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Rock Street, San Francisco

Jonathan Eduardo
RE531
First Exam
5-7-18
First Exam Answers
Using the assumptions provided in the question, please view the attached excel document for expected cash flows and IRR for both the LP and GP. The party earning a promote will be receiving a special type of profit sharing compensation. This promote will be payable to the GP, Newton Development. The promote is given in exchange for creating value or bearing a disproportionate share of the downside risk. Newton is responsible for the development and property management. This promote increases as IRR increases, thus incentivizing the GP.
If the hurdle is calculated on a leveraged basis, then it relates to equity. As a result, financing with an effective rate that is less than the hurdle rate will accelerate the achievement of the hurdle and the payment of the promote. Additional financing may increase the financial partner’s IRR, but may reduce the total dollars the financial partner receives from the project. Positive leverage is a useful way to increase the project IRR, but because of the promote (unless unleveraged), the service partner may obtain a disproportionate share of its benefits.
EX.) 12% annual return is compounded monthly and financial partner contributes $100x to purchase a project. One month after acquisition, the project is under contract to be sold 11 months later, which will generate $103x of net sale proceeds. The project will generate $8x of net operating income before the sale. The service partner has found a lender willing to make a no-cost, $103x loan at the time the sale contract is entered into that is payable in one installment of $109x at the end of 11 months. With financing the property is sold at the end of the 11-month contract period and generating $103x of net financing proceeds immediately and $2x of distributions at the time of sale.

LP Partner With Financing ….

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Net Financing Proceeds-$103x
Net Operating Income after loan payment- $2x
Net Sale Proceeds- $0
Total- $105x
Financial Partner’s IRR =>12%
Investments in non-bank lending and private debt can offer attractive risk adjusted income returns and provide a defensive strategy through market cycles. Non-bank lending category is growing and can be attributed to many factors. Due to outsized yields and a short duration, debt funds offering bridge loans and mezzanine debt are growing rapidly. There has been a regulatory impact that has led to a shift. Post-GFC regulation has reduced risk tolerance within traditional lending institutions and opened the market for private lenders. In addition, demand for customized, timely and flexible debt solutions is creating opportunity for private lenders. Cumbersome process at traditional lending sources continues to push borrowers to private lenders with strong reputations, especially for speed and surety of execution. Private credit markets are projected to surpass $1 trillion in size by 2020. Furthermore private senior debt strategies have a priority claim on collateral and cash flow, which insulates investors from volatility. However there always lie risks within the market. As rates continue to rise, cap rates may be affected. Debt service coverage ratios have become very tight. In certain markets, rent growth has slowed significantly, leading to lower asset value growth rates and, with rates rising, cap rate pressure has increased.
18% Alternative. The service partner may receive 18% of the total residual as a promote in addition to 10% of the total residual on account of its capital interest. In that event, the promote comes after, and does not dilute, the 10% share of the total residual the service partner would have received had there been no promote. Example (10%x 100%)+ 18%=28%
20% Alternative. Alternatively, the service partner may receive 20% of the total residual as a promote and then 10% of the 80% balance on account of its capital interest. In that event, the service partner still ends up with a 28% share of the residual. Example 20%+(10%x80%)=28%. Under this approach, the promote comes before, and does dilute, the 10% share of pro rata distributions the service partner would have received without a promote.
Preferred return/ return of capital and IRR method are two common approaches to calculate the promote hurdle. These are alternatives that are said to try and achieve the same result. However there are key differences that may arise with both approaches. Preferred return/return of capital hurdles often, if not usually, do not allow for negative hurdle balances, whereas IRR formulations generally do. Also preferred returns are often, if not usually, calculated using simple (proportionate or linear) returns for partial-compounding periods, whereas the IRR generally uses equivalent continuously compounded exponential returns.
Negative hurdle balances can lead to double counting. This problem is often addressed with the reserves and clawbacks, in which event the first difference may not matter much. But some relatively common clawbacks may not correct the double-counting problem. When such a flawed clawback or no clawback is used, there is potential for a shocking result. The second difference doesn’t arise at all unless there are cash flows or hurdle calculations that do not occur at the beginning of one of the stated compounding periods. But when it does arise, the two approaches may reflect different effective rates for partial compounding periods, which, in turn, can lead to materially different hurdle balances. In terms of favorability for an LP partner, it is assumed that if there is a preferred return/return of capital hurdle, it allows for negative balances (which earn a return at the hurdle rate) and provides for equivalent continuously compounded returns for partial compounding periods. By making these assumptions, it will be possible to consider the promote hurdle either as a typical IRR hurdle or as an equivalent preferred return/return of capital hurdle. In particular, it will be possible to view the IRR hurdle through the lens of a preferred return/return of capital hurdle (the calculation of which may be more intuitive than a typical IRR calculation). In this way, there will always be an amortizing balance, which earns an equivalent continuously compounded return and is increased by contributions and decreased by distributions. It will not matter whether distributions are first applied to capital or return because of the continuous compounding.
In terms of components of credit investment return, the fund leverage contributes to 7.5- 9.5% of return range. Major feature of fund leverage is the maximum 45% of collateral asset value. According to LIBOR benchmark, fund leverage is showing an identified return with a 43% of real estate value. As of 2017 there has been nearly a 3% increase of fund leverage IRR. These leveraged investments are using debt to increase their gains in a short period of time.
Green Street shows great importance towards the NAV based valuation methodology. High-quality estimates of marked-to-market asset value require a great deal of effort and resources, but the estimate can be reasonably precise when done properly. It is also important to mark-to-market the right-hand side of the balance sheet, as the cost of in-place debt can stray substantially from prevailing market. Many market participants skip this important step. When the replacements are market value of assets and market value of liabilities on the REIT balance sheet the result is the marked-to-market equity value per share. I would definitely agree with the approach because calculations would prove to be accurate with a market based pricing model.
Example: You have two identical office buildings, except that one is encumbered by a 60% LTV mortgage carrying a 7% interest rate with another five years to run, while the other has an identical loan at a 5% rate. We want to find out which building will command the higher price. Building prices are profoundly impacted by assumed debt, and a high-cost mortgage negatively impacts pricing. The same holds true when those buildings are held by a REIT and if the debt is unsecured rather than secured. Marking assets to market without doing the same for liabilities yields the wrong answer.
Low leverage is said to be better. The information on the balance sheet matters and identifies risks. Even though property prices have risen more than 50% over the last ten years, REITs that have employed less leverage have delivered far better returns over that time period than REITs with higher leverage. The same statement has held true over the vast majority of ten-year periods since the Modern REIT era commenced in the early-’90s. Not surprisingly, investors are willing to ascribe much higher NAV premiums to REITs with low leverage. Leverage has impacted total returns. A 10% variance in the leverage ratio has been associated with a 5% gap in total returns every year for the last 10 years. In addition, leverage has a big impact on pricing. A 10% variance in the leverage ratio currently equates to a 4% variance in the UAV premiums at which REITs trade.

