The net target in the deck is only as credible as the gross IRR the deals can deliver after fees, expenses and the waterfall.
Work backwards through the fund's terms: model the fees, expenses and waterfall, then solve for the gross IRR that leaves the target net IRR to investors. On an illustrative 100 million fund charging 1.5 per cent and 20 per cent carry over an 8 per cent preferred return, a 12 per cent net IRR needs a gross IRR of 16.3 per cent, a spread of 430 basis points. Fees and expenses take 231 of them and carry the other 199.
Worked in full in Raising a Real Estate Fund by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A manager raising a real estate fund markets a target net return, because that is what investors receive. But the deals are underwritten gross, at the asset level. The bridge between the two decides whether the strategy in the deck is credible: if the pipeline underwrites at 14 per cent, a 12 per cent net target is not a target, it is a hope.
| Term | Value |
|---|---|
| Commitments | 100 |
| Investments in years 1, 2 and 3 | 30 / 35 / 25 |
| Hold per investment, then sold | 5 years |
| Management fee: on commitments years 1 to 4, then on cost held | 1.50% |
| Fund expenses a year (audit, administration, legal) | 0.25 |
| Preferred return, compounding / carried interest | 8% / 20% |
| Waterfall | Whole of fund, full catch-up |
Of the 100 committed, 90 is invested. The rest is drawn over the life to pay fees and expenses. The gross IRR is the return on the 90 at the asset level, before any fund cost; the net IRR is the return on every amount the investors actually pay in.
Contribution each year = investments + management fee + expenses. The fee is 1.50 a year for four years on commitments, then 1.5 per cent of the cost still held: 10.0 over the life. Expenses add 2.0. Total paid in: 102.0.
Each investment is sold for cost × (1 + gross IRR)5. At 16.3 per cent the three sales return 191.5, a gross multiple of 2.13 on the 90 invested.
Investors first receive their 102.0 back plus 8 per cent a year compounding. The GP then takes 100 per cent until it has 20 per cent of the profit, and the rest splits 80/20. Carry: 17.9, exactly 20.0 per cent of the 89.5 of profit after fees.
Net IRR = IRR of (distributions to investors − contributions), year by year. Change the gross IRR until the net IRR equals 12 per cent: Goal Seek on the gross rate, or a one-variable data table.
| Year | Paid in | Asset sales | Net to investors |
|---|---|---|---|
| 1 | 31.75 | 0.0 | −31.8 |
| 2 | 36.75 | 0.0 | −36.8 |
| 3 | 26.75 | 0.0 | −26.8 |
| 4 | 1.75 | 0.0 | −1.8 |
| 5 | 1.60 | 0.0 | −1.6 |
| 6 | 1.60 | 63.8 | 62.2 |
| 7 | 1.15 | 74.5 | 73.3 |
| 8 | 0.62 | 53.2 | 34.7 |
| Total | 102.0 | 191.5 | Net IRR 12.00% |
The investors pay in 102.0 and receive 173.6, a net multiple of 1.70 against the gross 2.13. The whole 17.9 of carry is paid in year 8, once the investors have their capital and pref back, which is why the last distribution to investors is so much smaller than the asset sale behind it.
Solve again with carry set to zero and the gross IRR needed falls to 14.31 per cent. So the fees and expenses cost 231 basis points, of which the management fee is 196 and expenses about 35, and the carry costs 199. A fee of 1.5 per cent a year costs more than 1.5 points of IRR in the early years because it is charged on commitments while much of the capital is not yet invested, and less later, when it runs on a shrinking cost base.
| Net target | Gross needed | Spread |
|---|---|---|
| 8% | 11.9% | 386 |
| 10% | 14.1% | 410 |
| 12% | 16.3% | 430 |
| 14% | 18.7% | 466 |
| 16% | 20.9% | 487 |
The spread widens as the target rises, because carry takes a fixed share of a bigger profit. A core-plus fund targeting 8 per cent net loses 386 basis points; an opportunistic fund targeting 16 per cent loses 487. The fee matters at the margin too: at 12 per cent net, a 1.25 per cent fee needs 16.0 per cent gross and a 1.75 per cent fee 16.6 per cent, a spread of 399 against 461 basis points.
The test an investor will run. Take the gross IRRs in the pipeline or the track record, put them through these terms, and see what net comes out. If the deals underwrite at 14.1 per cent gross, the honest net target under these terms is 10 per cent, not 12.
Build the net target from the gross, not the other way round. Under 1.5 and 20 with an 8 per cent pref, a 12 per cent net target needs 16.3 per cent gross on the capital invested, and the deck should show the bridge. The same arithmetic run on past deals is in how to calculate a pro forma net IRR for a track record, and the free workbook that runs the raise on a calendar is on the Raising a Real Estate Fund companion page.
It depends on the terms and the return level. Under a 1.5 per cent fee and 20 per cent carry over an 8 per cent pref, the illustrative fund loses 386 basis points at an 8 per cent net target and 487 at a 16 per cent target. Carry takes a fixed share of a larger profit, so the spread widens as returns rise.
More than its headline rate in the early years, because it is charged on commitments before the capital is invested. In the worked case a 1.5 per cent fee costs 196 basis points of gross return. Moving the fee from 1.25 to 1.75 per cent moves the gross IRR needed for a 12 per cent net from 16.0 to 16.6 per cent.
Not with a full catch-up, if the fund clears the hurdle. The 8 per cent pref decides when the GP is paid, not how much: in the worked case the GP's 17.9 of carry is exactly 20.0 per cent of the 89.5 of profit after fees. Only a fund that falls short of the pref, or a partial catch-up, changes the share.
This article is one calculation from Raising a Real Estate Fund. 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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