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Consider an IRR 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 results. But no one should enter into such an arrangement without a firm grasp of how it works.

Traditional profit split

A traditional real estate development deal 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’s subordinated to the equity investors’ preferred returns. Additional profits are split between the investors and the developer, at a rate of, say, 90/10 or 75/25.

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, as well as how much more volatile the developer’s returns are. 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 falls off as the developer’s share goes up.

In other words, if the returns are lower than forecasted, the investors receive a bigger piece of the profits pie than the developer does. 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. (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.”)

If the project ultimately sells at or around the sales price projected when the development deal was entered, 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’s set too high, the developer won’t feel adequately incentivized to pour in sweat equity.

IRR waterfalls offer numerous benefits for investors and developers. But they’re not right for every development project. Contact a CPA professional to help set up an IRR waterfall arrangement, estimate a reasonable sales price and administer profit allocations from the project’s start to finish.

© 2019

 

HMWC CPAs & Business Advisors specialize in serving the financial and tax needs of privately-held businesses and their owners throughout Southern California.

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