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hey everyone spencer burton here allow me to introduce ron rohde he is our acre legal contributor and he'll be sharing a walk through of one of his real estate legal documents hey guys ron rohde here again with you today we're really excited to create a waterfall template partnership agreement now this is something that a lot of the viewers have asked me for they have a model they have a partnership between two parties usually a general partner and a limited partner how do these two people come to agreement on the terms of their investment well this is the document that you need to outline the rights and responsibilities of both parties as well as outlining the return of capital when certain thresholds are met there's a wide range of legal options as well as modeling options that you can put into a sophisticated project correspondingly you should understand how the legal document works so today i have with me matthew green who is a seasoned real estate analyst and acquisitions expert he's been buying multifamily for over eight years and we're just really happy to have him today so matt happy to be here good afternoon ron and good afternoon to the adventures and commercial real estate community very excited to discuss this uh this afternoon at the end of the day you can have the best potential acquisition on deck you can model it to the best of your of anyone's ability and uh have a great deal in front of you but if you don't have um the correct you know legal nuts and bolts uh in in place you could really be placing yourself at risk or you know a slight deadline or anything uh in breach of the contract i can really put the deal off to the wayside unfortunately and so that's what we're here to discuss today absolutely absolutely legal it's an important component it's not the end-all be-all but it is important and you should allocate a fair amount of time to understanding what your options are within the legal document as well as incorporating terms in the model we have a lot of assumptions on here but for the most part tell us about a typical structure matt you know the general partner how much authority and leeway do they have when they're negotiating with a limited partner well the first rule of putting these together is always remember never ever forget that anything is negotiable the first rule of negotiation is always ask so if it's a deal with someone who you've done business with before kind of have an idea of what works for both of you but oftentimes when two capital partners you know a capital partner is coming together with general partner for the first time often it can be very interesting when you're negotiating your first partnership agreement it's definitely worth it you know to see kind of where the the other party lies and then eventually come to an agreement and these you know it's not uncommon for it to take weeks and weeks uh to get this hammered down you know it might seem like any and all scenarios are laid out but this is why the law is always an evolving subject because unprecedented things happen whether it's in the economy or with a you know the physical aspects of an ass uh forced majority and things like that you know it's always evolving nature of these partnership agreements it will never cover the full scope of what could happen but you know first and foremost you're looking to protect yourself and your interests while also aligning the interests at the end of the day with your partners because this is why you're doing business together because you're both in it for the same economic ends absolutely so that is a lot of uh great legal insight sounds like you've looked at a lot of these contracts before oh man well for well first of all not so much at the analyst level but when you start getting up to the associate level you're more you know making deals happen rather than doing a lot of the analysis you're checking a lot of things and that's when i really got i think the bulk of my experience we'll jump right in the the first assumptions that we make there are a lot of terms that are thrown around like general partner and general partner manager sponsor i don't think that they're all interchangeable but it all depends on consistency in terms of how you refer to an agreement for the purposes of this video and and truly you know most of my articles not the legal documents but the articles we use those uh pretty interchangeably you have a sponsor you have a developer you have a general partner somebody who is responsible for the day-to-day decisions organizing the property the financing the debt the project plan the business plan calculating the model the returns and it will correspond you know matt refers to a capital partner that can be your limited partner essentially that's somebody who is going to contribute money and have a passive role and that role is just passive defined as less than active so that's i'm not going to dig into that too much but just so you guys have a general idea for people coming up with this or if your your documents use different terms it doesn't necessarily mean that you're referring to a different situation you just may use different definitions just wanted to clear that up let's go right into it one of the things that i want to talk about is matt how have you guys defined irr it's something that is is like a can of worms and legally i've dealt with it a lot how have you guys dealt with the different ways to define an internal rate of return irr is not always used you know it is one of several metrics that you can use to form the basis of economic distributions from the cash flows that come out of a real estate deal or any other deal for that matter debate the basic thing remember so it's usually it's either cash on cash or irr 95 plus percent of the time that that is what it's going to be sometimes that they might do like some other metrics like you know an overall return or in an equity multiple but really i mean all of those tied