• Tue. Jun 21st, 2022

Real Estate Investment Valuation – Cascades | Whitman Legal Solutions, LLC


The Théâtre Graslin de Nantes opened in 1788 and quickly became a grand opera house. Built in the Italian style based on the design of architect Mathurin Crucy, the theater features seven towering Corinthian pillars on the front above wide staircases spanning the front of the building. But in August and September 2020, art, rather than opera, drew people to the Graslin Theater.

The installation by artist Stéphane Thidet, Rideau, which translates to “curtain” in English, was on display to the public. Thidet’s “curtain” was not made of fabric but in cascade. Life-size statues of the Nine Muses stood at the edge of the roof as water flowed from the roof of the Graslin Theater and cascaded past the Corinthian pillars before plunging down the front stairs into a newly constructed basin where the water would be captured and recycled for repeated travel.

Although the waterfall prevented entry through the main entrance to the Graslin Theater, devoted spectators could enter through the performers entrance to see the opera live. Perhaps it was no coincidence that the performed opera, L’Orfeo by Monteverdi, was a transformational composition, which created the genre of opera and helped bring classical music into the Baroque period.

While a stunt in an opera house can be unusual and transformational, cash flow “stunts” are common in real estate and other financial investments. This article is one of a series on real estate investment valuation and discusses these investment drops.

What is a waterfall?

In real estate and other financial investments, a waterfall is the distribution of the investment money to the investors and the sponsor or founder (which I will call the sponsor). You can think of the way funds flow (like water in a waterfall) to the different parts of the investment.

At a minimum, two groups receive part of the cash flow from the cascade: the investors and the sponsor. In more complex structures, there may be several categories of investors, each with different rights. But the two fundamental groups that receive money in a cascade are still the investors and the sponsor.

Investors’ cash flows are tied to their investments in stocks. Sponsor’s cash flow is due to “deferred interest”. This is a right to receive cash granted to the sponsor as part of his remuneration for the constitution and management of the fund.

Many investments have at least two cascades, one for cash from operations and a second for cash flows from liquidity events, such as sales, refinancings, or recapitalizations. The differences between these cascades are often based on the concept that investors’ return on capital is a priority during liquidity events.

Elements of a waterfall

The Graslin Waterfall consisted of several stages of water flow – the bottom of the roof, freefall to the top of the stairs, flow down the stairs, and collecting in a reservoir at the bottom. Fund stunts also consist of two or more stages of cash flow for the investor and the sponsor. Possible elements of a cascade include (NOTE: some of these phrases are not “official” terms):

Repayment of capital A return of capital is the return of the investors’ cash investment. Since investors don’t want to lose money, return of capital is essential.

Preferred return – A preferential return generally works like interest on debt and is generally described as an annual percentage of investors’ principal outstanding. The purpose of a preferential return is to ensure that investors receive a return on their capital investment before the sponsor makes a profit. However, since Preferred Returns are often cumulative and not compounded, an investor’s actual return may be less than the Preferred Return Percentage shown.

DivisionsSplits are what they sound like – they’re an allocation of cash flow between the investor and the sponsor. The sponsor’s share of spinoffs is their “share of the profits” and is called deferred interest.

LandmarksBenchmarks, which are often expressed in terms of internal rate of return (IRR), are stopping points at which the waterfall moves to a new level.

Sponsors catch-upSometimes sponsors will delay their return until investors receive a stated return. When this happens, the sponsor may receive a catch-up payment to align their deferred interest performance with that of the investors.

RecoveryIf the sponsor receives money from the spinoffs before investors receive a specified return, often the return of their capital investments, they can agree to return that money if the investors still have not recovered their capital at the end. of investment. This arrangement is called a “clawback”.

Sponsorship feesSponsors frequently receive fees for services rendered. Asset management fees, disposition fees, and other sponsor fees are usually not part of the cascade. Most sponsor fees are paid BEFORE the waterfall, although sometimes a sponsor defers it until investors receive a specified return.

Basic Cascading structures

Real estate and many other financial investments are risky. While investors expect a great return on their investment (ROI), their most fundamental concern is not losing money.

