Merchant Builders and How They Operate
Merchant builders are commercial real estate developers who build properties and sell them in a short time frame. Merchant builders develop properties in all asset classes, including multifamily and single-family homes. However, many of them choose to develop single-tenant retail properties for well-known tenents, such as CVS, Costco, or McDonald’s.
Leasing properties to national companies with good credit reduces the risk for all parties involved, particularly the investor(s) who will purchase the property from the merchant builders.
These types of tenants, known as anchor tenants, usually sign long-term (think 20-year) triple net (NNN) leases. This means that the tenant pays for nearly all the expenses of the property, including utilities, maintenance, permits, and needed renovations.
Some merchant builders have in-house construction companies, while other merchant builders outsource construction to a separate firm. Either way, most successful merchant builders have significant construction know-how.
How Do Merchant Builders Finance Their Properties?
Banks often end up financing merchant builders by providing them with commercial construction loans. Construction loans are usually full-recourse, but the recourse may partially “burn-off” as the property gets closer to completion and reaches important construction. Banks are much more likely to provide high-leverage, lower-rate financing for properties that will be leased by better-known and more prominent tenants, and often provide loans with a loan-to-cost (LTC) up to 75% for well-qualified borrowers.
Joint Venture Partnerships and Merchant Builders
Merchant builders often will partner with investors, who will put up the majority of the capital prior to the beginning of the deal. After construction, merchant builders will sometimes sell their equity in the project back to the original investors. In other cases, the merchant builder will sell the property to another investor, and return the original investors’ capital, along with any return they achieved.
Sample Merchant Building Return Calculation
Let’s say a merchant builder has agreed to develop a 50,000 square feet retail property for a national grocery chain at a construction cost of $3 million.
If they get a bank loan at 70% LTV ($2,100,000) with around 7% interest, they would need $900,000 in cash for the downpayment, as well as additional funds for taxes, brokerage fees, financing fees, third-party reports, and other expenses. This could bring the cash needed at closing to $1,000,000.
Let’s say the developer puts 10% equity into the transaction ($100,000) the investors put in 90% ($900,000), a split that is common in the industry. If, after a year of construction, the property sells for $4,160,000 and the closing costs are again $100,000, with the overall cost of financing being $60,000, $1 million of profit would be obtained from the deal.
This would equal an unlevered IRR of 33% and a levered IRR of about 100%. That would mean a 100% levered IRR for both the investor and the developer if funds were distributed equally. However, in these deals, the developer generally gets more money after a financial hurdle called a preferred return is reached.
For example, if, in the deal above, the preferred return hurdle was 20%, the developer would get a higher percentage of the funds, say 40%, for any and all returns above 20%. In this case, the investors will get their initial 20% return on $900,000 invested ($180,000) plus 60% of the remaining returns ($432,000).
The developer would get their 20% return on the $100,000 invested ($20,000), plus 40% of all remaining returns (368,000). Therefore, the investors would achieve a levered IRR of about 62%, while the developer would receive a levered IRR of 338%.
To explain more clearly, the developer put in only $100,000 of equity and came out, after 1 year, with $388,000 in profit. This calculation’s numbers are highly unrealistic, as IRRs are generally not nearly this high, but the example does show the huge profits that builders can make by putting in very little equity into a property and re-selling it for a quick profit.
Merchant Building vs. Longer-Term Investment Strategies
When it comes to investing in or developing commercial or multifamily real estate, there are a variety of business plans a company can execute. These can include ground-up development, distressed real estate investing, value-add strategies, and turnkey investing.
Developing real estate from the ground up is the riskiest, but potentially most lucrative venture. Multiple problems can plague a construction project, from zoning and permitting to legal issues and even weather problems.
Distressed real estate investing is less risky, as investors take properties with serious maintenance or tenant issues and rehab them to raise rents and increase occupancies. Value-add strategies sit in the middle, as inventors typically target well-built, older properties with some deferred maintenance in order to raise rents and implement “forced appreciation” on the property by fixing things up and giving the property new life.
In contrast, turnkey investors take on the least risk, but get the least reward, as they typically buy brand new properties from developers. There is little these investors can do to increase the value of the property except to hope for property prices to appreciate in their local market.
No one style of investing is better than the other, as different investors have different needs and are different risk requirements. Some may want a low-risk investment providing cash flow, while others want to ensure the highest amount of potential profit, regardless of risk.