The IRR Waterfall: Splitting Real Estate Profits - Lenders, Investors, and Developers

How can equity investors in commercial real estate transactions shield themselves from downside risk, provide enough incentive for the development partner, manage the upside, Read more

How to Turn a Dud into a Stud: Using Legislation to Reduce the Liability and Costs Associated With Groundwater Contamination

By Duke Dennis What do parties to a real estate transaction think when they hear that the property acquisition they have been working on has Read more

Mile High City’s Industrial Real Estate Hits New “High”

By Charley Babb The vacancy rate for commercial real estate industrial space in Denver is hovering at just over 4%, which is a historically low Read more

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Metropolitan Capital Advisors Closes $5,560,000 Construction Loan For Speculative Industrial Project In Oklahoma City, OK

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MCA Closes Two Single-Tenant Government Office Loans Totaling $19,900,000 in Oklahoma

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The IRR Waterfall: Splitting Real Estate Profits – Lenders, Investors, and Developers

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:

IRR waterfall image 1

 

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.

IRR waterfall image 2

 

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.

IRR waterfall image 3

 

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.

The author, Joshua Siegel, is an associate analyst at Metropolitan Capital Advisors. He can be reached at jsiegel@metcapital.com or by calling our Dallas Office at (972) 267-0600.

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How to Turn a Dud into a Stud: Using Legislation to Reduce the Liability and Costs Associated With Groundwater Contamination

By Duke Dennis

What do parties to a real estate transaction think when they hear that the property acquisition they have been working on has groundwater contamination?

Owner:  How do I limit my liability and the future owner’s liability in order to sell the property?

Lender:  How do I protect my liability if I have to foreclose on the property?

Developer: What is the cheapest way to remediate contamination in order to reduce the development budget?

City Official:  How can we support remediation and development of contaminated properties in our city?

Investor:  How can we limit the costs of remediation so as not to eat up all of my profits?

Normally groundwater contamination would be a deal-killer due to the abnormally high risks and potentially exorbitant costs associated with such properties; however, this does not have to always be the case, especially in Texas where two pieces of legislation were put in place to incentivize remediation and development of properties with this very problem.  The Texas Voluntary Cleanup Program along with the Municipal Setting Designation have changed the way owners, lenders, developers, city officials, and investors look at the prospect of remediating a property with groundwater contamination by reducing the costs and liability of doing so.

Created in 1995 the Texas Voluntary Cleanup Program (“VCP”) offers protection to future lenders, landowners, and all non-responsible parties from liability to the State of Texas only after you have gone through the following steps: the current owner of the property must submit an application for the property to the VCP along with an Affected Property Assessment Report describing the contaminated area of concern and a $1,000 application fee. In the application there must be a signed agreement describing a schedule of events to achieve cleanup and an agreement confirming that the applicant agrees to pay all VCP oversight costs. Post-cleanup applicants will receive a Certificate of Completion (“COC”) from the Texas Commission on Environmental Quality (“TCEQ”), releasing all non-responsible parties from further liability to the state for cleanup of areas covered by the certificate.

The VCP process sounds simple enough, but limiting liability is only half the battle.  The other half is reducing the costs of remediation, so that begs the question, “Exactly what does “cleanup” for groundwater contamination entail under VCP guidelines?”  This is where the second piece of legislation, Municipal Setting Designation (“MSD”), comes in.

Under the VCP an acceptable form of groundwater remediation is obtaining a Municipal Setting Designation.  An MSD is a legally binding ordinance that prevents the use of groundwater at the site for drinking water now or in the future, thereby protecting public health.  Once the MSD has been obtained the subject property is considered to have been remediated, thus reducing the costs typically associated with remediation.  As the steps to entering the VCP were simple and straight forward, so are the steps to gaining an MSD.

To gain an MSD the property owner must do three things:

  • File for a resolution of support within the city that houses the property.
  • Notify landowners with water wells within a 5-mile radius of the subject property receiving the MSD of the following: purpose, eligibility criteria, location and description, type of contamination, and identification of the parties responsible (if known).
  • File an MSD application with the TCEQ along with a $1,000 fee and proof of meeting the first two conditions.