It is common for the sponsor to receive a fee for services rendered in the organization and management of the fund before the investors get their full investment back. However, since the purpose of deferred interest is to encourage the performance of the sponsor, the stunt must be aligned with this incentive.

To do this, for a company with one investor unit category plus the sponsor’s deferred interest, I generally recommend one of three simple cascade structures:

Option 1 – Investor’s Preferred Return, followed by investor return of capital, followed by split

Option 2 – Repayment of the investor’s capital, followed by splits

Option 3 – Investors receive all funds until a target IRR is reached, followed by splits

Although the first structure is the most popular, all three structures are easy to manage and ensure the return of investors’ investments before the sponsor receives their deferred interest. Options 1 and 3 ensure that investors not only receive the return on their investment, but also receive a stated profit before the sponsor receives their deferred interest.

More complicated waterfall structures

Some waterfalls include additional elements. The following modification to Option 1 provides for a sponsor “catch-up” designed to replicate investor performance:

Option 1A – Investor’s Preferred Return, followed by Investor Return of Capital, followed by Sponsor Catch (designed to replicate the Investor’s Preferred Return on an assigned value of deferred interest), followed by of splits

Option 3A – Investors receive all funds until a target IRR is reached, then the sponsor receives all funds until an amount designed to replicate the investor’s target IRR is reached, then divides itself

It is easier for investors to understand and the fund accountants to calculate to modify the splits to be more favorable to the sponsor. The exact percentages require a reference to the fund’s proforma. But for example, an 80% / 20% investor / sponsor distribution in option 1 can be replaced by a 70% / 30% investor / sponsor distribution to reproduce the catch-up.

Some sponsors don’t want to wait to receive their deferred interest, especially when the sponsor doesn’t collect a significant fee during the hold period. They can choose these options:

Option 1B – Investor preferred return, followed by splits, with sponsor clawback if investors do not receive their principal repayment at the close of the fund

Option 2B – Splits, with a clawback from the sponsor to ensure investors receive repayment of their principal before the fund closes

These options, especially the first, might be acceptable for an established sponsor with many holdings and significant net worth supporting recovery. However, with a new sponsor, these structures present a considerable risk to investors since the sponsor has little support for their clawback obligation.

As a sponsor becomes more experienced and offers larger funds, there may be multiple classes of shares (for example, preferred shares that are redeemed first but do not receive a split, and shares ordinary which receive a division).

With larger funds, IRR benchmarks can be used to increase the sponsor’s share in divisions as profitability increases. For example, a sponsor might receive a 20% share until investors receive 12% IRR, then a 30% split until investors receive 15% IRR, then a share of 50%. While it can be complicated to follow, an established sponsor and a larger fund can usually bear the additional accounting burden.

Best practices

Investors come first Reputable sponsors put their investors first. Sponsors deserve honoraria for their services and hope to benefit from their deferred interest. But the main concern of sponsors should be the return on investor capital and the return on investment for investors. And with a well-structured stunt, the investor’s ROI will translate into a sponsor ROI from their interest.

Keep it simple – Stunts shouldn’t be more complicated than necessary. Complex structures can be difficult for investors to understand and to manage for sponsors. And complicated financial calculations can tax a sponsor’s infrastructure and increase accounting costs.

Financial results model – Sometimes stunts and models look like a chicken or egg situation. Some sponsors develop a stunt without reference to the model based on what they think will impress investors, and then try to force the model to take over that stunt. The waterfall should give way to the modeled financial results, not the other way around.

Under promise and over deliverReal estate investments are risky and financial models are, by necessity, based on speculative financial assumptions. Aggressive stunts that depend on every penny of expected net cash flow to achieve high preferred return percentages or IRR goals are more likely to fail than more conservative and easily achievable structures. High expected returns could attract investors, but investors will be disappointed if the forecast turns out to be too aggressive.

This series draws on Elizabeth Whitman’s experience and passion for classical music to illustrate creative solutions to legal challenges faced by businesses and real estate investors.