The debt yield is becoming an increasingly important ratio in commercial real estate lending. Traditionally, lenders have used the loan to value ratio and the debt service coverage ratio to underwrite a commercial real estate loan. Now some lenders use debt yield as an additional underwriting ratio. Debt yield is calculated by dividing the net operating income by the loan amount. The debt yield provides a measure of risk that is independent of the interest rate, amortization period, and market value. Lower debt yields indicate higher leverage and therefore higher risk. Conversely, higher debt yields indicate lower leverage and therefore lower risk. The debt yield is used to ensure a loan amount isn’t inflated due to low market cap rates, low interest rates, or high amortization periods. 
There is 40% increase in loan proceeds. Today versus the traditional standard pro-forma, they are looking to be more aggressive. As a result they are achieving higher net operating income and net cash flow, which may appear as attractive to some investors. Lower vacancy rates, lower management rates, lower replacement reserves, and higher LTVs are all changes made today. If the market falls there is a huge risk.

Allstate works with their bread and butter. They allocate such a meaningful allocation to fixed income. This is where they are successful as mentioned by Scott Rosburg. Their team primarily focuses on sourcing fixed income investments that offer attractive returns and high book yields over an intermediate investment horizon. Opportunities are sought across the capital structure and across the ratings spectrum. Their current focus is on higher book yields, with an emphasis on deal structure and asset value to protect principal. Allstate’s portfolio objective is to pursue intermediate term lending opportunities in fixed or floating rate private debt and middle market loans. While primarily focused on senior, senior secured and first-lien opportunities, they also selectively pursue attractive subordinated or second-lien investments. Overall their return goal is to realize higher absolute returns in comparison to owning a diversified portfolio of public high-yield bonds and broadly syndicated loans. Incremental return factors include illiquidity, structural complexity, and subordination.

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