How can equity investors in commercial real estate transactions shield themselves from downside risk, provide enough incentive for the development partner, manage the upside, and still maximize equity returns?
The Internal Rate of Return (“IRR”) Waterfall structure is a methodology by which the equity partner can accomplish these objectives.
First, let’s establish the key players to a real estate development transaction and evaluate their risk profile:
Lenders, with first payment priority, accept a predetermined return, namely, the interest rate on their provided debt capital. Next, the Equity Investor invests capital that is subject to the success of the project. Finally, the Developers (who may also be an equity investor) takes on the highest level of risk both in terms of their own capital as well as using their balance sheet to provide guarantees for the lender. Both lenders and equity partners will require developers to contribute equity up front so that they have quantifiable “Skin in the Game.”
All three players contribute something essential to a real estate development project, and as such, they typically struggle for the most advantageous position when it comes to sharing profit. A traditional profit split structure will use an inverse hierarchy of front-end risk and payment priority in determining profit splits.
The allocation of risk and return is a central component to commercial real estate development. An IRR waterfall arrangement accomplishes this by positively compensating the developer for meeting or exceeding project expectations and also by shielding the equity investor from unfavorable downside risk.
Let’s consider an example. Prior to a development, an equity investor puts up $4.5 million while a developer contributes $500k. After a 4-year hold and stabilization period, the property sells for $22 million, sales costs are $100,000, a $10 million loan is paid off, $5 million of equity is returned to the partnership, and there is $6.9 million in profit to distribute.
In a traditional payout structure, the equity investor receives an 8% preferred return, and the partnership agrees to split the net profits pari-pasu, or 90/10. From this traditional split structure, the equity investor will receive $10,710,000 – a 24.2% IRR, and the developer will receive $1,190,000 – a 24.2% IRR.
In contrast, the IRR waterfall is a progressive split that will yield a higher proportion of the returns at lower overall profit levels to the investor, while the developer will see a higher return at the higher profit levels. When realized profits are higher, the developer benefits disproportionally from the waterfall structure – this is known as the developer’s “promoted interest,” extra profit earned by the developer for exceeding pre-negotiated benchmarks in the return structure agreement.
Assuming the same scenario as above, the investor would receive $9,076,584 or $4,576,584 in profit and a 19.2% IRR while the developers would receive $1,008,509 or $508,509 in profit and a 19.2% IRR on their contributed capital. The developers will also realize $1,814,906 in profit as their promoted interest.
Developer’s returns are significantly more volatile as compared to the equity investor given the inherent risks associated with development (i.e. changing market conditions, long lead times, cost overruns, rising construction costs, etc.). Lenders mitigate this risk by securing the first lien position in the collateral and receiving debt service payments before profits are distributed to the partnership. This volatility is a key reason lenders will require developers to have quantifiable “Skin in the Game,” so when profits are lower than expected, developers won’t be tempted to hand over the keys and walk from the project. Conversely, equity partners (and lenders) want to provide assurance and incentive for a developer’s job well done. To mitigate this risk, equity investors can offer the developer a promoted interest.
Negotiating the IRR waterfall structure can be critical to the success of a commercial real estate investment and transaction. Understanding the nuances of the technique will give you a better understanding of how to maximize your returns and limit your exposure to unfavorable downside risk.