Limited Partner Bargaining Power Leads to Better Deals

Over the last 6 months, we’ve seen some creative trends from developers in response to the competitive capital environment.

In this edition of the Bird's Eye View, we look at deal structure changes that developers are making to attract LP investors, and how these features are making deals more attractive on a risk-adjusted basis.

If you were to focus on media headlines alone, the only logical conclusion is that the world of real estate is a post-apocalyptic barren wasteland from which it will never recover.

Yes, there is uncertainty about the economy, demand growth, and ability to pay higher prices. Land, building and borrowing costs are high. In the U.S., many markets are still dealing with oversupply.

We have no intention of minimizing the challenges associated with those points, though we do want to stick our heads out and highlight some of the positive developments we’ve seen in private real estate over the last 6 months, specifically as a result of increased LP bargaining power.

In this edition of the Bird's Eye View, we look at deal structure changes that developers are making to attract LP investors, and how these features are making deals more attractive on a risk-adjusted basis.

Focus on risk-adjusted returns

When we talk about better deals, we mean deals that are more attractive on a risk-adjusted basis. Functionally, this can happen either by reducing risks while maintaining or increasing returns, or increasing returns while maintaining or reducing risks (for more on risk premiums and how they have changed between 2021 and 2024, see our previous article, Where’s the Opportunity in Private Real Estate in 2024).

With that said, let’s take a look at 3 deal features we’ve seen in the last 6 months that have improved projected risk-adjusted returns for LP investors.

LPs Hold the Cards

For the first time in many years, there is heavy competition for capital both inside and outside of real estate, putting LPs in a strong bargaining position. The result is that developers are giving up margin and getting creative to try and attract LP investment. Here are some of the ways we’ve seen this increased bargaining power manifest in deals:

1. Improved Access

We've seen a growing number of developers that have traditionally raised capital solely from institutions open up to the possibility of working with individual investors and family offices, providing access that would have been unheard of three years ago.

Where a substantial portion of project risk comes from execution, being able to invest with AAA developers - those with access to low-cost debt and a proven track record of profitable projects over decades - mitigates some of this risk.

In addition to better access, we are also seeing earlier access to deals, providing a healthier environment to complete proper due diligence.

2. Participation in the Land Lift

It is common for developers to raise capital in two tranches, the first at the time of land-purchase and the second typically when the project is ready to begin construction. In many cases, the land has appreciated in value between the first and second tranches, particularly if it has been rezoned.

In most circumstances, the first-tranche investor, which is often the developer, will keep some or all of this increased land value to themselves. The rationale is that the first-tranche investor(s) took on higher risk by buying unzoned land, and should therefore be eligible for a greater reward. 

This makes sense because particularly in Canada, there is a sizable risk associated with entitlement. Even though these processes are usually successful, they are often lengthy, acting as a drag on returns.

However, we’ve seen some situations this year where second-tranche investors, entering a deal that is ready for construction, have captured the full benefit of the increased land value, making returns to LPs much more attractive on a risk-adjusted basis. 

3. Improving Fee and Profit Split Structures

Some developers have also shifted their compensation and waterfall structures, so that if a deal does underperform, investors take proportionally higher amounts of the profit.

In practice, this concept isn’t new. Preferred returns and hurdle rates have long been used to accomplish this purpose, though we are seeing more creativity and emphasis on structures that reduce downside risk for investors. In other words, if the pie ends up smaller than anticipated, investors are ending up with a larger portion of it than we’ve ever seen. 

Conclusion

Over the last 6 months, we’ve seen some creative trends from developers in response to the competitive capital environment.

While we don’t believe it’s time to hit the “risk-on” button in general, we are excited about the pro-LP deal structures that we are seeing top developers adopt. In our view, these types of measures go a long way toward making private real estate deals more attractive on a risk-adjusted basis, even after accounting for current market conditions.