Real Estate Professionals (the “Sponsor”) commonly create Real Estate LP/GP Structures as a tool to facilitate the acquisition of real estate assets and structure these acquisitions with multiple investors. These structures provide investors (“Investor”) with an opportunity to invest in large real estate acquisitions that they may otherwise do on their own. The Sponsors leverage this tool to raise capital for purposes of acquiring real estate assets they have identified. In order to compensate both Investor and Sponsors equity waterfall calculations are incorporated in Limited Partnership Agreements (“LPA’s”).
Real Estate Waterfall models in commercial real estate deals are one of the most challenging concepts to understand when dealing with cash flow distributions. The Waterfall is the approach for splitting free cash flow among Investor and Sponsor in a real estate investment that allows for uneven distributions. This type of planning provides an incentive bonus to the Sponsor to participate in a disproportionate share of the returns. This bonus is often called ‘the promote’.
The Waterfall model typically includes a preferred return and a return hurdle rate. Internal Rate of Return (IRR) is commonly used as the hurdle rate. IRR is a metric that identifies to an investor the average annual compounded return they have realized from a real estate investment over time, expressed as a percentage.
The preferred return is the first claim on free cash flow distributions. Once the preferred return, expressed as a percentage, is achieved then any excess free cash flow is split as agreed. The LPA will also deal with the following elements for the preferred return model.
The Business Deal
A real estate investment opportunity may include a waterfall calculation that provides the Limited Partner with a cumulative rate of return (“Preferred Return”) equal to a nominal annual rate of 7% per annum compounded semi-annually on invested capital. After the 7% preferred return has been achieved, all additional cash flow distributions up to a15% IRR will be allocated at a proportion of 25% to the General Partner and 75% of the Limited Partner. After a 15% IRR hurdle has been achieved, all additional cash flow distributions will be allocated at a rate of 50% to the General Partner and 50% to the Limited Partners.
LPA’s will often specify when capital contributions are deemed to be made. Most commonly this will be stated as the actual day of activity. This becomes important when determining the amount of preferred return attributable to a capital contribution when the preferred return is expressed using an annual rate.
Let’s determine the preferred return on a $100,000 capital contribution made on January 1, 2021 and subsequently distributed on August 1, 2021. If we simply took the number of days the contribution was outstanding and prorated over 365 days, we would calculate the preferred return to be $4,085. Using XIRR function in excel this preferred payment provides an XIRR of 7.14% which is higher than the required rate of return of 7%. However, if we applied a more accurate rate of return formula using (1 + Rate) ^ (number of days / 365) we would calculate a preferred return of $4,008. The use of this approach prevents an overpayment of preferred return by 1.92%.
Hurdle Rate Compounding
The compounding period for the hurdle rate will also affect the calculation of the effective rate of interest. In the above example the nominal 7% preferred return compounded semi-annual equates to an effective annual interest rate of 7.12%. If only the nominal rate of return is used, then the preferred return per annum would be understated by $120 per annum.
Calculating the accrued preferred return on initial capital contributions
The preferred return is calculated on the initial capital contributions using the preferred rate of return outlined in the LPA. The preferred return may either be calculated on a cumulative or noncumulative basis. A preferred return calculated on a cumulative basis is added to the initial capital contributed. Distributions are deducted from the cumulative preferred return earned. The LPA needs to clearly specify what events can cause the initial capital contribution to be reduced. These events are typically restricted to the sale of the real estate asset or refinancing. Under these circumstances the preferred return earned in the current period cannot be reduced if the previous periods distributions exceed the preferred return. If the initial investment was $100,000, for 90% of the equity, with a preferred return of 7% in year(s) 1 to 5, the real estate investment returns $10,000 per year. If the preferred return is calculated assuming that cash flow distributions in excess of the preferred return are a reduction to the initial capital contribution instead of a distribution, it is subjected to a waterfall calculation. This may cause an overstatement of distributions to the initial capital contribution. Over a 5-year period this overstatement will be $2,252 or 4.46% of the total distributions.
Understanding the economic terms of a real estate transaction are critically important in ensuring that returns to investors are consistent and correctly calculated in accordance with the LPA and the marketing materials that may been shared with the investors.