Hearthstone's recent $19 million lot-option commitment to John Laing Homes marked a major milestone for the nation's largest investor in residential development. Structured financing transactions of this sort now account for nearly half of the San Rafael, Calif.–based firm's deals with home builders.

When Hearthstone was founded in 1992, it did mostly joint venture partnerships with builders, in which it would provide up to 100 percent of the money needed to acquire the land, develop finished lots, and construct the houses. In return, Hearthstone would receive roughly half the profits when the houses were sold.

“The builder gets a little more than half, but I would call it a 50-50 split,” says Anthony Botte, senior vice president for the investment firm's western region. “We put up all the money and they do all the work.”

Over the last five years, however, a structured financing package in which Hearthstone purchases the ground, hires a developer, and then sells the finished lots has increasingly become a popular form of financing for big public and private builders alike, according to Botte. That is so much the case that the deal with John Laing Homes to build 145 units in Chino, Calif., is more significant for its form than for anything else.

“Probably [almost] half of our transactions are now lot-option packages,” says the Hearthstone executive. “We provide the acquisition and development dollars, and builders get control of finished lots when they need them.”

Structured financing offers builders a couple of advantages over traditional joint venture transactions, mainly risk avoidance and balance sheet maintenance. By not taking title to the ground until construction is about to start, builders are able to better manage the risk involved with carrying too much land for too long a period. And perhaps equally important, they also are able to keep the expense of holding costly ground off their all-important balance sheets.

“The cost of the option payment is generally higher on these deals—probably around 300 basis points higher on a blended cost of capital—but they have the opportunity to lay off future market risk,” according to Botte. But the developer Hearthstone reimburses to ready the ground for construction is typically the builder who brings the land to the company in the first place. And lots are sold back to the builder at a predetermined price that is set going into the transaction. Although it is “very rare” that a builder would forfeit some options, Botte says it can happen when the market turns suddenly or the builder decides to exit the area.

Hearthstone was the first and now is the nation's largest institutional investor in housing. Since its inception 14 years ago, it has committed more than $10 billion in funds it manages on behalf of public and private pension plans, university endowments, major corporations, and large private trusts. In 2005, it provided more than $2 billion to 15 builders in seven states, funding more than 30 developments and some 7,000 houses in the process.

But the fund manager does more than invest other people's money. As part of its modus operandi, it also requires each member of its investment committee to put their own money into each transaction. That way, the company's executives also have a significant portion of their personal net worth at risk.