Sharing Real Estate Investment Profit The Internal Rate of Return (IRR) Waterfall Technique

Parties in Real Estate Development Real estate investment requires the coordination of capital and talent from various parties Equity partners -- equity contribution Lenders --- debt capital Developer --- skill + tenacity +vision +equity These partners have always struggled for position when it comes to sharing profit from real estate investment

The Risk-Return Trade-off Among the Parties Lender First position -- lowest risk Predetermined return with no upside Equity Investor: Second Position – medium risk Risk capital subject to volatility Return depends on project success Developer Third Position: takes most risk May invest equity Provides talent (skills, tenacity, vision, leadership) necessary for project success Return has unlimited upside potential depending project performance

Traditional Method of Sharing Profits Traditionally, the equity partner and developer may have agreed on sharing profits as follows: Preferred return to equity partner, say 10% Preferred return to developer, say 9% Net profit after subtracting these returns is split according some schedule, say 75/25 One argument against this arrangement is that it may not induce the developer to do his very best to create the biggest pie possible

In Search of Optimal Strategy for Sharing Profit Developer’s talent and expertise are critical to project success Developer also assumes the highest risk level But traditionally developers returns have subordinate to the lenders’ and the equity investors’ returns. Ideally, there should be a progressive strategy of sharing profit between the parties that is commensurate with degree of risk exposure Such strategy typically shifts downside risk away from the equity investor to developer In return, the strategy provides greater upside potential for developer to compensate for greater risk or volatility assumed

The ‘Waterfall Technique’ An Incentive Compatible Arrangement based on the ongoing shift in the Internal Rate of Return (IRR) The IRR waterfall technique aligns the incentive by progressively compensating the developer for superior performance At the same time the IRR waterfall minimizes the downside risk of the equity investor The concept is intuitively appealing and easy to implement: If returns are lower than expected the equity investor gets a greater proportion – a bigger piece of the smaller pie. If the returns are greater than expected a larger share goes to the developer The IRR waterfall technique is incentive compatible since the developer has greatest influence over project success

Traditional versus Waterfall payout method Example: Traditional versus Waterfall payout method To illustrate the difference between the traditional and waterfall payout methods consider the following real estate project. The total project cost is $14,200,000, sourced as follows: Lender = $10.5 M; Equity partner = $3.5M; developer = $200,000. After a 4-year construction period, lease up, and stabilization, the developed property sells for $16.5M. Selling expenses are $90,000 and the construction loan amount of $10,500,000 is repaid at closing. Under a traditional payout method the equity partner is to get a preferred return of 8% and the developer gets a preferred return of 7%. The net profit after deducting these preferred return is to be divided as follows: 75% to equity partner and 25% to developer. Development and Sale Parameters Sale Price = $16,500,000 Total project cost = $14,200,000 Selling expenses = $90,000 Loan to repaid = $10,500,000 Equity partner capital = $3,500,000 Developer capital = $200,000 Cash to distribute (between equity partner and developer) = $5,910,000

Traditional Payout Method Table 1 shows how the returns from the project are distributed between the equity partner and the developer, based on traditional payout agreement Under this agreement the equity partner gets 8% preferred return and developer gets 7% preferred return The remaining net profit is split 75/25, that is 75% to equity partner and 25% to developer This agreement results in the equity partner getting $5,426,308 of the cash flow or 11.59% IRR, and the developer gets $83,692 or 24.71% IRR The issue here is whether this arrangement fairly compensates the parties relative to their risk exposure

Waterfall Payout Method Under this method Cash flows are distributed between equity partner (EP) and developer (D) as follows: Up to 8% IRR = 100% to EP and 0% to D 8.01 to 10% IRR = 75% to EP and 25% to D 10.1 to 12% IRR = 60% to EP and 40% to D > 12% IRR = 50/50, split For each split the distribution of cash flow is determined by future value of equity capital at the waterfall IRR Under this method the equity partner receives total cash flow of $5,408,23, or IRR of 11.49%, and developer gets $501,770 or IRR of 25.85% As can be seen in Table 2 the equity partner gets a higher percentage of return at lower profit level, and the developer gets a higher percentage at higher profit level

Variation in Returns to Parties From Tables 1 and 2 it is clear there is little difference between the traditional method and waterfall arrangement There is however a dramatic difference in returns to parties when the actual selling price varies significantly from the expected price Tables 3 and 4 show the return distribution when the actual selling is lower, at $16.2M and when it is higher at $16.8M, respectively The Waterfall Method protects the equity partner against downside risk and penalizes the developer when selling price is lower than expected When selling price is higher than expected the developer gets most of the upside return

Which Method is Preferable for the Developer? To answer this question Table 5 shows the distribution of returns at various selling prices As shown in the exhibit if the expected selling price is greater than the crossover point of $16.4M the developer is better off with the Waterfall arrangement If the selling price is lower than $16.4M the traditional method is preferable to the developer Thus Waterfall method has built-in incentive that rewards the developer for superior performance (AND superior performance is always in the best interest of the investor!) Tables 6 and 7 show that the return to developer is much more volatile than the returns to equity partner This level of volatility is consistent with the additional risk borne by the developer

The Developer’s IRR is much more volatile than the Equity Partner’s

Negotiating the Waterfall Agreement Negotiating the IRR waterfall is critical to equity partner and developer relationship and the success of the project The crossover point should be realistic and according to expectations If the crossover is set too low it penalizes the equity partner If the crossover point is too high it penalizes the developer Developers who believe they can add more value may be willing to accept more downside risk in exchange for additional upside This means the developer should get a higher compensation if the project turns out much better than expected

Negotiating the Waterfall Agreement (cont’d) Current agreements often call for multiple break points which are keyed to the IRR of the Investor at the end of each year, and most call for the split to become 50/50 by the time all of the Investor’s capital has been returned (above preferential returns). Most Waterfall agreements look backward to determine breakpoints and changes in splits, which means the parties wait until the property is sold to make final profit determinations and distributions. New software engineering techniques make it possible to track and alter profit-sharing divisions ‘along the way’, so some distributions can be earlier, and the parties have a better sense of where they stand for asset management and tax planning long before the venture is concluded.