduce their Resource Risks. If you do, the cost will come down – if not from the developer you’re negotiating with, from another developer who’ll underbid them.

Oh Lord, please don’t let me be misunderstood.