Understanding the Promote in a Real Estate Deal
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Introduction
In the world of real estate investing, there are various ways to create profit-sharing agreements to maximize returns for all parties involved. One such financial structure, often used in joint venture partnerships, is known as a "promote." This article aims to provide a detailed explanation of the promote in a real estate deal, how it works, and its implications for both the investor and the real estate developer or sponsor.
What is a Promote?
A promote, also known as a "carried interest" or "performance fee," is a financial incentive given to the real estate developer or sponsor when a project or investment reaches a certain performance milestone. Essentially, it is a type of reward system designed to encourage the developer or sponsor to strive for higher returns on an investment.
In a typical real estate joint venture, partners agree to share profits according to their proportionate share of capital contributed. However, a promote allows the developer or sponsor to receive an additional percentage of the profits above a specified return threshold, also known as a preferred return or "hurdle rate."
The promote is most often found in limited partnerships and limited liability companies (LLCs) where the general partner (developer/sponsor) and limited partners (investors) pool their resources to finance a real estate project.
How Does a Promote Work?
A promote is structured on a tiered system called a "waterfall," which establishes various return thresholds that dictate how profits are distributed among the partners. It is essential to understand that the waterfall structure is unique to each deal and can be customized to fit the specific needs and risk profiles of the partners.
Below is an example of a standard real estate deal waterfall structure:
Return of Capital: Initially, all cash flow is first used to return the initial capital investments to investors. In other words, investors get their money back before any further profits are distributed.
Preferred Return: After capital is returned, investors are entitled to receive an agreed-upon percentage return on their investment before the developer or sponsor receives any profits. This is known as the preferred return or hurdle rate, which is often between 6-10%.
Catch-Up: Once the preferred return is paid, the developer or sponsor "catches up" by receiving enough profits to bring them to the same percentage return level as the investors.
Promote Tiers: After the catch-up, any remaining profits are distributed based on predefined tiers, with the developer or sponsor getting a higher share once each tier is reached, encouraging-optimal performance.
Suppose we have a waterfall structure with a preferred return of 8%, a 50/50 catch-up, and promote tiers of 20% at a 12% internal rate of return (IRR) and 30% at a 15% IRR. In this case, the profits will be shared among partners as follows:
Tier 1: 100% of profits to investors until they receive an 8% IRR;
Tier 2: 50% of profits to investors and 50% to the developer until the developer catches up;
Tier 3: 80% of profits to investors and 20% to the developer above the 8% IRR and up to the 12% IRR;
Tier 4: 70% of profits to investors and 30% to the developer above the 12% IRR.
Implications for Investors and Real Estate Developers/Sponsors
Investors benefit from a promote structure by having clear expectations for returns and knowing that the developer or sponsor is incentivized to produce higher returns. It ties the real estate developer’s or sponsor’s profits to the success of a project, aligning their interests with investors.
For developers or sponsors, the promote structure allows them to maximize their returns by achieving higher performance levels. By successfully reaching certain milestones, developers can substantially increase their profits with a relatively small investment.
Conclusion
A promote is a powerful tool in real estate investment deals, enabling investors and developers/sponsors to share risks and rewards, while aligning their interests for the success of a project. Understanding the mechanics of a promote and the waterfall structure is crucial for all parties involved in a real estate joint venture to make well-informed decisions and structure investments that produce mutually beneficial outcomes.