Article written by Hayley Wong of DMCL in the Canadian News Quarterly, a newsletter published by the Canadian member firms of Moore North America. These articles are part of our mission to become the partner of choice for your success by keeping you up to date.
Real estate professionals (“limited partners”) commonly create real estate limited partnership or general partnership structures as a tool to facilitate the acquisition of real estate assets and to structure these acquisitions with multiple investors. These structures offer investors the chance to invest in major real estate acquisitions that would otherwise be unattainable by investing alone. Limited partners use this tool to raise capital to acquire real estate assets they have identified. To compensate investors and limited partners, cascading equity calculations are incorporated into the
limited partnership agreements (the “Agreement”).
Cascading real estate models for commercial real estate transactions are one of the most difficult concepts to understand when it comes to cash flow distributions. The cascade consists of dividing free cash flow between investors and limited partners in the following way
a real estate investment allowing for uneven distribution. This type of planning offers the sponsor an incentive to participate in an inordinate share of the returns. This bonus is sometimes called an “incentive bonus”.
The cascade model usually includes a preferential rate of return.
and a minimum rate of return. The internal rate of return (IRR) is often used to
minimum rate of return. The IRR is a measure of return on investment
average compound annual return on real estate investment over time, expressed as a percentage.
The preferred return is the first claimant on distributions of free cash flow. Once the preferential yield expressed as a percentage has been achieved, excess free cash flow
are then separated as agreed. The agreement will also address the following elements of the performance model
preferential.
- Which equity investors receive the preferential return?
- Is the preferential return cumulative?
- Is preferential yield compounded and how often?
The case
A real estate investment opportunity may include a cascading calculation that provides the limited partner with a cumulative rate of return (the “Preferred Return”) equivalent to an annual nominal rate of 7% per annum compounded semi-annually on the capital invested. Once the preferential yield of 7% has been reached, all additional cash flow distributions up to 15% of the IRR will be allocated in a proportion of 25% to the general partner and 75% to the limited partner. Once the 15% IRR has been reached, all additional cash flow distributions will be allocated 50% to the general partner and 50% to the limited partners.
Common problems
Model frequency
Agreements often specify when capital contributions are deemed to have been made, which generally corresponds to the actual day of activity. This information is important in determining the amount of preferential return attributable to a capital contribution when preferential return is expressed using an annual rate.
Let’s determine the preferential return for a capital contribution of $100,000 made on January 1, 2021 and distributed on August 1, 2021. Simply using the number of days the contribution was outstanding and prorating over 365 days, the preferential return totals $4,085. Using the TRI function. PAYMENTS in Excel, this preferential payment provides an IRR of 7.14%, which is higher than the required rate of return of 7%. However, by applying a more exact rate-of-return formula using (1 + rate) ^ (number of days/365), the preferential yield equals $4,008. Using this approach prevents overpayment of the 1.92% preferential yield.
Minimum compounded rate of return
The interest calculation period for the minimum rate of return will also have an impact on the calculation of the effective rate. In the above example, the nominal prime rate of return of 7% compounded semi-annually equals an effective annual rate of 7.12%. Using only the nominal rate of return, the preferential return per year is underestimated by $120 per year.
Calculate the preferential yield accrued on initial capital contributions
The preferential return is calculated on the initial capital contributions using the preferential rate of return specified in the agreement. Preferred return can be calculated on a cumulative or non-cumulative basis. If calculated on a cumulative basis, it is added to the initial capital contribution. Distributions are deducted from the cumulative preferential return earned. The agreement must clearly specify the events that may reduce the initial capital contribution. These events are usually limited to the sale or refinancing of real estate assets. In these circumstances, the preferential return earned in the current period cannot be reduced if distributions in prior periods exceed the preferential return. If the initial investment was $100,000 for 90% equity with a prime rate of return of 7% for years 1 to 5, the real estate investment has a return of $10,000 per year. If the preferential return is calculated on the assumption that cash flow distributions in excess of the preferential return reduce the initial capital contribution rather than being a distribution, it is subject to a cascade calculation. This can lead to an exaggeration of distributions to the initial capital contribution. Over a 5-year period, this exaggeration will total $2,252 or 4.46% of total distributions.
Understanding the economics of a real estate transaction is very important to ensure that returns to investors are consistent with, and calculated in accordance with, the agreement and any marketing materials that may be provided to investors.
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