Once the application has been received by the TCEQ, there is a state-mandated 60-day period for the TCEQ to review and render a decision.  At this point if you followed all of the preceding steps to the letter, then it is a mere formality that you will get your MSD. For the cost of a $1,000 application fee and the cost to mail some letters to adjacent land owners you have now successfully remediated your property for a fraction of what it potentially might have cost.  Also, now that you have remediated the contamination you will receive a Certificate of Completion from the TCEQ eliminating any future liability to the State of Texas for cleanup of the property.

Using the Voluntary Cleanup Program and Municipal Setting Designation, you can reduce liability and costs of remediating properties with groundwater contamination.  If you are looking to buy, finance or redevelop a property with groundwater contamination you should be aware of these two pieces of legislation as they can protect your liability and your financial ability to do so.

The Author, Duke Dennis, is a Senior Analyst at Metropolitan Capital Advisors.  Duke may be contacted at ddennis@metcapital.com or (972) 267-0600.

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Mile High City’s Industrial Real Estate Hits New “High”

By Charley Babb

The vacancy rate for commercial real estate industrial space in Denver is hovering at just over 4%, which is a historically low point. Rental rates for “C” class properties have increased from nearly $4.00/sf NNN to as much as $18.00/sf NNN. The property values have in many cases more than doubled over the past two years. So, what is wrong with this picture? It depends on whom you are.

If you happen to be the traditional user of this type of space, it is problematic. Gloria Staebler, owner of the natural history publishing company Lithographie, is being forced out of her 3,600 sf space in a dated Denver warehouse. Her building sold last year to a new landlord who gave her an ultimatum. Sign a new lease within thirty days that increases her rental rate for a three-year renewal term to $18.00/sf from the current $8.00/sf or get out when her lease expires. So, who is willing to pay top dollar for this otherwise mundane space and drive poor Gloria to the hinterlands?

Here is a hint. Certain “plant husbandry” tenants have leased more than four million square feet of industrial space since the growing of a certain plant was legalized in Colorado. That’s right. Medical and recreational marijuana plant growers are gobbling up industrial space at an unprecedented clip.

Twenty-three states have laws legalizing pot in some form, but Colorado has become the epicenter for the marijuana industry since legalizing recreational cannabis by voter referendum in late 2012. It became available to the public through licensed dispensaries on January 1, 2014, and it is estimated that last year retail and wholesale sales exceeded $805 million according to the ArcView Group, which provides data on the legal marijuana industry.

Colorado law requires growers to produce their product indoors or in greenhouses, and thus the demand for the industrial space. High energy uses for lighting and elaborate water systems are necessary for optimal growing conditions. Landlords can offer these services and are most often located in areas away from the churches, schools, parks and residential areas as most municipalities require. This was all well and good in the “early days” when vacant and otherwise obsolete buildings were being flipped into cultivation sites, but today non-pot grower users like Gloria Staebler are being priced out of the city. It is a weird form of gentrification.

The amazing part of the story is that all of this is being done without the benefit of a normal lending environment for the owners of such real estate. Federally insured banks, credit unions, life insurance companies and CMBS lenders are completely avoiding placing debt on such properties. Thus far, only private sources such as “hard money” lenders have seen fit to venture into this arena. It is staggering to imagine what may transpire once a normalized capital market develops for the industry. One person’s boon is another person’s bane. All eyes in the legit weed world are on Colorado to see how this burgeoning industry evolves.

And, get a nice whiff of this: other industrial markets are having the same “Renaissance in Valuation.”  States such as Washington, Oregon and Alaska have already seen increases in rents, occupancy and valuation of once functionally obsolete industrial areas where pot is either legal or expects to be legalized soon.  Beauty truly is in the eyes of the beholder or “user” as the case may be.

The author, Charley Babb, is a Senior Director and Principal of MCA’s Denver office.  Charley can be reached at CBabb@metcapital.com or 303-647-9032.

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