When you mess up, how do you react? Wouldn't it be wonderful if we had as much foresight as hindsight, if we were able to avoid ever making a mistake? Not only is that unrealistic, it's unwise… Out of mistakes come major accomplishments—because mistakes are often the springboard for success.
Once, Thomas Edison was working with a lab assistant who was coming up dry after more than 700 experiments. In discouragement, he told Edison that after all these mistakes, errors and false starts, he simply did not believe the project was valid. Edison quickly told him that he was not wasting his time, that he now knew more about the project than anybody alive—that he had not made "mistakes" but had acquired an "education" as to what would not work. And so the assistant went back to his project with renewed vigor.
It's safe to say that if each of us took that approach to life, we would end up accomplishing much, much more. After every mistake, we need to understand that we can look back and learn so that we can move forward with confidence and avoid making the same mistake again.
Here are three tips on how best to handle a mistake:
When you mess up, how do you react?
1. See the mistake as a step on the road to a solution.
Don't let mistakes depress or discourage you. We must realize that depression and discouragement are negatives that limit the future.
2. Admit the mistake.
I'll admit that takes courage, but recognition of errors is a sign of maturity. Not to recognize them is to deny them. The reality is that "denial" is more than just a river in Egypt—it's something that will limit your future.
3. Know that it’s only when you ignore the mistake that it is negative.
When we confront mistakes, we are taking full advantage of it as the "positive" they are.
While many analysts expected economic growth to be weak in the first quarter, no one expected it to be as weak as it actually was. The Bureau of Economic Analysis (BEA) “advance” estimate for the gross domestic product (GDP) growth rate in Q1 reported a rate of 0.5 percent for the quarter. And while Q1 has had its problems in recent years—the GDP grew at only 0.7 percent for the first quarter of 2015, then shot up to 3.9 percent for Q2—none were expecting it to be that low.
GDP growth was 1.4 percent in the fourth quarter of 2015.
According to the BEA, the slow Q1 GDP growth reflected a larger decrease in nonresidential fixed investment, a deceleration in personal consumption expenditures (PCEs), a downturn in federal government spending, an upturn in reports, and larger decreases in primary inventory investment.
These factors were partially offset by an upturn in local government spending and an acceleration in residential fixed investment, according to the BEA. “Our forecast was about 0.7 growth and it came in at 0.5,” said Fannie Mae Chief Economist Doug Duncan. “People's expectations had adjusted toward that. The good news in there was that housing actually increased its contribution, and that's consistent with our forecast. The thing I think people continue to be disappointed with is the consumption numbers and the business fixed investment numbers were quite weak. That's actually not surprising, given that corporate profits have fallen over the last several months, and companies typically don't invest when profits are falling.”
Duncan added that is a risk component of the economic picture going forward, there is a “pretty high correlation between a decline in profits and a recession, even though most people don't have that in their forecast at the moment.”
With the GDP growth that low, is a recession in the cards for the near term? Capital Economics said the likelihood is low. “Following on from the 1.4 percent gain in the final quarter of last year, (growth of less than 1 percent) suggests the U.S. economy lost more momentum and could be headed for a full-blown downturn,” Capital Economics said in a recent report. “The risk of a recession this year is still relatively low, however, particularly as the improvement in the activity surveys points to a rebound in GDP growth soon.”
Fannie Mae has again downgraded expectations for economic growth in 2016. Doug Duncan, senior vice president and chief economist and the ESR Macroeconomic Forecast Team said on Tuesday that the 0.5 percent annualized growth in the first quarter GDP was the weakest in two years, well below the company's expectations at 1.2 percent. It was the third year in a row that first quarter growth was below 1.0 percent although in the previous two there was a bounce back in the second quarter.
The economic team had originally projected 2.2 percent annual growth this year but downgraded that in its April forecast to 1.9 percent. The Economic Summary for May now projects growth of 1.7 percent. The slowdown was broad-based but the one bright spot was residential investment which added 0.5 percentage points to growth, the largest contribution since the fourth quarter of 2012. There was also what the economists called modest stimulus from the recent federal budget deal. They expect both housing and government to contribute to growth for the remainder of the year.
