The promote starts where the investor's hurdle account is cleared, so the threshold is a price you can solve for in advance and compare with the purchase price and the entry yield.
The promote starts to pay at the exit price whose net equity proceeds exactly clear the preferred return: the partners' capital rolled forward at the hurdle rate, less the distributions already paid, plus the loan, grossed up for sale costs. On an illustrative venture bought for 245 with a 150 loan and 100 of equity, an 8 per cent hurdle is cleared at an exit price of 264.03 in year 5, 7.8 per cent above the purchase price and a 5.65 per cent exit cap rate. Below that the sponsor earns no promote at all; the top 30 per cent tier starts at 297.53.
Worked in full in Real Estate Joint Ventures by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Term sheets negotiate hurdles and splits as percentages. Neither partner sees, at signing, the property price that turns them into money. That price is the useful number: it can be set against the purchase price, against the entry yield and against a broker's view of the exit, and it tells the sponsor how much has to go right before its promote is in the money. It also changes with the hold period in a way a percentage does not show.
| Input | Value |
|---|---|
| Purchase price, including costs | 245.0 |
| Loan, interest only at 5% | 150.0 |
| Equity: investor 90%, sponsor 10% | 100.0 |
| Of the 250.0 raised, spent on fees and reserves and not recovered at exit | 5.0 |
| Net operating income, year 1, growing 2% a year | 13.5 |
| Entry cap rate | 5.51% |
| Sale costs at exit | 2% |
| Tier 1: pro rata to an 8% IRR, compounded annually; promote | 0% |
| Tier 2: to an investor 12% IRR; promote, rest pro rata | 20% |
| Tier 3: above; promote, rest pro rata | 30% |
Interest is 7.50 a year, so the operating distributions are 6.00, 6.27, 6.55, 6.83 and 7.11 over five years, 32.75 in all, each below the 8.00 the hurdle accrues. Every one of them falls inside tier 1 and is paid pro rata.
1. Hurdle balance: start at 100.0, each year multiply by 1.08 and subtract that year's distribution. At the end of year 5 it stands at 108.75. (The same as 146.93 of capital compounded, less 38.18 of distributions compounded.)
2. Net equity proceeds needed = 108.75. Add the loan: 108.75 + 150.0 = 258.75.
3. Gross up for sale costs: 258.75 / (1 − 2%) = 264.03, +7.8% on the purchase price.
4. Forward NOI in year 6 is 14.91, so the threshold is an exit cap rate of 14.91 / 264.03 = 5.65%.
5. Top tier: the investor's own 12% balance is 121.51; tier 1 has paid it 97.88; it needs 23.64 more and gets 72% of tier 2, so tier 2 is 23.64 / 72% = 32.83 wide. Equity proceeds 141.58, exit price (141.58 + 150.0) / 98% = 297.53, a 5.01% cap rate.
Excel: hurdle balance =Prev*(1+Hurdle)-Dist down the years; threshold price =(Balance+Loan)/(1-SaleCost).
| Exit price | Exit cap | Net equity | Deal IRR | Promote | Investor IRR |
|---|---|---|---|---|---|
| 245.00 | 6.08% | 90.10 | 4.72% | 0.00 | 4.72% |
| 260.00 | 5.73% | 104.80 | 7.34% | 0.00 | 7.34% |
| 264.03 | 5.65% | 108.75 | 8.00% | 0.00 | 8.00% |
| 280.00 | 5.32% | 124.40 | 10.46% | 3.13 | 9.98% |
| 297.53 | 5.01% | 141.58 | 12.91% | 6.57 | 12.00% |
| 300.00 | 4.97% | 144.00 | 13.24% | 7.29 | 12.24% |
| 320.00 | 4.66% | 163.60 | 15.76% | 13.17 | 14.09% |
An exit at the entry cap rate, on income that has grown 2 per cent a year, is 270.50: past the threshold, but only just, with a promote of 1.27. The sponsor's promote is in the money on income growth alone in year 5. It needs the cap rate to compress to about 5.01 per cent before the 30 per cent tier is reached.
| Exit year | Hurdle balance | Promote starts at | Above purchase | Cap rate | Price at entry cap | 30% tier starts |
|---|---|---|---|---|---|---|
| 3 | 105.66 | 260.87 | +6.5% | 5.49% | 260.00 | 278.40 |
| 5 | 108.75 | 264.03 | +7.8% | 5.65% | 270.50 | 297.53 |
| 7 | 111.15 | 266.48 | +8.8% | 5.82% | 281.43 | 320.33 |
The threshold price rises with time because the hurdle compounds faster than the distributions pay it down, but income grows faster still, so a later exit clears it more comfortably at a constant cap rate. A year-3 sale at the entry yield, 260.00, falls short of the 260.87 threshold: the sponsor of a quick flip needs the market to move, not just the asset.
The book's complete venture, with a downside sheet that finds the exit at which its promote first becomes payable, is in the free workbook for this case; the tiers themselves are worked in how to calculate a multi-tier IRR waterfall, and the JV waterfall and promote model runs any structure.
Because the preferred return keeps compounding faster than the operating distributions pay it down. In the illustrative venture the exit price at which the promote starts is 260.87 in year 3, 264.03 in year 5 and 266.48 in year 7, against a purchase price of 245.
Only if income has grown enough. In the illustrative venture, net operating income growing 2 per cent a year and an exit at the 5.51 per cent entry cap rate in year 5 gives a price of 270.50, which clears the 8 per cent hurdle and pays a promote of 1.27. The same exit in year 3 gives 260.00, short of the 260.87 needed.
Where the investor, not the deal, reaches the upper hurdle after receiving only its share of the middle tier. In the illustrative venture the investor's 12 per cent balance needs 23.64 more after the first tier, and it receives 72 per cent of tier 2, so the tier is 32.83 wide and the 30 per cent tier starts at an exit price of 297.53.
This article is one calculation from Real Estate Joint Ventures. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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