RED 375
Structuring Equity: Cash Flow
Waterfall
1
Equity Funding
− Equity funding is the most critical piece of any real estate development project.
• Why?
− Generally, the amount of debt available will depend on:
• The quality of the project
• The cost of the project
• The level of operating cash flow that the project will generate
• Capital market conditions
− The types of debt available may vary from project to project
• Construction (permanent) loan
• Mezzanine loan
• Public debt
2
Equity Funding
− It is possible that the equity piece is provided by different investors with different return
objectives.
• These investors will of course share the equity return piece that we explored in the
previous lecture.
− How the equity piece is structured may depend on the type of project and the type of
investors involved.
• Remember, equity capital can come from your golfing pals, private equity firms, or even
institutional investors.
• It will be more challenging to raise equity from more distant investors.
− Generally, the equity piece is predominantly financed by an outside investor(s) with the
developer only keeping a tiny piece – 1 to 10% at most.
• It could be that the developer does not put in any equity (e.g., LIHTC projects)
3
Sourcing Equity Funding
− Equity is generally more difficult to source than debt, whether it is for a new
development or a property acquisition, but it is far harder for real estate development.
− Securing equity funding does not necessarily guarantee bank funding, but it is a precondition.
− Equity investors are not a monolithic group; some are seeking to take more risk, thus
looking for higher returns, than other equity investors.
− It is not often the case that one investor (e.g., you) will be able to fund the required
equity.
• Think about equity as a capital stack.
• Two basic types of equity capital: promotional equity and preferred equity
− For development project, the developer will generally hold the riskiest equity piece.
4
Sourcing of Equity Funding
− Promotional equity
• Project general partner, friends, family, and business partners
• High-net worth individuals investing in local area (country-club money)
• Partnership with landowners
• JV partner
• Public funds (multifamily)
− Preferred equity
• Pension funds
• Private equity funds
• Insurance companies
• Listed and unlisted REITs
5
Structuring the Equity Transaction
− To structure a deal with equity investors, knowing that all have their uniqueness, it is
important to consider the following issues:
• Types of ownership vehicles which is most advantageous for the transaction.
• Profit sharing arrangement between the developer and other equity investors.
− There are many types of ownership vehicles used to structure the deal between the
developer and equity investors:
• JVs
• Partnerships
− The investors’ attorneys and accountants should evaluate the alternatives and decide
which vehicle is the most appropriate for this new association.
− The equity partnership arrangement will determine the best combination of returns and
profit split the developer must offer investors to attract the required equity for the project.
6
Structuring the Equity Transaction
− Partnership structure
• Developer: general partner
• Investor(s): limited partner(s)
− Partnership agreement will specify:
• Equity structure
− The investors will put up most of the equity (90% or more), with the developer keeping the remaining
portion.
• Renumeration structure: Waterfall distribution of project profits generally involve two pieces:
1. Cumulative preferred return: 8 to 12% in most markets
2. Promotional return after repayment of principal and preferred return based on a formula agreed
between the developer and the investor.
• It is common the developer takes a large share of remaining cash flows after cumulative preferred
returns and equity payback than his equity share.
7
Priority Over Cash Flows
− Investor priority over project cash flows after debt repayment, project costs, and
any taxes at the partnership level takes generally two forms.
• A “pari passu” arrangement where all equity investors, including the
developer, are treated equally with each investor receiving her pro-rata share
of payments.
• A subordination structure where the equity investor has priority relative to
the developer with regard to specific payments.
− It is possible that the equity investor group includes several investors with some
investors having priority over others.
− Again, there is no typical deal structure.
8
Distribution Level
− Waterfall distribution of cash flows will depend on how the equity is
structured and the outcome of negotiations between the developer and
the outside equity investors.
− There can be one or several levels of cash flow distribution.
− Generally, more levels allow for the creation of different types of equity
investors.
− The number of distribution levels and the priority over cash flows give the
cash flow waterfall, i.e., the cash flows each group of equity investors will
receive.
− These cash flows are then used to compute the return each investor group
will receive.
9
Equity Waterfall
Project cash flows after loans and costs
1st Dollars out
•
•
Preferred return
Principal payback
•
•
2nd Dollars out
Promotional
Return
3rd Dollars out
Promotional
Return
Promotional return to meet target total
return
Some percentage distribution to developer
•
•
Larger percentage return to developer
Ongoing small percentage distribution to
investors
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Equity Cash Flow Distribution (Waterfall)
− Common equity waterfall distribution structure:
1.