The possibility of a rate hike at the June 2016 Federal Open Market Committee (FOMC) meeting remains on the table and Fannie Mae notes that the post-meeting statement from April suggests that the Fed is less worried about financial turmoil abroad. Still, Fannie Mae is sticking with its earlier projection of only one 2016 rate hike, probably in the second half of the year. (Who knows how this view might change following this week's FOMC Minutes...)
Home sales in the first quarter of 2016 were moderately better than in the last quarter of 2015 although month-to-month changes have been "lackluster." New home sales have fallen for three straight months while existing home sales partially rebounded in March from a February slump. Leading indicators suggest a pickup in home sales going into spring. Pending home sales rose in both February and March and the average purchase mortgage application index rose in March and April while mortgage rates continued to edge lower.
Homebuilding activity continued to disappoint although the decline in both permits and housing starts were largely due to the volatility of the multi-family sector. One of the main headwinds for multi-family construction is an excess supply of high-end apartment buildings in ten of the largest cities although there is still plenty of demand for affordable rentals. The financing environment for new multifamily construction has become more difficult. The Federal Reserve's Senior Loan Officer Opinion Survey shows a net percentage of banks are tightening standards for commercial real estate loans.
Single-family construction is more positive. Starts are up 22 percent from the same period last year, but that gain is still off of depressed levels. The leading home price indices - Case-Shiller, FHFA, and CoreLogic - show strong annual appreciation ranging from 5.3 to 6.0 percent during the first two months of the year. Lean inventory and fewer distressed sales continue to support price gains. Homeownership appears to be stabilizing. The Census Bureau's Housing Vacancy Survey for the first quarter shows the rate down 0.3 percent from the previous quarter and 0.2 points from a year earlier to 63.5 percent which Fannie Mae says is the level around which it has hovered for the last four quarters. That the Baby Boom generation is still maintaining high rates has helped offset the low homeownership so far among the even larger Millennial generation.
The company still expects the 30-year fixed rate mortgage to be at 3.7 percent in the fourth quarter but has raised its total home sales forecast for the year to 6.02 million as the upward revision in existing home sales outweighed the downward revision in new home sales. Incoming data suggestions that mortgage originations for both purchase and refinance have been stronger than anticipated so the company has upgraded its estimates for the first quarter and the entire year. "For purchase originations, we lowered our assumed share of home sales using cash through the first quarter of 2017. For all of 2016, we expect total mortgage originations to decline 3.7 percent from 2015 to $1.65 trillion, as the 18.8 percent drop in refinance originations outpaces the 9.4 percent rise in purchase originations. The refinance share should decline to 39 percent in 2016 from 46 percent in 2015. Total originations should decline further in 2017, as a drop in refinance originations continues to outweigh an increase in purchase originations. We project total production volume to be $1.45 trillion in 2017, with the refinance share sliding further to 30 percent," the report says.
If the May Wall Street Journal economist survey is any indication, the economy is a lot worse off than it was as recently as a month ago. In the last three surveys conducted by the Journalin which economists are asked when they think the Federal Reserve will next raise the federal funds target rate, the consensus answer has been June. In April’s survey, three-quarters of economists surveyed said they believe that a rate hike by the Fed will be announced at the next FOMC meeting on June 14 and 15.
May’s survey told a different story, however. Less than a third (31 percent) out of the 70 economists surveyed said they believe the rate hike will take place in June; 21 percent said they believe it will take place in July. The same percentage of economists who believe that a June rate hike will take place (31 percent) said they think it will take place in September.
What happened to the economy in the last month? A couple of setbacks—first, in late April, the Bureau of Economic Analysis announced GDP growth for the first quarter was a mere 0.5 percent (in their advance estimate). Then, last week, the Bureau of Labor Statistics reported that labor market gains fell short of expectations with just 160,000 jobs added during April.