together in the end you know irr you know if you've taken some basic finance classes you may know about the present value of money you take overall economic contribution is so that includes everything that the partnership puts toward equity toward the purchase price and on top of that any capex so capital expenditures like renovations or any maintenance upfront or deferred maintenance that you're you're doing as part of the overall economic plan for the project so that is considered your upfront investment and then in let's say hypothetically it's on maybe a five-year timeline so you know year one you have the purchase price and then you have additional capex you have in so that is your initial big investment middle three years you know you will have cash flow cash flow cash flow for each of those years and then say we have a sale in year five you have the cash flow and then on top of that any economic capital gains you have from the gain in price property yeah and so you take that and divide it by the number of time periods and then factor in of course you know the time value of money and then that is how you get your internal rate of return the irr we can use we can incorporate the legal definition of irr to reference microsoft excel and specifically how they calculate it you know whether it's on a 360 period or 365 however you want to be precise in defining your model the legal documents should take that into account i think this is an important point of definitions of ir it's not enough to use a generic definition if it changes the cash distributions in your model relying on another form of calculating the you know the economic return like matt just so eloquently described you need to make sure your legal documents match that otherwise an angry investor can recalculate using what they interpret as their definition and come up with a different number against the sponsor so as simple as that may seem this happens all the time i cannot put that out there enough it you know so make yeah you absolutely need to agree on the definition because i i mean i hear about it all all the time the more precise the more ambiguities that you can eliminate that is what's going to eliminate this stressful back and forth uh time tell us about the internal contribution what does the procedure look like when you guys have a lp quote subscribe what happens if they sign the agreement and they don't wire the full amount of their funds what would you guys do in a situation like that google document can have a couple different options you can you can sue the investor to make them pony which which you know you kind of smile but it's like some people do yeah you promised me a hundred million dollars you're saying you only want to do 50 it's really up right now because of my other commitments and i can't get enough money and i'm going to lose 10 million dollars i put down as earnest money because i can't close i'm going to sue you to put in the rest of the 50 because you've signed and agreed to commit a hundred and an investor subscribes they they agree to commit they sign the agreement what happens if they don't uh put all their money in situation or outcome that the gp wants they should be sure to change their document their partnership agreements that reflects it because you want to have as many protections for yourself as possible and obviously your lp is going to want as many protections for them so for themselves as possible as well i mean the at the end of the day the essence of a partnership agreement is to make sure that um the parties are held accountable to their commitments and that incentives are aligned and i would also say there's there's a third people should know what they're going into even if i agree to give the general partner a lot of discretion i need to know where that line is um and i need to know how money is going to be returned i even need an agreement i'll just give you a check and be like please give me my money back so let's keep going for the legal documents i think it's important to understand you know i will look at what type of project so if the project is identified matt tell us about a new construction the phases of a new construction development and how does that affect it versus say buying a core disabled property sure um so it really depends on the timeline of the investors um because you know for well for construction i mean you can have oftentimes it depending on the size of the development firm sometimes the partners with the development firm will be able to um you know put up the money and then be able to uh you know you know on on that basis be able to get a construction loan and take it all the way through but often yes you are going to need outside investors you know to invest and get the construction they could um the sponsor or the gp could take down the land first for example pay for all the architect fees pay for entitlement pay for zoning yes you know they they are sinking a lot of money of their own money first prior to any transfer from uh from an investor yeah and yeah the lps really don't get involved until it's time to get a big uh construction loan and really get uh vertical go vertical intensive on yes um or like literally until you get right before you get the construction permits because and then and that's a fairly short time horizon because maybe you have a two year construction period and then maybe uh a 12 to 18 month lease up period and once you get it stabilized that's when they look to exit right as i say you know those phases are really important because um one of the decisions that that i hear a lot is what are the rules on distributions because during a leesa period you know you just gave a nice window 12 to 18 months what happens if the lease up takes a little bit longer than that do they distribute the cash what are the gps options that you've seen let's say that if lease up takes longer than expected what what what options do you see for the gp well this is no different uh than your typical