Start by answering this question: What is the overall average annualized cash-on-cash return (AAR) for the project?
If you don’t know how to calculate this, please follow the steps below. If you don’t want to do this yourself, there are plenty of deal-analyzer tools available in the marketplace that will help you calculate and present this information, such as CommercialUnderwriter.com, RentalSoftware.com; or you can get them from REMentor, Jake and Gino, Joe Fairless, or Michael Blank.
Once you have done all of this, you will incorporate it into a Property Package/Investment Summary showing the projected income and expense statements and proposed exit strategy. From this, you can determine a proposed waterfall scenario that will work for you and your investors.
How to calculate AAR and Investor Splits:
(Hint: It is better to calculate AAR for the overall project before determining investor/management splits.)
The number you get for the overall annualized cash-on-cash return will tell you what the investor/management splits need to be in order to get the investors an AAR in the mid to high teens, which is your target in today’s market. You will generally only change the splits on sale (or refi) after you have refunded 100% of the capital contributions to investors plus a specified AAR (e.g., 18% or so). After that, you can change the splits to 50/50 or 30/70.
Here is how to determine AAR:
- Create a projected yearly income and expense statement for the number of years you plan to own the property with investors. Keep a list of your assumptions.
- Add a line item to your income and expense statement showing the overall Distributable Cash the property is projected to generate from cash flow. Divide this amount by the amount you raised from investors and convert it to a percentage. This is your annual return on investment (ROI) from cash flow.
- Calculate projected Distributable Cash from sale (equity). (Hint: This is the amount left after paying the loan, costs of sale, and a return of capital to investors.) Keep a list of your assumptions.
- Add all of the Distributable Cash from #2 and #3 together. This is your projected Distributable Cash for the entire project.
- Divide the overall Distributable Cash from #4 by the number of years you expect to own the property with investors. This is your annualized overall return for the property in dollars.
- Next, divide the amount you calculated in #5 by the amount of capital contributions you raised from investors, and convert it to a percentage. This is the overall annualized return on investment (ROI) (aka cash on cash return, or AAR) for the project.
- Now that you know the overall AAR for the project, you can determine what the investor/management splits need to be in order to get the investors an AAR in the mid to high teens, which is your target in today’s market.
- If you want to place a cap on investor returns, you can change the splits on sale (or refi), but you generally won’t do this until you have refunded 100% of the investors’ capital contributions plus given them a specified AAR (e.g., 18% or so). After that, you can change the splits to something like 50/50 or 30/70.
- Now, create a spreadsheet showing the AAR that you can share with your investors. Include a list of your assumptions.
- Next, determine your waterfalls from: a) cash flow, and b) from a capital transaction such as a sale or refinance.
- Put all of this information into your Property Package/Investment Summary.
- Show everything you have created above to your corporate securities attorney before you start showing it to investors.