Following the April FOMC meeting, the Committee announced that it would “closely monitor inflation indicators and global economic and financial developments,” to determine when would be the appropriate time to raise the federal funds target rate from its current range of 0.25 percent to 0.5 percent. The minutes from the FOMC meeting will be released on Wednesday, May 18.
Even before the economic turbulence experienced April, Fed Chair Janet Yellen suggested in late March that the Fed was in no hurry to raise rates further after the historic rate hike in December.
“Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower.”
Fed Chair Janet Yellen
“A key factor underlying such modest revisions is a judgment that monetary policy remains accommodative and will be adjusted at an appropriately gradual pace to achieve and maintain our dual objectives of maximum employment and 2 percent inflation,” Yellen said. “Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower.” Yellen also noted at that time that “the housing market continues its gradual recovery, and fiscal policy at all levels of government is now modestly boosting economic activity after exerting a considerable drag in recent years.”
Also, in mid-April, Fannie Mae announced it had downwardly revised its forecast and was now expecting only one rate hike by the Fed for the rest of 2016 instead of two. The Journal noted that it is rare for economists to be divided as to when the Fed would raise rates, with Capital Economics North American Chief Economist Paul Ashworth stating that a June rate hike by the Fed would require “stronger incoming data and no renewed market turmoil.” There will be one more employment situation released by the BLS before the next FOMC meeting.
Minneapolis Fed President Neel Kashkari said in a speech earlier this week that financial markets’ focus is in the wrong place if they are concentrating on what the Fed does with the short-term interest rates. “Given all the attention market participants pay to every FOMC statement, one would think the Fed could control a lot,” Kashkari said. “But the truth is that central banks can’t influence many of the things that really matter to the long-term well-being of a society. We can’t influence trend productivity growth. We can’t influence competitiveness. We can’t influence educational performance.”
Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. Cash flow from a development or investment project can be split in a countless number of ways, which is part of the reason why real estate waterfall models can be so confusing. In this article we’ll take a deep dive into real estate waterfall distributions, dispel some common misconceptions, and then we’ll tie it all together with a step-by-step real estate waterfall example.
What are Investment Waterfall Distributions?
First of all, what exactly is a “waterfall” when it comes to cash flow distributions? An investment waterfall is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools.
This type of arrangement is beneficial because it allows equity investors to reward the operating partner with an extra, disproportionate share of returns. This extra share of returns is called the promote, which is used as a bonus to motivate the operating partner to exceed return expectations. Under a waterfall structure the operating partner will receive a higher share of profits if the project’s return is higher than expected, and a lower share of profits if the project’s return is lower than expected.
The Importance Of The Owner’s Agreement
With investment waterfalls, cash flows are distributed according to the owner’s agreement. Because there are so many variables when it comes to investment waterfall structures, it’s critically important to always read the owner’s agreement. The agreement will spell out in detail how profits will be split among partners. While there are some commonly used terms and components in investment waterfall structures, waterfall structures can and do vary widely. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement.
Common Real Estate Waterfall Model Components
Although waterfall structures vary widely, there are several commonly used waterfall model components. Before we dive into our step-by-step waterfall model example, let’s first take a look at some basic building blocks.
The Return Hurdle
The return hurdle is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are what trigger the disproportionate profit splits. Since the term “rate of return” can be defined many different ways, the return hurdle in a waterfall distribution structure can also be defined in many different ways. In practice, the the Internal Rate of Return (IRR) or the Equity Multiple are commonly used as return hurdles. The IRR is the percentage rate earned on each dollar invested for each period it is invested. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity].
Once the return hurdle has been defined the next logical question is, from what perspective will the return be measured? Since a project will have a sponsor and at least one other investor, the return can be calculated from several different perspectives. The return hurdle could be measured from the perspective of the project itself (which could include both the sponsor and the investor equity), the third-party investor equity only, or the sponsor equity only.
The Preferred Return
Another common component in equity waterfall models is the preferred return. What exactly is the preferred return? The preferred return, often just called the “pref”, is defined as a first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before any other investors receive a distribution of profit. Once this “preference” return hurdle has been met, then any excess profits are split as agreed.
