Calculating IRR for distribution waterfalls - help!

7 Replies

Hello!

I'm working on a real estate investment project for a class I'm taking and I'm having a little bit of trouble fully understanding the equity distribution calculations (pref and hurdles). When you are calculating the pref payout to see if you've made it to X% of IRR to be able to make it to the promote tiers, how do you calculate that IRR? Is it the equity contributed and the cash flows generated through each year, calculated on an annual basis?

Also, does return OF equity come before the promotes?  

Thank you for any guidance you can give! I know there's a lot to be learned from this community. 

@Ashley Gold

Ahhh.  This is one reason I never invest in a waterfall deal.   Too confusing.  But, the biggest problem is waterfall deals create tension between investor and syndicator.    If the deal is doing poorly, the investor usually gets most of the profit and the syndicator has less incentive to work hard.  If the deal is a home run, the syndicator reaps on over-sized gain that can be unfair to the investor.   I prefer my syndication and syndications I invest in to have a fixed % for the syndicator.

To actually answer your question Ashley, the result completely depends on the return expected by the deal and varies widely even as the total returns vary.   So, even if the property performs 10% better, the returns on the waterfall can change significantly more or less, depending on what side of the deal you are on.

IRR typically looks at the complete lifecycle of a deal which is why it is called Internal Rate of Return. (Cash flow is typically an annual number.) Compare the initial cash outlay to all the returns of cash including cash flow, capital events, and sale, to calculate your IRR.

Determine your cash flows on a yearly basis, including your acquisition at year 0 and your disposition at year x. 

The amount of equity put in a deal is your beginning capital. The amount after distribution in a year is ending capital.

Your first hurdle is your preferred equity. It's simply your preferred return multiplied by the beginning capital. For year one, multiply your pref times the beginning capital. If your cash flow available for distribution for that year is greater than the product of (pref x beginning capital), you'll subtract it from your beginning capital. If you don't have enough cash to distribute to hit the pref in that year, you add the (pref x beginning capital) + cash available for distribution to the beginning capital for the next year. When your ending capital is 0, you can move on to your next IRR hurdle.

Hope this helps a bit. 

Updated almost 2 years ago

Meant (- cash available for distribution) in that second to last sentence.

@Tristan H. , just want to confirm I understand correctly. So if the cash flow is greater than the pref,  that overage becomes return OF capital and decreases the remaining capital that needs to be returned to the investor (is the sponsor's capital included here?). Once the remaining capital that needs to be returned is $0, we get to our promotes. 

Did I get that right? I really appreciate your detailed response!

Yep. Your remaining capital at the end of year 1 is: (Beginning capital + Preferred Return) - Cash flow distributed. In scenarios where the cash flow IS suffice to cover the pref, it does decrease remaining capital that needs to be returned to investors. In scenarios where the cash flow does NOT cover the pref, your remaining capital will increase. To answer your question about the sponsor equity, it's on a deal-by-deal basis. GP equity is usually included in the pref but its split pro-rata with the other investors. As in 10%/90% or whatever way it was structured up to that decided preferred return.

There are tons of various ways syndicators set up their deals.

The big ones I have seen keep it simple.

Something like 8% preferred return then 50/50 split therafter of cash flow and upside plus return of investors original capital upon sale or refi etc. If preferred return that was cuumulative had not been paid back in full at time of sale then that should be caught up as well.

I agree with the other poster about syndicator and investors need to be aligned. If both are not winning then there will be a disincentive to perform at the highest level and investors will not want to return to reinvest on other deals. You want both parties handsomely rewarded so they both feel good about the deals and the relationship long term.