The IRR waterfall technique provides equity in allocation of risk and return.
Today's developers and their equity partners often opt for progressive strategies that shift downside risk away from the equity investor and provide greater upside potential for the developer. The internal rate of return waterfall technique is an increasingly popular method that accomplishes these goals.
Debt investors, equity investors, and developers always have jockeyed for position in splitting profits. The traditional structure represents an inverse hierarchy of risk and payment priority. The debt investor, or lender, has the first repayment priority and the lowest element of risk. In exchange, the lender accepts a predetermined return, namely the effective interest rate.
Next in line is the equity investor, who invests risk capital and is subject to a fluctuating return, depending on the project's success. Finally, the developer, who also may be an equity investor, takes on the highest level of risk. While the developer's skill, tenacity, and vision often are critical to a project's success, the developer's return typically is subordinate to both the lender's and the equity investor's.
An IRR waterfall arrangement remedies this by positively compensating the developer for a project well done, while at the same time minimizing downside risk for the equity investor. The concept is simple. If the returns are lower than expected, a greater proportion flows to the equity investor; if the returns are greater than expected, a larger share flows to the developer. Since the developer has the greatest influence on a project's success, the waterfall arrangement allocates risk and return in a more equitable fashion.
You are a developer negotiating with your potential equity partner for a new shopping center development in a prime suburban location. The grocery anchor is fully committed, and you see the risk in this development as low to moderate. The total cost of the development will be $12.35 million. You can most likely obtain construction financing for $8.5 million, so that leaves only $3.85 million between you and the deal. You can put in $350,000, but you need your potential equity partner to put in the other $3.5 million.
Your potential equity partner, Morris Equities, is a private company that you have dealt with successfully before. Morris typically requires a preferred return of 10 percent, then is willing to split 90 percent/10 percent thereafter. You have argued successfully in the past that you also need a preferred return on your equity of 7 percent; however, your preferred return is subordinate to Morris Equities.
The traditional split is pretty simple: Morris gets a 10 percent preferred return, then you get a 7 percent preferred return, and then you split 90 percent/10 percent. You realize that under the traditional arrangement, you will always get slightly less than the deal IRR and Morris will always get slightly more.
You, together with Morris Equities, have jointly underwritten the development and what follows are the development parameters and the resulting traditional split cash flows. (See Table 1: Traditional Payment Agreement.)
You anticipate the investment period to be 24 months, and you expect to sell the entire center to a real estate investment trust after the 24-month construction and lease-up period. The sale price of the property is a function of the net operating income of the center upon completion and lease-up, the quality of the tenants, and the cap rate you can negotiate with the REIT.
Since you think the project has potential, you want to propose a waterfall agreement as opposed to a traditional split. Your experience with Morris Equities and the current deal underwriting tells you that the company is happy with about a 20 percent yield on development equity for a moderately safe development such as this. Can you devise a waterfall that will satisfy Morris Equities and also give you a higher yield?
Your initial projections are for an NOI of $925,000 and a selling cap of 6.5 percent. Morris Equities has underwritten the deal and agrees with these assumptions. You, however, are a bit more optimistic than Morris and are hopeful that either the NOI will be higher or the cap rate will be lower at the time of sale. You assume selling costs will be 1 percent. You also assume that the construction loan payoff, including accrued interest, will be $8.5 million.
Morris Equities is happy with the traditional split format, but you want more of the upside if the deal is to be the home run you think it can be. You will have to show Morris Equities that the waterfall will protect its downside if things don't meet initial projections. Start with the notion that to sell Morris Equities on the concept of the waterfall, you will have to demonstrate a better return than the traditional split if things go according to pro forma. (See Table 2: IRR Waterfall Payout Agreement.)
Traditional vs. Waterfall Payout
The following example illustrates the differences between the two payout methods.
A traditional payout split gives the equity investor a preferred return of 10 percent and the developer a preferred return of 7 percent, and the equity investor agrees to a net profit split of 90 percent/10 percent. From this arrangement, the investor, Morris Equities, receives a 20.62 percent IRR using the traditional split and an almost identical 20.6 percent IRR under the waterfall agreement. (See Table 3: Similar Returns.)
The IRR waterfall agreement resembles a progressive commission split. The equity investor gets a higher percentage of the return at lower profit levels, but the developer gets a higher percentage at higher profit levels. You want to demonstrate to Morris Equities that it will receive protection from downside risks in return for giving you more of the upside potential.
First, look at a situation where you end up selling at a 6.75 percent cap rate instead of 6.5 percent.
Demonstrate to Morris Equities that if the deal IRR ends up profitable but less than a 16 percent IRR, you will get far less than the project IRR and Morris will get more than the project IRR. (See Table 4: Lower Returns.)
However, if things go better than planned, then of course Morris Equities will do better than pro forma, but you also will do much better than pro forma. Now if where the selling price is higher than expected, the deal IRR is 26.41 percent, marginally better than the 20.48 percent as per pro forma. Morris will get a 24.34 percent IRR from the waterfall agreement and you will get 45.52 percent. For a deal better than projected, Morris Equities will get slightly less than it would have under the traditional split, but you will get significantly more. (See Table 5: Greater Returns.)
In this example, using the expected selling price of $14.2 million, there is little difference between the traditional and the waterfall arrangements in the returns to the equity investor and the developer. However, when the actual selling price varies significantly from the expected price, the differences are more dramatic.
Lower returns. Keeping all other parameters the same, but using a selling cap rate of 25 basis points higher, the equity investor is protected marginally against downside risk at the developer's expense.
Higher returns. If the selling price is higher than expected, for example using a disposition cap rate 25 basis points lower than pro forma, then the developer's yield increases at a rapid pace when using the waterfall arrangement.
Which Is Better?
Obviously, when the sales price is higher, the developer benefits more from the waterfall agreement. But the waterfall is a double-edged sword: As the actual price varies downward from the expected price, the developer loses profitability.
Depending on the particular arrangement negotiated, typically there is greater upside potential for the developer using a waterfall agreement, but there is a crossover point that represents the selling price where the traditional split and the waterfall arrangement yield the same result. Keep in mind that depending on how the waterfall is negotiated, a developer could face a situation where the property breaks even, but the developer loses money.
A Negotiating Tool
Negotiating the IRR waterfall agreement is critical to the relative success of the equity investor and the developer. The crossover point, or sales price projection, should be the point of reasonable expectation. If this point is set too high, the developer suffers; if it is set too low, the equity investor suffers.
Understanding the technique allows developers to better advise their clients when making preference and profit split agreements. For developers who believe they can add value to a project, the idea of accepting more downside risk in exchange for additional upside potential may be particularly appealing.
Editors note: This article originally appeared in the September/October
2005 issue of Commercial Investment Real Estate and has been updated for
more about splitting profits in CCIM’s
90-minute online course, taught by Jeff Engelstad, CCIM. Students discuss and
model various methods of sharing the wealth in transactions, including the
traditional split, rake, preference, carried interest, waterfall, pari passu,
and reversionary interests. Students learn to model profit splits among
investors, developers, promoters, and other transaction parties.