In waterfall models this preferred return can either be cumulative or non-cumulative. So, overall, these seem to fit with the assumptions that were given to us. We discussed some common components in equity waterfall models and emphasized the importance of reading the owner’s agreement in order to truly understand a waterfall structure. We’re going to start by calculating how much we should earn in a given year based on the IRR hurdle that we’re at. Another common component in equity waterfall models is the preferred return. We can’t really go too much higher in terms of LTV because we’re pretty close to that minimum 1.25x for the debt service coverage ratio in fiscal 2023. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. The agreement will spell out in detail how profits will be split among partners. All IRR hurdle calculations will be at the project level. The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics. I also need to flip the signs on all this, I should have done that earlier. The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. We need to enter some dates at the top because we’re going to use the XIRR function here, so we use the EOMONTH function and just copy this over. Year 0 is the beginning of the project and as you can see our beginning balance is $0. And I’m just going through and pressing F2 quickly to check this, we’re looking at the cash flow to equity investors and we can see that to get up to this 20% IRR we need a project-level equity balance of around $31.5 or $31.6 million at the end. And this just gives us a sense of what we should be earning if we assume that 10% IRR each year. Would lenders be likely to approve of this deal? But then beyond that, we start splitting it at 80/20 at just above 10% IRR. We said overall, we’d be against this deal because of the issue with excess land, the fact that the IRR doesn’t meet the target, and we think the permanent loan refinancing and the waterfall structure could use some work. So, we should end up with $29.2 million at the very end. So, let’s go into tier 2 now and link up to our numbers at the top to get all these assumptions. And the IRR goes down a little bit. We have that. With the waterfall return schedule, it’s pretty similar in some ways to what we looked at in the last case study. Coming up next, we’re going to look at a few other types of properties and deals, including a hotel acquisition and renovation and also a pre-sold condo development. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution). Last Updated on November 30, 2016 By Robert Schmidt 34 Comments. Here is a summary including percentage allocations of the total equity contributions to the project: As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Again, the important thing to remember about waterfall structures is that there is no one sized fits all solution and these terms and conditions will all be spelled out in the owners agreement. So, for example, a lender might go up here and say, “Okay, let’s see what happens if there are 12 months of downtime and the renewal probability is only 40%.” If you do this, and you go down and you look at the ratios, in fiscal 2023 we run into some serious problems because our interest coverage ratio is way below the minimum, and so is the debt service coverage ratio. So, that’s how much we potentially get back; we’re looking at it at a project-level so it’s 100% here, and then let’s compare that to the beginning balance plus the returns accrual here. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement. We don’t know about the construction costs, so we’re not really sure about that part. You should now have an idea of how to combine everything we’ve learned in the first few case studies for office, retail, and industrial properties, for both acquisitions and new developments, and create this type of model and use it to answer case study questions. We’re subtracting that because we distribute all of the cash flows in this tier to the limited partners and developer. So, we have that. To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. So, for the tier 1 IRR—I’m re-assembling all of these cash flows now—let’s link up to our repayment for the limited partners and then let’s link up to our repayment for the developers in tier 1. But the biggest problem, we think, is the fact that we buy so much excess land in the beginning. And so we have that. In other words, the pref is both cumulative and compounded. Splitting the IRR up to 10% and then splitting it differently beyond 10% might work if it’s a lower-risk, lower-potential-return deal such as for a stabilized property or simple renovation, but we don’t think it’s appropriate for a new development. We’re also going to go through and answer the case study questions. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this. Then we’ll take the sum of our interest expense and permanent loan principal repayments here and we’ll copy this through each year. So, we have these Cap Rate trends, but we haven’t really looked at the deal and seen what happens if the Cap Rate goes down to 5% or up to 6.5% or even up to 7% or something much higher. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model. As you can see here, the main problem is that the interest coverage ratio and debt service coverage ratio fall far below the minimums in year one; the debt yield is also below the level that lenders are usually seeking. And in this case, the ratio still looks fine. So, I just undid everything. And then we’ll keep going down and we’ll take the amount that goes to the limited partners here, 1 minus the developer cash flow above IRR hurdle 1. So, we think the rental assumptions are fine. As usual, to save some time, I’ve written out the actual answers to these questions, and you can read them yourself. Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. That’s one difference. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. And that’s something that we’ll discuss further in the case study answers later on. And then for tier 3, we can just take everything that we’d get to at the very bottom and split that up. Next, let’s take a look at a summary of our promote structure discussed above: There are 3 tiers (or hurdles) in this promote structure. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. We are going to take a look at the waterfall returns schedule in this part. And then to get the IRR, we can just use the built-in IRR function. The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. We’re actually looking at tiers where we go up to 10% and then up to 20%, and then above 20% in the final tier. The interest coverage ratio has to be at least 1.5x, and it’s only around half of that. That happens because of the very short time frame here and because of the fact we’re capitalizing the interest and the loan fees so that our ending repayment at the end is higher than the total amount of investment that we actually made as lenders; they’re higher than the total amount of loan that we funded over the life of this because the fact that these are capitalized, also, the loan issuance fee should add at around 1% to this. So, we’ll divide this lesson into two main parts and look at the waterfall return schedule first and then go into those case study questions and answers. We might look at a changing LTV ratio. And we can bring down this formula as well. Real Estate Modeling + Excel & VBA + Financial Modeling Mastery. The first tier distributes cash flow to the partners until the LP has achieved some defined preferred return and received a full return of capital. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity]. Who gets the preferred return? This additional 10% is the “promote”. The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow.
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