A few key questions with the preferred return are:
· Who gets the preferred return? Preferred investors could include all equity investors or only select equity investors.
· Is the preferred return cumulative? This becomes relevant if there isn’t enough cash flow to pay out the preferred return in any given year. In waterfall models this preferred return can either be cumulative or non-cumulative. If the pref is cumulative then it will be added to the investment balance for the next period and accumulate until it’s eventually paid out.
· Is the preferred return compounded? A preferred return can also be compounded or non-compounded. When the pref is cumulative a key question is, is this unpaid cash flow compounded at the preferred rate of return as it accumulates?
· What is the compounding period? If the pref is compounded then it’s also important to know the compounding frequency. The compounding frequency could be annually, quarterly, monthly, daily, or even continuous.
The Lookback Provision
The lookback provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.
The Catch Up Provision
The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. Then, after the investor achieves the required return, 100% of profits will go to the sponsor until the sponsor is “caught up.”
The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).
Again, the important thing to remember about waterfall structures is that there is no one size fits all solution and these terms and conditions will all be spelled out in the owners agreement. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model.
Multi-Tier Real Estate Investment Waterfall Calculation Example
Suppose we have a general partner and an outside investor who contribute a combined total of $1,000,000 into a project. The general partner invests 10%, or $100,000, and the outside investor contributes the remaining 90%, or $900,000. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. If distributions in any year fall below the preference level of 10%, then the deficiency will be carried over to the following years and compounded annually at the preferred rate of return. In other words, the pref is both cumulative and compounded.
After the 10% preferred return hurdle has been achieved, then all additional profits up to a 15% IRR will be allocated at a rate of 20% to the general partner and 80% to the equity investors. After a 15% IRR hurdle has been achieved, then all additional profits will be allocated at a rate of 40% to the general partner and 60% to the equity investors. All IRR hurdle calculations will be at the project level.
So, based on the above assumptions, we have a 3 tier waterfall model with all IRR hurdles measured at the project level. The first tier or hurdle is a 10% IRR, the second tier is a 15% IRR, and the 3rd tier is anything above a 15% IRR.
The first line is simply our before tax cash flow calculation from a standard real estate proforma. As you can see, the calculated IRR for the entire project is 21.24%. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. The next few lines show how much equity is contributed to the project by the sponsor and investor and when it is contributed. Since all of the equity for this project is required at the beginning, it is all shown at time period 0.
Here is a summary including percentage allocations of the total equity contributions to the project:
As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Next, let’s take a look at a summary of our promote structure discussed above:
There are 3 tiers (or hurdles) in this promote structure. Profits are split pari passu up to a 10% IRR. After the 10% IRR is achieved, then profits will be split disproportionately. Profits above a 10% IRR up to a 15% IRR will be split 80% to the third-party investor and 20% to the sponsor. In other words, the sponsor gets an additional 10% of profits in addition to his 10% pro-rata share of profits. This additional 10% is the “promote”. Finally, all profits above a 15% IRR will be split 60% to the third-party investor and 40% to the sponsor. This means the sponsor is getting a 30% promote after the final 15% IRR hurdle is achieved.
So far all of our assumptions are pretty straight forward and easy to understand. We have a 90%/10% equity split between the third-party investor and the sponsor, and then we have a 3 tier promote structure. Now we need a way to actually calculate the profit splits at each tier.
Real Estate Waterfall Model Tier 1
To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. Then, we’ll allocate these cash flows to the sponsor and the investor based on the agreed upon profit splits at this tier. Finally, we’ll calculate how much remaining cash is available from the project that can flow into the next waterfall tier.
This is where waterfall distribution models get complicated, so let’s take it step by step.
