Consider an Internal Rate of Return Waterfall for Your Next Development Project

The internal rate of return (IRR) waterfall arrangement has gained popularity in recent years as a way to shift risk from equity investors, while rewarding developers for strong performance. But neither a developer nor an investor should enter into such an arrangement without a firm grasp of how it works.

Traditional Profit Split

A traditional real estate development deal typically involves an institutional lender, equity investors and the developer (who also may be an equity investor). The lender generally has the least risk, because it has the first repayment priority, but its return is limited to interest payments.

Equity investors have second repayment priority and receive a preferred return on their original capital investments paid out before profits are split. The developer also may receive a preferred return, though it is subordinated to the equity investors' preferred returns. Additional profits are split between the investors and the developer at a rate of 90/10 or 75/25, for example.

IRR Waterfall Profit Flow

The IRR waterfall arrangement recognizes the critical role a developer plays when it comes to the ultimate success or failure of a project. It aligns the developer's interest with those of the investors so that both benefit from the developer's superior performance.

The IRR is a discount rate that makes the net present value of all cash flows (both positive and negative) from a project equal to zero. In an IRR waterfall arrangement, equity investors receive the majority of profits up to specified IRR thresholds (known as waterfall tiers). When profits exceed those rates, the investors' share decreases as the developer's share increases.

In other words, if the returns are lower than forecasted, the investors receive a bigger share of the profits than the developer. Conversely, if the returns are greater than forecast, the developer enjoys a larger share than it otherwise would and investors get a smaller share. The extra profit the developer earns for exceeding expectations is referred to as its promoted or carried interest. It is important to note that promoted interests traditionally are given only to developers who invest their own money in the project, that is, those with "skin in the game." Additionally, the carried interest often qualifies for more favorable capital gains tax treatment.

If the project ultimately sells at or near the original projected sales price projected, the investors and the developer will see similar returns under both the traditional and the waterfall approaches. When the sales price for the project is lower than projected, though, the investors are better protected from risk under the IRR waterfall method and the developer's profits drop.

If, on the other hand, the project sells for more than the projected price, the developer's profits grow significantly as the waterfall tiers are eclipsed. For example, the developer might receive 30% of the profits on an IRR below 12%, 40% of the profits on an IRR between 12% and 18%, and 50% of the profits on an IRR above 18%. Equity investors continue to reap a healthy return, but the developer is directly rewarded for superior performance.

What's the Right Tipping Point?

The so-called "tipping point" — the projected sales price — is one of the most critical issues when negotiating an IRR waterfall arrangement. In the long run, both sides will benefit from reasonable expectations. If the projected sales price is set too low, equity investors will be unhappy and perhaps unwilling to invest in future projects. Conversely, if it is set too high, the developer will not feel adequately incentivized to pour in sweat equity. Moreover, IRR waterfall arrangements are greatly affected by the timing of any future sale. The quicker the sale, the greater the IRR, everything else being equal.

IRR waterfalls offer numerous benefits for investors and developers. But they are not right for every development project.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.