(IRR) Waterfall Technique

Report
Sharing Real Estate
Investment Profit
The Internal Rate of Return (IRR)
Waterfall Technique
Parties in Real Estate
Development
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Real estate investment requires the
coordination of capital and talent from
various parties
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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
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Lender
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Equity Investor:
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First position -- lowest risk
Predetermined return with no upside
Second Position – medium risk
Risk capital subject to volatility
Return depends on project success
Developer
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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
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Traditionally, the equity partner and developer
may have agreed on sharing profits as follows:
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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
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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)
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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:
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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
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
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Table 1 shows how the returns from the project
are distributed between the equity partner and the
developer, based on traditional payout agreement
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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
Table1: Traditional Payout Agreement
$
CF0
(3,700,000) $
Return of capital:
Preference earned:
Preference received:
Split:
total:
IRR
CF4
IRR of Project
5,910,000
12.42%
Equity Partner
$ 3,500,000
$ 4,761,711
$ 4,761,711
$
664,597
$ 5,426,308
11.59%
Developer
$
200,000
$
262,159
$
262,159
$
221,532
$
483,692
24.71%
Waterfall Payout Method
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Under this method Cash flows are distributed between
equity partner (EP) and developer (D) as follows:
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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
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%
Variation in Returns to Parties
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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
Table 3:Lower Sales Price Parameters
Sale price
Cost of sale
Loan repayment
Cash to distribute
Equity partner capital
Developer capital
$
$
$
$
$
$
16,200,000
90,000
10,500,000
5,610,000
3,500,000
200,000
Table 3: Lower Returns
Traditional Cash flow Chart
Equity Partner
Developer
Total
CF0
$
(3,500,000) $
(200,000) $ (3,700,000)
CF4*
$
5,201,308 $
408,692 $ 5,610,000
IRR
10.41%
19.56%
10.97%
Waterfall Cash Flow Chart
Equity Partner
Developer
Total
CF0
$
(3,500,000) $
(200,000) $ (3,700,000)
Table 4: Higher Sales Price Parameters
Sale price
$
Cost of sale
$
Loan repayment
$
Cash to distribute $
Equity partner capital
$
Developer capital
$
16,800,000
90,000
10,500,000
5,610,000
3,500,000
200,000
Table4: Higher Returns
Traditional Cash flow Chart
Equity Partner
CF0
$
(3,500,000)
CF4
$
5,651,308
IRR
12.72%
Developer
$
(200,000)
$
558,692
29.28%
Total
$ (3,700,000)
$ 6,210,000
13.82%
Waterfall Cash Flow Chart
Equity Partner
CF0
$
(3,500,000)
CF4
$
5,558,230
IRR
12.26%
Developer
$
(200,000)
$
651,770
34.36%
Total
$ (3,700,000)
$ 6,210,000
13.82%
Which Method is Preferable
for the Developer?
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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
Table 5: Comparing returns at Various Selling Prices
Equity Investor
$
Traditional IRR
Waterfall IRR
15.0
5.95%
4.73%
15.5
8.83%
7.71%
16.0
9.61%
9.98%
Selling Price(in Millions)
16.2
16.4
16.6
10.41%
11.20%
11.97%
10.60%
11.23%
11.75%
16.8
12.72%
12.26%
17.0
13.47%
12.76%
16.0
15.72%
10.28%
Selling Price(in Millions)
16.2
16.4
16.6
19.56%
23.06%
26.29%
16.86%
22.59%
28.88%
16.8
29.28%
34.36%
17.0
32.08%
39.24%
16.0
0.37%
-5.44%
Selling Price(in Millions)
16.2
16.4
16.6
0.19%
0.03%
-0.22%
-2.70%
-0.47%
2.59%
16.8
-0.46%
5.08%
17.0
-0.71%
7.16%
Developer
$
Traditional IRR
Waterfall IRR
15.0
0.00%
0.00%
15.5
0.00%
0.00%
Table 6: IRR Volatility
$
IRR Var (Eqiuty Investor)
IRR Var (Developer)
15.0
-1.22%
0.00%
15.5
-1.12%
0.00%
The Developer’s IRR is much more volatile than the Equity Partner’s
Exhibit 7: IRR Variance
Equity Investor
Change in IRR
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
Selling Price(in millions)
16.8
17.0
17.2
Negotiating the Waterfall
Agreement
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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)
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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.

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