Waterfalls Can Be Beautiful Even When Not on Vacation
JEFFREY C. NEWMAN, CPA, JD
Consider an Internal Rate of Return Waterfall for Your Next Development Project
The internal rate of return (IRR) waterfall arrangement has gained popularity in recent years as a way to shift risk from equity investors, while rewarding developers for strong performance. But neither a developer nor an investor should enter into such an arrangement without a firm grasp of how it works.
Traditional Profit Split
A traditional real estate development deal typically involves an institutional lender, equity investors and the developer (who also may be an equity investor). The lender generally has the least risk, because it has the first repayment priority, but its return is limited to interest payments.
Equity investors have second repayment priority and receive a preferred return on their original capital investments paid out before profits are split. The developer also may receive a preferred return, though it is subordinated to the equity investors’ preferred returns. Additional profits are split between the investors and the developer at a rate of 90/10 or 75/25, for example.
IRR Waterfall Profit Flow
The IRR waterfall arrangement recognizes the critical role a developer plays when it comes to the ultimate success or failure of a project. It aligns the developer’s interest with those of the investors so that both benefit from the developer’s superior performance.
The IRR is a discount rate that makes the net present value of all cash flows (both positive and negative) from a project equal to zero. In an IRR waterfall arrangement, equity investors receive the majority of profits up to specified IRR thresholds (known as waterfall tiers). When profits exceed those rates, the investors’ share decreases as the developer’s share increases.
In other words, if the returns are lower than forecasted, the investors receive a bigger share of the profits than the developer. Conversely, if the returns are greater than forecast, the developer enjoys a larger share than it otherwise would and investors get a smaller share. The extra profit the developer earns for exceeding expectations is referred to as its promoted or carried interest. It is important to note that promoted interests traditionally are given only to developers who invest their own money in the project, that is, those with “skin in the game.” Additionally, the carried interest often qualifies for more favorable capital gains tax treatment.
If the project ultimately sells at or near the original projected sales price projected, the investors and the developer will see similar returns under both the traditional and the waterfall approaches. When the sales price for the project is lower than projected, though, the investors are better protected from risk under the IRR waterfall method and the developer’s profits drop.
If, on the other hand, the project sells for more than the projected price, the developer’s profits grow significantly as the waterfall tiers are eclipsed. For example, the developer might receive 30% of the profits on an IRR below 12%, 40% of the profits on an IRR between 12% and 18%, and 50% of the profits on an IRR above 18%. Equity investors continue to reap a healthy return, but the developer is directly rewarded for superior performance.
What’s the Right Tipping Point?
The so-called “tipping point” — the projected sales price — is one of the most critical issues when negotiating an IRR waterfall arrangement. In the long run, both sides will benefit from reasonable expectations. If the projected sales price is set too low, equity investors will be unhappy and perhaps unwilling to invest in future projects. Conversely, if it is set too high, the developer will not feel adequately incentivized to pour in sweat equity. Moreover, IRR waterfall arrangements are greatly affected by the timing of any future sale. The quicker the sale, the greater the IRR, everything else being equal.
IRR waterfalls offer numerous benefits for investors and developers. But they are not right for every development project.
Please contact Jeff Newman at [email protected], or call him at 312.670.7444 to help structure an IRR waterfall arrangement, estimate a reasonable sales price and administer profit allocations from a project’s start to finish. If you are an investor, we can also help analyze the waterfall provisions of a prospective deal.
Commercial Leases: What’s the Deal with Gross-up Provisions?
While rental vacancy rates rise and fall with the real estate market, property owners look for ways to mitigate their financial exposure and reduce expenses paid directly out of pocket. Many commercial landlords limit their financial burden through the use of gross-up provisions included in their lease agreements. Having a gross-up provision allows landlords to allocate a number of operating costs to the tenants regardless of occupancy rates.
These provisions ensure that the landlord is not solely financially liable for these expenses, but that these costs are partly, if not entirely, shouldered by the occupants of multi-tenant properties. A gross-up provision benefits both the property owner and the tenants since the allocation protects lessees from unexpected cost increases throughout the year and provides landlords with a steady revenue to cover the costs of managing the building when occupancy is low. If you are a lessor, it may be time to consider using gross-up provisions in your lease agreements.
What Is a Gross-up Provision?
A gross-up provision is an allocation of operational expenses calculated as if the property were fully occupied and paid by tenants through their rent payments collected each month. Every month, tenants pay a fixed pro-rata amount of these operational costs in order for landlords to maintain building spaces and operations.
In addition to rent, commercial landlords typically require leaseholders to pay a portion of the property’s operational costs, including:
- Real estate taxes;
- Maintenance; and
- Trash removal.
The allocation of both these fixed and variable costs is determined by the individual tenant’s portion of property leased and occupancy rates of the building.
If a multi-tenant property is not fully leased, the responsibility and burden of paying these expenses for unoccupied units and office spaces fall to the landlord. However, the cost of maintaining vacant units are typically lower than occupied units. Therefore, a higher occupancy rate results in increased coverage of monthly expenses for the property.
However, if monthly expenses for the building are higher for a certain period than previously projected, that additional cost may not be covered by the calculated provision. As a result, the landlord would be responsible for subsidizing a portion of the tenants’ operating expenses — since the tenants continue to pay based on their square footage rather than on their actual variable expenses.
How it Works
A tenant’s share of the operating costs is generally allocated based on the tenant’s square footage occupied compared to the overall total available square footage of the rental property.
Let’s say, for example, there is a commercial property that offers ten rentable office spaces at 15,000 square feet each. The total square footage is 150,000 for the property. One tenant’s pro-rata share would be calculated as ten percent since they are renting 1/10 of the 150,000 square foot building. That tenant would be responsible for covering ten percent of operating costs incurred for that rental property.
Let’s say that the building’s operating expenses totaled $30,000 for the month, $26,000 in variable costs, and $4,000 in fixed costs, and all ten units have been leased, resulting in a 100% occupancy rate. As a result, each tenant would be responsible for paying $3,000, or ten percent, of the total cost for the month. The tenants were able to cover all operating expenses resulting in the landlord paying nothing out of pocket.
What if only one unit was occupied, and variable expenses reduce to $5,000? The total operating expenses would be $9,000 for the month, including the $4,000 of fixed costs. Without a gross-up provision included in the lease agreement, the tenant’s share would be $900 (ten percent of $9,000), leaving the landlord to pay the $8,100 difference in operating expenses.
However, under the gross-up provision, the landlord is allowed to overstate the variable operating expenses, like utilities, to reflect a 100% occupancy rate. The overstatement of expenses allows monthly operational costs to be covered by tenants, even when occupancy rates are low.
Under the provision, the variable expenses would be grossed-up to 100% (or $26,000), and including the $4,000 of fixed costs, the total costs would be $30,000. The building is treated as if fully occupied, and the tenant would pay its ten percent share of $3,000. The landlord would still cover $6,000 of expenses, but save $2,100, compared to the lease without the gross-up provision.
Why Have One?
A gross-up provision benefits both the landlord and the tenant. A landlord benefits from having a provision within their agreements when occupancy rates are below average and can shift operational costs related to vacancies to the tenants. As demonstrated in the example above, having a gross-up provision included in your rental agreements can save a landlord thousands in monthly expenses, thus protecting their income streams.
Tenants also benefit from gross-up provisions, including protecting them from fluctuations in operating expenses charged throughout the lease agreement period. Minimizing cost variance allows for better budget planning since typically, operational costs could drastically vary year to year.