A small but significant part of my firm’s practice involves doing corporate and securities work on real estate development deals. I’m not a real estate lawyer (or, a “dirt lawyer” as they sometimes call themselves, in a bit of rather harsh-sounding self-deprecation), who handles core real estate transactions like purchases and leases of real estate, but I collaborate with those attorneys by forming entities and drafting their operating agreements, and ensure compliance with securities laws when there are outside investors helping to fund the projects.
The operating agreements for the entities formed for the project need to address the economics of the deal, including how any earnings from the project are divvied up between the developer (or, the “sponsor”) and the outside investors. These structures tend to be quite complex, and they have their own jargon that corporate attorneys who practice outside the real estate industry will find quite forbidding, even those who have plenty of experience with sophisticated transactions. Therefore, I thought it would be helpful to decipher a bit of that jargon as a service to the uninitiated among the corporate attorney community. I won’t address here the various other terms of art in real estate finance (cap rates, loan-to-value ratio, etc.) that aren’t directly relevant to the attorney needing to draft the operating agreement, nor will I address operating agreement concepts that are common outside the real estate context on the assumption that, if you’ve made it this far in this post, you know them already.
From a 30,000-foot perspective, in most cases, the outside investors will get most of the first money to come out of the project, to ensure they get at least their investment back plus a reasonable return, and the sponsor will have more of the back end, so they will do quite well if the project is successful over the long term.
Fees – There are a variety of flavors of fees that are paid to the sponsor or others for serving certain functions at various stages of development:
- Acquisition fee –for the work in locating and purchasing the property.
- Refinance fee – for the work in securing a mortgage to replace the one used to purchase the property, which often involves additional cash borrowed that is immediately distributed to the members.
- Asset management and property management fees – these are ongoing fees, as opposed to fees triggered by a particular action, for work done on the regular operation of the property.
- Development fee – for coordinating construction work.
- Leasing fee – for securing tenants.
- Disposition fee – for work done to sell the property.
Most of these fees are expressed in the operating agreement as a percentage, e.g., the sponsor will receive an acquisition fee equal to 1% of the purchase price for the property. While as noted above the investors tend to receive the first money out, these fees are a way to compensate the sponsor for its work throughout the process, and they are paid as company expenses before any distributions are made to the equity holders.
Waterfall – This is the informal term describing the distributions section of the operating agreement, setting forth the rules by which earnings are distributed to various classes of members at different times. Think of it like a literal waterfall, with money raining down and landing on various rock formations as it goes down.
Hurdle – The various elements of the waterfall are separated by milestones that lead you to the next step, i.e., the investors get all the initial distributions until “X” happens, at which point distributions are split between investors and sponsor. “X” is the hurdle.
Preferred Return/IRR – This will be familiar to most corporate attorneys as the LLC equivalent of preferred stock. In real estate, it is common to use internal rate of return (IRR) for calculation purposes. For example, the investors could receive all initial distributions until they have received a 7% IRR (that’s the hurdle).
Promote – In this context, “promote” is a noun, not a verb. With investors often getting the first money out through a preferred return, the promote is the sponsor’s way of getting a larger share of the back end. As an example, after the preferred return hurdle is reached, the sponsor may receive a promote of 30% of all future distributions, indefinitely. This is a similar concept as a “carry” in the world of funds.
Tiers – Hurdles such as preferred return can be split into tiers, e.g., investors receive all returns until they reach an IRR of 7% (Tier 1), then there is an 80/20 investor/sponsor split until the investors receive an IRR of 14% (Tier 2), and thereafter there is a 60/40 investor/sponsor split.
Catch-up – In this scenario, the investors get the first distributions, and after the first hurdle is reached, then the sponsor can receive all distributions until a second hurdle is reached (i.e., they are catching up), after which there is a split.
Capital Event – The waterfall will often have different provisions for a “capital event” like a sale of the property or a mortgage refinance that results in a special distribution to the members, as opposed to ordinary distributions reflecting earnings from the regular operation of the property such as rent payments.
Crystallization – While the promote is generally deferred to a later portion of the waterfall to reward the sponsor for a good job over the long term, to provide a reward and incentive to the sponsor, the parties can negotiate an earlier installment of promote payments, triggered by particular events. This is called “crystallization” of the promote.