waterfall model you know if you have a core property or a value-add property basically an existing asset rather than a development i mean you just have these of these hurdles um and then you know certain financial hurdles will not be able to be met right if you're not leasing up at the pace that you proform it um and this is why you know remember in terms of the risk spectrum the highest risk and highest return is in development and really it comes in the case of multi-family uh you know the the crucial those 12 to 18 months are absolutely crucial because every month that you're not getting to your pro forma you know those are more uh units which are going to be finished but they're not um filled economically you know with um with paying tenants and so that you know the difference between an 18 month lease up and it taking 24 months it's only six months but i mean that can materially reduce the returns and if you are a gp uh that could seriously limit your ability your ability to break into the promote wow okay so so breaking through the promote because the preferred is still carrying if they're not meeting even the preferred for example um for distributions and then that just puts them behind the eight ball when they even they do lease up that sort of thing right right gotcha so again very critical to understand what your timing is going to be because it costs a ton of money to to pay service the debt to service your lp um that sort of thing so another big area i get a lot of focus on this from my clients both on the gp side as well as the lp vetting a contract is fees you know matt tell us tell us a laundry list of the fees that the gp is allowed to charge and and who are they paying for these again always try first rule negotiation ask see what what they can do um this is real estate fees are everywhere especially in a low return environment high price low return environment like today gps are going to make their their money somehow because you know they obviously you know that they have to well people are are working remotely these days but in normal times they'll have to pay for office space they have to pay for their staff um you know and to run their business and so on and so forth it's not it's very common these days to see many fees in areas that we used to not see them um but that said though most respon investors will seasoned investors will push back as a gp you should expect it um so tell me a list can you just you know acquisition fees permitting reimbursement fees uh what kind of fees are we talking yeah so in general again you can attach a fee to anything but the most common one is acquisition fee it's usually one percent or so of the purchase price that is more or less the standard again it is negotiable um and uh another one of course is the disposition fee yeah as as well you can also have an asset management fee and this is one which it is a very it can it can mean basically just we want an extra fee for your so we're just going to call it an asset management fee um some people don't do some gps not charge an asset management fee most don't uh but okay in in the recent market especially in the um in the apartment acquisition space of existing assets a lot of these syndicators who are working more with mom and pop investors and not with sophisticated investors i i see these offering member memorandums and i say what is this asset management fee and it's just an extra 25 or 50 basis points for them and you say it's it's not justified or i'm i'm hearing that it's not justified because with with one property under the belt they've got a single debt source they've got you know a handful of lps there's really not much asset management to to be done you know they've got one property manager they've got one software system right that handles everything for them so so what that you know if it's a complicated cap stack it might justify um you know with government credits low income and and you know tax credits and different government issues that i could maybe see justifying more of a asset management yeah and and let me quickly um just point out that i am not referring to a property management fee because you know if you're working with a vertically integrated sponsor who also has a management division they essentially are paying themselves to manage the property they're not making much on that but it essentially should be viewed as more or less a zero profit area of the country or of the of the company of the company so like most of those um sponsors are those are not the ones who are going to be charging an asset management fee that does not mean a management fee that's totally different yeah and also to clarify too when you talk about acquisition fee this is in in addition to commissions and closing costs you know it's it's another layer on top of already high commissions to brokers to you know your lawyers you might have a debt origination fee i mean you might have points for your loan so this is the acquisition is purely on top another very common one too is your due due diligence fee and that that can vary a lot i've seen it where it's a reimbursement of actuals um an estimated reimbursement or you know just a flat fee and they don't tell you how much they've spent because there are a lot of chase costs for travel and you know salary analysts and time those are real but people pick and say well we have an acquisition we have a a due diligence fee of you know 200 grand like right well it's just 200. we spent way over 200 you know chasing down the last six properties um and that's the reality right they do have to spend time looking at non-viable candidates and that costs money how many do they look at how much do they spend on each property well they got to make it up on the deals they do close but you have no idea as an investor how to vet that or you could you know how do you push back so exactly yeah i mean the the best real estate businesses at least in the acquisition side are the ones that have a cost structure that's