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

Equity Investor:

First position -- lowest risk Predetermined return with no upside Second Position medium risk Risk capital subject to volatility Return depends on project success Third Position: takes most risk May invest equity Provides talent (skill, tenacity, vision) necessary for project success Return has unlimited upside potential depending project performance

Developer

Traditional Method of Sharing Profits

Traditionally, the equity partner and developer may agree 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

Developers talent and expertise are critical to project success Developer also assumes the highest risk level But developers return are subordinate to lenders and the equity investors 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 Internal Rate of Return (IRR) Waterfall Technique An Incentive Compatible Arrangement

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 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

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, with capital contributions as follows (1) Lender = $10.5 M; Equity partner = $3.5M, and developer = $200,000. After a 4-year construction period, lease up, and stabilization the developed property sells for $16.5M. Selling expenses is $90,000 and the construction loan amount of $10,500,000 is to be repaid at closing. Under the 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

Exhibit 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

Ta ble 1: Tra ditiona l Pa yout Agre e me nt CF0 (3,700,000) CF4 5,910,000 IRR of Project 12.42%

Return of capital: Preference earned: Preference receiv ed: Split: total: IRR

Equity Partner Dev eloper $ 3,500,000 $ 200,000 $ 4,761,711 $ 262,159 $ 4,761,711 $ 262,159 $ 664,597 $ 221,532 $ 5,426,308 $ 483,692 11.59% 24.71%

Table2:IRR Waterfall Payout Agreement CF0 (3,700,000) (3,700,000) (3,700,000) (3,700,000) CF4 5,033,809 5,417,170 5,822,022 5,910,000 IRR 8% 10% 12% 12.42% Split(EP/Developer) 100% 0% 75% 25% 60% 40% 50% 50% Profit Equity Total IRR Eqiuty Partner $ 1,333,809 $ 287,521 $ 242,911 $ 43,989 $ 1,908,230 $ 3,500,000 $ 5,408,230 11.49% Developer $ $ 95,840 $ 161,941 $ 43,989 $ 301,770 $ 200,000 $ 501,770 25.85%

$ $ $ $

$ $ $ $

Waterfall Payout Method

Under this method Cash flows are distributed between equity partner (EP) and developer (D) as follows:

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 Exhibit 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

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

Variation in Returns to Parties

From Exhibits 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 Exhibits 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

Low e r Sa le s Price Pa ra me te rs Sale price Cost of sale Loan repayment Cash to distribute Equity partner capital Dev eloper capital $ $ $ $ $ $ 16,200,000 90,000 10,500,000 5,610,000 3,500,000 200,000

Ta ble 3: Low e r Re turns Tra ditiona l Ca s h flow Cha rt Equity Partner CF0 $ (3,500,000) CF4* $ 5,201,308 IRR 10.41% W a te rfa ll Ca s h Flow Cha rt Equity Partner CF0 $ (3,500,000) CF4 $ 5,237,028 IRR 10.60%

$ $

Dev eloper (200,000) 408,692 19.56%

$ $

Total (3,700,000) 5,610,000 10.97%

$ $

Dev eloper (200,000) 372,972 16.86%

$ $

Total (3,700,000) 5,610,000 10.97%

Highe r Sa le s Price Pa ra me te rs Sale price $ Cost of sale $ Loan repayment $ Cash to distribute $ Equity partner capital $ Dev eloper capital $ 16,800,000 90,000 10,500,000 5,610,000 3,500,000 200,000

Ta ble 4: Highe r Re turns Tra ditiona l Ca s h flow Cha rt Equity Partner CF0 $ (3,500,000) CF4 $ 5,651,308 IRR 12.72% W a te rfa ll Ca s h Flow Cha rt Equity Partner CF0 $ (3,500,000) CF4 $ 5,558,230 IRR 12.26%

$ $

Dev eloper (200,000) 558,692 29.28%

$ $

Total (3,700,000) 6,210,000 13.82%

$ $

Dev eloper (200,000) 651,770 34.36%

$ $

Total (3,700,000) 6,210,000 13.82%

Which Method is Preferable for the Developer?

To answer this question Exhibit 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 induces the developer for superior performance Exhibits 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

Table 5: Comparing returns at Various Selling Prices Equity Investor $ Traditional IRR Waterfall IRR Developer $ Traditional IRR Waterfall IRR Table 6: IRR Volatility Selling Price(in Millions) 16.2 16.4 16.6 0.19% 0.03% -0.22% -2.70% -0.47% 2.59% Selling Price(in Millions) 16.2 16.4 16.6 10.41% 11.20% 11.97% 10.60% 11.23% 11.75% Selling Price(in Millions) 16.2 16.4 16.6 19.56% 23.06% 26.29% 16.86% 22.59% 28.88%

15.0 5.95% 4.73%

15.5 8.83% 7.71%

16.0 9.61% 9.98%

16.8 12.72% 12.26%

17.0 13.47% 12.76%

17.2 14.19% 13.25%

15.0 0.00% 0.00%

15.5 0.00% 0.00%

16.0 15.72% 10.28%

16.8 29.28% 34.36%

17.0 32.08% 39.24%

17.2 34.71% 43.66%

$ IRR Var (Eqiuty Investor) IRR Var (Developer)

15.0 -1.22% 0.00%

15.5 -1.12% 0.00%

16.0 0.37% -5.44%

16.8 -0.46% 5.08%

17.0 -0.71% 7.16%

17.2 -0.94% 8.95%

The Developers IRR is much more volatile than the Equity Partners

Exhibit 7: IRR Variance

Equity Investor Developer

10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% 15.0 15.5 16.0 16.2 16.4 16.6 16.8 17.0 17.2 Selling Price(in millions)

Change in IRR

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