By Kenneth J. Abner

I am often asked to help conceptualize deal structures for real estate projects that bring together the expertise of a developer with the capital of investors. Over the last 22 years, I have seen it from all sides – not merely as an attorney. I have been a real estate developer and I have also invested money in the real estate deals of others. Real estate deals can be as complex as someone is willing to make them. And I intend to explore some of those complexities in subsequent articles. Here, I want to lay the foundation for what a typical economic ownership structure looks like. An economic structure must address a couple of fundamental issues: (1) when and how much cash will each or the parties receive and (2) does the anticipated cash flow supply all parties with an acceptable return.

It is almost unheard of for a developer to obtain 100% financing. Regardless of the type of development (multifamily, retail, office, etc.), I typically see lenders requiring somewhere between 20% and 50% equity. Almost always, the developer does not have either the ability or the desire to fund the equity requirement itself. So, the developer needs cash investors to get a deal done. As an aside, I will mention here that lenders sometimes will recognize certain forms of non-cash equity such as land equity or development fees that are deferred by the developer. This will reduce the cash equity requirement. As between the developer and the cash investors, there are open questions as to whether the developer should get credit for such non-cash equity (usually, yes) and whether the developer’s non-cash equity should be treated the same as cash equity (usually, no). I’m going to ignore non-cash equity for purposes of this article.

So, the ownership of the venture generally is split into two groups: the developer and the equity. The developer’s ownership interest is sometimes called a “promote” or a “sponsorship interest”. If all goes well, the project will makes money and have cash it can distribute the owners. The mechanism for determining how cash will flow among the owners is customarily referred to as a “waterfall”. For simplicity’s sake, I am going to limit the waterfalls to three steps: (1) the preferred return, (2) the return of equity, and (3) the “profit” split. The waterfall addresses both when and how much cash goes to each of the parties.

The first step in a waterfall generally is for the investors to receive a preferred return on their equity investment. A preferred return is simply a rate, calculated like interest, on the equity. I structure a fair number of transactions where there is no preferred return. The second step in a waterfall generally is for the investors to get their equity investment back. The third step in a waterfall is for the remaining cash to be split between the investors’ ownership interest and the developer’s promote. As you can see from this structure, investors will get all of their money back with a return before the developer is entitled to receive any cash.

(Sophisticated developers and investors will recognize that there are a potentially infinite number of permutations to a waterfall. For example, some deals will have “hurdles” where the splits between the investors and developers change as certain overall rates of return are achieved. As another example, some deals will have one waterfall for operating cash flow and a different waterfall for cash received from a capital transaction such as a refinancing or a sale.)

I am often asked what I think is an appropriate preferred return and developer promote. I mention customary ranges for each below. But I think it is useful to understand why I see these ranges. Ultimately, an investor has to have an expectation of receiving a particular overall return on his investment to be enticed into making the investment. There are multiple ways of analyzing the potential return. Two of the more common measurements are “cash-on-cash” and “internal rate of return”. (For purposes of this article, I refer to these returns from the investor’s perspective rather than the project’s perspective. Because of the promoted interest, these are not the same.) The cash-on-cash return is just the annual (before tax) cash that an investor receives divided by the amount of cash the investor put in. That’s easy enough. The technical definition of an IRR is the rate that makes the net present value of all cash flows (investment in and cash received out) equal to zero. Come again? Just think of it as the total annual percentage return on the investment. Every real estate project is different and so the returns required by investors among classes of real estate (e.g., multifamily, office, retail, etc.) are different. The lower the risk, the lower the return. That said, I typically see cash-on-cash returns of 6% to 12%. I typically see IRRs of 15% to 30%. I personally find IRRs a problematic measurement for several reasons that I will save for another article. In spite of its problems, this measurement is probably the most popular means by which investors compare real estate deals.

To achieve those returns, the deal structure must have a preferred return and developer promote that allows the waterfall to obtain those returns. I occasionally see deals where there is no preferred return. When I see them, they are usually in the range of 5% to 12%. If the preferred return is too high, the developer will fear that the project cannot generate sufficient cash to ever get to the step in the waterfall where the developer receives cash. This may create a dramatic disincentive for the developer to continue to manage the project well. Ignoring “hurdles”, I would typically see developer promotes in the 20%-50% range. Most deals cannot support a developer promote higher than this range and still achieve the returns that investors are looking for.

The waterfall that governs the economic structure will address when and how much cash each party will receive. Sometimes deals come across my desk that just don’t work for one side or the other. A well-structured waterfall has to allow for a sufficient flow of cash to both the investors and the developer for it to make sense for everyone.