Preferred return
− Preferred returns are generally paid first to each equity investors as a fixed percentage of
the amount of equity in the project. These payments are generally cumulative.
− Investor hierarchy: pari passu or subordination
2.
Equity payback
− Any remaining cash flows after preferred return payments are generally used to payback
initial equity investments in the project first.
− Investor hierarchy: subordination or pari passu, but subordination more common with
developer coming last
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Equity Cash Flow Distribution (Waterfall)
− Common equity waterfall distribution structure (cont.):
3.
Promotional return
− Any remaining cash flow after payment of preferred returns and principal payback are
shared by investors (developer and outside investors) according to a predetermined
formula.
− Developer generally receives a larger share of this cash flows than his/her share of the
equity put in.
− Investor hierarchy: pari passu
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Waterfall Calculations
Example from …
NOI YR1
Growth rate
Purchase price
Mortgage Loan
Interest Rate
Maturity (months)
Investment horizon
Selling price
Selling expense
$60,000.00
5%
$720,000.00
$504,000.00
8%
360
4 years
$860,000.00
4%
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Waterfall Calculations
BEFORE-TAX CASH FLOWS
NOI
DS
BTCF
YEAR 1
60,000
(44,378)
15,622
YEAR 2
63,000
(44,378)
18,622
YEAR 3
66,150
(44,378)
21,772
YEAR 4
69,458
(44,378)
25,079
BTER TAX EQUITY
REVERSION
Selling price
Selling expense
NSP
Mortgage balance
BTER
860,000
(34,400)
825,600
(484,944)
340,656
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Waterfall Calculations
WATERFALL
Equity
Investor Equity Contribution
Cumulative Preferred Return
Investor Share of Remaining Cash Flows
Distribution Method
$216,000.00
90%
8%
75%
Pari Passu
Initial Investment
Before-Tax Calculations
Initial Investment
Operating Cash Flows
Reversion Cash Flow
Total
Before-Tax IRR
Year 1
Year 2
Year 3
Year 4
$15,622
$18,622
$21,772
$15,622
$18,622
$21,772
$25,079
$340,656
$365,735
($216,000)
($216,000)
20%
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Waterfall Calculations
Before-Tax Calculations
BT Cash flows
Before-Tax IRR
Preferred Return
Beginning Equity Balance
Preferred Return Earned
Preferred Return Paid
Unpaid Preferred Return
Equity Account Balance
Beging Equity Account Balance
Equity Payback
Unpaid Preferred Return
Ending Balance
Remaining Cash Flow
Before-Tax Cash Flow
Total Payments
Remaining Cash Flow
Investor Share of Equity and Remaining Cash Flow
Investor Share of Equity Payments
Investor Share of Remaining Cash Flow
Total Share to Investor
Developer Share of Equity and Remaining Cash Flow
Developer Share of Equity payments
Developer Share of Remaining Cash Flow
Total Share to Developer
Investor Cash Flows
Before-Tax Cash Flow to Investor
Investor Before-Tax IRR
Developer Cash Flows
Before-Tax Cash Flow to Developer
Developer Before-Tax IRR
Initial Investment
Year 1
Year 2
Year 3
Year 4
($216,000)
20%
$15,622
$18,622
$21,772
$365,735
$216,000
$17,280
$15,622
$1,658
$217,658
$17,413
$17,413
$0
$216,449
$17,316
$17,316
$0
$211,993
$16,959
$16,959
$0
$216,000
$0
$1,658
$217,658
$217,658
$1,209
$0
$216,449
$216,449
$4,456
$0
$211,993
$211,993
$211,993
$0
$0
$15,622
$15,622
$0
$18,622
$18,622
$0
$21,772
$21,772
$0
$365,735
$228,952
$136,783
$14,059.73
$0
$14,060
$16,760
$0
$16,760
$19,595
$0
$19,595
$206,057
$102,587
$308,644
$1,562
$0
$1,562
$1,862
$0
$1,862
$2,177
$0
$2,177
$22,895
$34,196
$57,091
($194,400)
18%
$14,060
$16,760
$19,595
$308,644
($21,600)
33%
$1,562
$1,862
$2,177
$57,091
16
Case Study: West River
Commons
Reading: Ch. 4
17