A joint venture real estate deal is an arrangement in which two or more parties come together to jointly develop, manage, and/or own a real estate property or portfolio. An IRR (Internal Rate of Return) hurdle-based waterfall is a common method used to distribute the profits or losses of the joint venture between the parties involved.
The entire point of a hurdle schedule in these deals is to incentivize the GP (operator) to do a good job at getting higher returns for the LP (investors). The higher the investors return, the greater the share of cash flow for the operator. For example, if the LP never gets above their first hurdle of say 10%, then the cash may all go to the LP or it may be 90/10 or 95/5 split, but if the LP gets up above a 20% IRR, then any cash flows after that may be split 50/50. There are all sorts of ways to structure these hurdles. I have templates shown below that let you see the actual logic happening and play with the numbers to help you understand the underlying mechanics.
IRR Hurdles vs. Simple Interest Rate Hurdle vs. Equity Multiple Hurdle
To understand what is going on here, let's first look at the difference in naming. The main difference between an IRR hurdle and a simple interest rate hurdle is that the IRR hurdle takes into account the time value of money and the net cash flows generated by an investment, whereas the simple interest rate hurdle does not. The IRR hurdle provides a more comprehensive measure of the return on an investment, as it accounts for the timing and magnitude of the cash flows. The simple interest rate hurdle, on the other hand, is a simpler measure of return that is based solely on the amount of interest earned on the principal invested.
You could also have a preferred return joint venture structure that has no claim on equity. What that means is that the LP gets a defined percentage return on their equity each year, but after that return is given, the cash flows split based on a defined percentage and there is no consideration of the actual IRR or return multiple of the LP. So, for this, you may give an LP 10% on their investment each year and any cash flows above that are split 60/40 to the GP/LP accordingly. That may or may not result in a total return that is positive depending on what the profits of the venture end up being.
Going further, you could have a preferred equity agreement that is based on the LP receiving a defined equity multiple and this won't consider any timing or rates but rather just look at the total return achieved for the LP and split cash flow based on a given defined equity multiple. For example, if the equity multiple hurdle is 2.2x on a 1,000,000 investment by the LP, that means the LP gets 100% of the cash flows until they have gotten all their money back, then you may have a new cash flow split up until the hurdle multiple is achieved (in this case that would be 2,200,000 if the investment were 1,000,000), and then a final split after that multiple has been achieved.
Note that even in a simple preferred return structure, you still need to determine if shortfalls are added to the equity basis or if you re-start the basis in each period. Also, you will have to determine if the returns are calculated monthly, quarterly, semi-annually, or annually.
It is important to note that all types of agreements can be made and there is no hard and fast rule as to what is best or right. Whatever is agreed upon is what will be done, whatever that might result in.
Compounding Period
This is only really important for the waterfall that is based on IRR hurdles. If you have an annual IRR hurdle rate of say 8%, but you are distributing cash flow monthly, then you need to convert the hurdle rate to the monthly compounded rate that will result in the annual rate.
Here are the conversions to go from monthly to annual or annual to monthly (r = rate) and the '12' in the below image is for 12 months. If it were a quarterly rate, you would enter a '4' there or if semiannual you would enter a '2':
- Monthly to Annual: ((1 + r) ^ 12 ) - 1
- Annual to Monthly: ((1 + r) ^ 1/12) - 1
The above is the most accurate way to calculate the rates. The other option you could do is simply define the IRR hurdle as a monthly rate and not try to convert an annual rate into a monthly rate. That doesn't require any conversion and you just need to be clear the IRR hurdle is a monthly IRR, not an annual IRR.
For a simple interest hurdle, you can just divide the rate by 12 and apply that to the monthly period. Again, this is for situations where the cash flows are distributed monthly.
- IRR Hurdle Waterfall Template
- Simple Interest Hurdle Waterfall Template
- Preferred Return (no equity component)
- Preferred Equity (using an equity multiple as the hurdle) - This doesn't take into account time.
In addition to the distribution mechanics, there are also tax considerations to be aware of in a joint venture real estate deal. In the United States, real estate ventures are typically structured as either partnerships or limited liability companies (LLCs). The tax treatment of these entities varies depending on the structure and the specific circumstances of the deal.
In a partnership, the profits and losses of the venture are passed through to the individual partners and reported on their personal tax returns. The partners are responsible for paying taxes on their share of the profits, regardless of whether the profits are distributed or reinvested in the venture.
In an LLC, the profits and losses can be allocated in a variety of ways, depending on the terms of the operating agreement. The LLC itself is not taxed, but the members are responsible for paying taxes on their share of the profits.
It's important to work with a qualified tax advisor to ensure that the joint venture is structured in a tax-efficient manner and that all partners are aware of their tax obligations.
Being a member within the GP or LP pools
You could have a joint venture where multiple members are in the GP and/or the LP. For them, the general structure is that they get a percentage of the cash flows based on their investment compared to the other investors in the GP or LP. For example, if the LP contributes 1,000,000 and you have 5 investors each contributing 200,000, then each LP member will get 200,000/1,000,000 of the LP cash flows (20%). Same goes for the GP side. If the GP contributes 200,000 and that came from 2 GP members that both contributed 100,000, then each of them will get 50% of the GP cash flows (100,000/200,000).
The actual cash flows that happen are unknown until they actually exist. Because of this, the actual value of any given equity position is not really known until the entire deal is done. Cash will just keep getting split according to the hurdle schedule until the agreement is dissolved or the venture is fully exited.
Article found in Joint Venture.