The table above has a lot of information, so as we work through it below remember that all we are doing is calculating what a 10% IRR (Tier 1) looks like. Then, once we figure out what cash flows are needed for a 10% IRR, we simply allocate those cash flows (or available cash flows) between the Sponsor and Investor based on our Tier 1 promote structure. Finally, after netting out our Tier 1 cash flows from our before tax cash flows for the project, we figure out how much cash flow is remaining for Tier 2. With this big picture in mind, let’s walk through each line item in the table above.
Year 0 is the beginning of the project and as you can see our beginning balance is $0. On the next line below, you can see our equity contributions at the beginning of the project total $1,000,000. Next is the Tier 1 Accrual line item. This is simply the amount that is owed to the equity investors based on the 10% IRR. In this case the calculation is just 10% times the beginning balance, which for Year 0 is $0 since there is no beginning balance.
The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.
The Ending Balance line item takes the sum of the beginning balance, equity contributions, Tier 1 accrual, and Tier 1 distributions. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution).
In Year 1 we use the ending balance from the prior year (Year 0) as our Year 1 Beginning Balance. Then we simply repeat the process discussed above by calculating our Accrual based on the beginning balance for this period, then we calculate our actual distributions for this period, and finally our Ending Balance for this period. We continue this process for all years in the holding period and once completed we can then move on to splitting up cash flows between the Investor and the Sponsor in this tier.
The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow. Investor cash flow is the percentage of Tier 1 distributions that flow to the investor and sponsor cash flow is divided into two components. First, the sponsor equity cash flow is the portion of Tier 1 distributions attributed to the sponsor’s pro-rata (10%) equity investment. Second, is the sponsor promote cash flow, which is the bonus cash flow that flows to the sponsor for achieving the IRR hurdle. In Tier 1 there is no promote, which means 90% of the Tier 1 distributions flows to the investor and 10% flows to the sponsor.
Real Estate Waterfall Model Tier 2
Now let’s take a look at the second IRR hurdle and repeat the same process we followed for Tier 1:
This table is exactly like the table used above for the first hurdle. The key difference is that this time we are calculating the cash flows required for a 15% IRR and then we are splitting them up between the investor and the sponsor at different rates. When calculating the cash flow splits we are also taking into account any distributions made in Tier 1. Let’s take a look at how this works.
In Year 0 we start off with $0, contribute $1,000,000 in equity, and since our beginning balance is $0 there aren’t any accruals nor any distributions. In Year 1 we start off with the $1,000,000 ending balance from Year 0, and our Year 1 accrual is 15%, which is $150,000. However, the project cash flow before tax is only $90,000, so there is a deficiency of $150,000 minus $90,000, or $60,000. This $60,000 deficiency gets added to our ending balance and carried over to the next year, where this process continues.
Once we’ve followed this process for all years in the holding period, we can then move on to calculate the cash flow splits between the investor and the sponsor. This is the same process we followed for Tier 1, except now the sponsor has a 10% promote. This is an additional 10% allocated to the sponsor above and beyond the sponsor’s 10% pro-rata share. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2.
Besides including the promote in this Tier, the other difference here is that we are also netting out the cash flow taken in Tier 1. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).
Real Estate Waterfall Model Tier 3
Finally, let’s take a look at the last hurdle, which is an IRR above 15%:
This is the easiest to calculate since we don’t have to figure out the required cash flow for a particular IRR. Instead we simply take all remaining cash flow and allocate it according to the percentage splits at this tier. In this case the sponsor gets a 30% promote in addition to his original 10% share, which leaves the investor with 60% of the cash flow. Just like in Tier 2, all of the cash flow in years 1 through 4 is distributed in the prior tiers, which is why all the cash flows in Tier 3 are from the sale in Year 5.
Waterfall Model Returns Summary
The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics.
In this table we are simply adding up the cash flows from each tier for both the investor and the sponsor. Then we calculate the overall IRR and equity multiple for both the investor and the sponsor. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. However, based on our promote structure the sponsor earns a disproportionate share of these cash flows resulting in a 36.34% IRR for the sponsor and an 18.91% IRR for the investor. This disproportionate cash flow split is also reflected in the equity multiple, which is 1.98x for the investor and 3.85x for the sponsor.