Promotes are hard for me to begin with, but our CEO has asked a question which I can't figure out to save my life and I would really appreciate the insight of some of smarter monkeys than I. When I do a promote calculation on a development, the value of the promote (the extra 20% or so the partner gets when the project reaches the IRR hurdle) goes up each additional year the property is held. Makes sense - the more the property is worth at buyout, the more money the partner gets. That is true UNLESS the construction loan is refinanced in year one. Then the value of the promote goes down each additional year. WTF? Our CEO wants me to explain the logic behind why the promote goes down when we refinance, but I can't because I don't understand it myself. It seems to me that when there is more money available for distribution the partner would get more each year. Why does the promote go down? I'm begging for someone smart to explain this phenomena to me.
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My guess is that you're not sizing your perm loan correctly (LTC again not LTV) and that it is a modeling issue - quick fix though. The perm loan should be enough to take out the construction and cash out equity. If you do this the IRR (and promote) will go up. If you have the same proceeds your IRR will actually go down since you have to pay origination fees etc. Best explained in an example see below.
Let's say you're building a project for $100 and you're stabilized NOI is $7 (7% YOC). Maybe you were able to get $60 in loan proceeds originally (60% LTC). Now that the property is stablized you think it is valued at a 5.50% cap rate. So now the property is worth $127. You go out get a perm loan at 60% LTV which would be $76 dollars. You're able to pay off the construction and have an additional $16 cash flow to equity which increases the IRR. If you sized the perm loan to "LTC" not "LTV" you would have just refinanced with the same proceeds - $60.
Summary - look at the cash flow to equity in your model under both scenarios it's probably an issue with loan sizing.
You rock. Thanks so much, this is a big help!!
No prob
Promotes can be pegged to IRRs or EMs. The reason your promote decreases is because the longer you hold, the longer your IRR is stretched out, thus decreasing it.
similar to what other people said here, I think you have a modeling issue, but answers to the following questions would help nail down your issue:
if your promote is a static 20% then the only reason why it would be 'going up' is because cash available for distribution is increasing - so I am assuming that the new financing has more aggressive amortization or debt service than the original financing so your cash available for distribution is decreasing...
feel free to pm me the model and I would be happy to help...
let us know what you find out..
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