Hi all,
When looking at a potential commercial acquisition, I'm modeling a lot of negative free cash flow in years 2 and 3 of my hold as I'm assuming the single tenant 100% vacates. If I want to fund all negative cash flow associated with downtime/leasing/etc. upfront with equity day 1, would I show the periods with the negative cash flow as $0? Or still as negative values? I'm talking in terms of the IRR calculation. So as an example:
-There is $1M of negative free cash flow in year 2 due to downtime/lease-up costs
-I'm including $1M in my uses at closing as a part of equity to fund this missing cash flow
-Because I'm funding this shortfall at close, would the IRR calculation include those negative cash flows still or would I show those periods as $0 as they would be drawn out of the entity's account balance?
Yes CF should be zero.
If equity is in at close, you’ll start paying for it at close
Why on earth would you structure a deal this way?... It would be very atypical. The only reason I can see someone doing this is if they're a syndicator and are worried that their investors won't have cash to cough up when the time comes.
In this scenario, the likely outcome would be either (i) you'd have a future funding reserve from the lender that is available for shortfall and leasing costs when and if the tenant vacates or (ii) lender will be collecting reserves for such an event and if the tenant gives notice to vacate (typically 9-12 months before their lease expiration), the lender would then sweep all cash flows and that should be more than enough to cover TI/LC for the new tenant and probably enough or close to enough to cover any shortfall, or (iii) the tenant never leaves and if there is any money in escrow it should be released to you but if the lender gets their way they just never fund it and it never hits the balance of the loan.
But to answer your question... yes, the equity would go out day 1, and you'd have an equity reserve bucket within the model equal to the amount you believe will be needed. Then when the tenant vacates, you deplete that reserve by the amount you're short each month until the reserve is fully depleted. When in use, that reserve will go dollar for dollar to fund any shortfall and therefore your cash out, or cash flow, that month will be equal to 0. The IRR calc would inherently 'include' that negative cash flow so to speak because your beginning balance would include that equity reserve which is used to fund the shortfall. So... $10M to cover acq. costs let's say, + $1M to fund the equity reserve = $11M out day one, then any shortfall would equal 0 because the equity reserve is deployed to cover it.
It really depends on the capital and how it is structured.
We have 1 LP who account on a monthly basis (results wise, we refer to as drip-feed IRR), invoices are processed each month and then a capital call is made to the LP to pay them. So negative cashflow is treated on a 'as it comes'/monthly basis.
We have a 2nd LP who contribute all their cash on day 1 with inclusion of funding for any forecasted shortfall in expenses etc. So our cashflows are 1 lump sum cheque on the beginning date and then nothing further until the project becomes cash positive. Obviously this runs the risk of under drawing funds but generally we over ask at the start and then distribute any leftovers once the cash starts rolling in. This method definitely puts a lot more pressure on hitting those equity IRR returns hurdles especially if there are large swats of capex to be funded 2-3 years down the line...development rarely pencil out with these guys!
Say I don't fund any capital reserves at all at closing, only enough for the purchase price and closing costs. Let's use this scenario:
-By the end of year 1, I've built up free cash flow of $1M (assuming no distributions)
-For year 2, there are 9 months of negative cash flow associated with lease-up costs, totaling $800k
-Would I let those cash flows run as negative for my IRR calculation? Or would I make them $0 assuming any shortfall would be covered by our bank account reserves?
For context - My group would be syndicating the deal from friends and family and we want to be careful about capital calling down the line.
Yeah then just do it that way. Is there a mark to market? Can you tell us a little about the property? property type, MSA, etc... If you want a comprehensive answer I'd need that. If it's a small class A industrial building in SoCal for example, that market is hot so - I'd get a bridge loan, they'll take care of the structuring for you (trust me, they won't leave you short on reserves), then if and when tenant vacates, re-tenant and refi the bridge and get cash out or sell. Make sure you have flexible prepayment on the bridge loan and no exit fee. Take any fees you get as a result of acq. and mgmt and don't touch them... If in the unlikely scenario the loan reserves don't cover shortfall & TI/LC, and your LPs can't cover a capital call, put in that money and dilute them (I know it's friends and family, you can be nice about the dilution in the JV docs, you can even make it non-punitive and dollar for dollar).
By do it that way, I mean just don't make any distributions the first year, hold all positive CF in the operating account.
You can either call it upfront, or assume capital calls occur when the funds are needed down the road (I would do the latter - no investor is going to want to cough up for theoretical shortfalls in advance).
Either way, you should have an Operating Reserve line at the bottom of your cash flow that uses those funds to offset the negative amount and zero out your net line. Just make sure if you are assuming later capital calls that it's increasing your equity balance when the funds are called down the road.
But if you are going the capital call route, a month with negative cash flow would ultimately need to be a negative levered cash flow within the LIRR calculation, not netted to $0, right?
If it’s a capital call down the line or reserved down the line, either way it needs to be negative value in levered cash flow as that indicates an equity contribution. Whether that comes a month prior to the shortfall or at the shortfall month is your call.
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