well below what they're taking in and acquisition fees but um you know especially when uh people are getting started out are getting their businesses off the ground and um you know you don't know when the next acquisition fee is going to get or is going to come because you may have not really gotten off the ground yet yeah it can be tough it can be really tough and of course you know you don't have the track record so you know you're really having to deal with the fact that you really don't have as much leverage in your terms absolutely and i think we you you hit on that earlier but everything is negotiable but it comes down to who has the leverage in the situation if you're the gp with a stellar track record and you've done a couple projects and you're doing another one that's right in your wheelhouse you're probably going to be able to dictate terms if they're within market and you don't have to negotiate much if you're a newer developer and you need this capital you're going to probably concede and you're not going to have leverage with the capital providers so it's it's all an incredibly um soft skill you know it's it's like a social political question it has nothing to do with what the model says and what the return is and the risk adjusted returns should be for this property it's just a negotiation that again can make or break your investment if if you don't pay attention to it and just let it slide um i think you brought up a great point too because i've seen legal language about self-dealing and a lot of gps will explain it to the investors oh well we have a in-house property management so what it means is we're allowed to hire and no bid the property management because it's internal but they do a great job everybody uses them blah blah blah and investors a lot of times they might just nod their head and say okay that makes sense i will agree to it and then the same gp will turn around and hire his affiliated concrete company for an inflated 2x bid and he escapes through that same clause you know you kind of like created a path a hole it's a little mouse hole to get through and the investor has agreed to it by thinking oh he means the property management cost fee and then later it's no no no i actually did it for my law firm my concrete you know whatever the self-dealing is no bid requirement sneaks through so again i i i feel like the best investors are the people that read it you've got to be cynical but at the end of the day you still have to trust your gp because they're always going to find ways to cheat you out of money but the legal document will give you hints maybe you know to give you an idea of how egregious they're trying to be what do you think matt is that is that yours oh no yeah absolutely and it it it almost see you would wonder like why would that happen because it almost seems counterintuitive because like you shouldn't expect an nlp investor um or a capital partner as i've put it you know to even invest the bulk of the money into a deal if the gp is not does not have a significant financial in interest in it i mean ronnie hit the nail on the head i mean we still see that it seems like something like out of the last like century almost um but any you know like yeah with like self self dealing and uh you know contracts and stuff like that almost like like like you're dealing with the mob or something like that but no the fact of the matter is yeah hopefully not offend anyone like yeah union contracts no but e yeah like like no bid contracts but i mean even if it hurts the gp or maybe like reduces his potential on the gp side economically yeah there are situations where they can make a lot more money on on the management side that way so that's why yeah you do have to be careful um and you need to be ready uh to to negotiate for sure yep yep absolutely and again i i think our audience is going to be a mix of investors who are capital partners and then a mix of of developers or gps starting off as well and they're figuring out how do i draft my first set of partnership documents so this is my advice is you know put something fair it can it can still lean towards you it can still favor you as a gp but you're going to lose credibility with the sophisticated investors when they say who are these guys they're putting fees on top of fees on top of fees i don't even trust i don't want to deal with them and i don't trust them if you want to be a trustworthy partner you need to be in the market you need to be in the range otherwise it looks like you're just trying to to make a quick buck and and move on because i guarantee you the investors won't be happy when they get their distribution checks at the end [Music] if it's if it's you know costs are inflated from the budget so the topic i want to talk about you know is how do you look at control uh within the group obviously broad discretion is is appropriated to the general partner but what decisions can the limited partner actually influence the limited partner um again because remember i mean most of the time in terms of the equity position the limited partner can be putting in 90 or more of the money so you know the the deal doesn't happen without them i mean just the the number one example is whether or not they have the power to determine when to sell the property because especially if the gp if everyone has done great on the deal a lot and you know the gp tend to be the deal guys always looking out you know for where the next great you know set of multi-year returns may come from uh they may be they may be setting their sites elsewhere or or if it's an asset if it's a great piece of land alternatively that they want to keep their money in for decades and all of a sudden you have an lp that says well no we we want them we want to pull our money out well if they want to pull their money out they can have a clause in there to force a sale and so this all needs to be this unfortunately you know even though no one has a crystal ball about the future this all needs to be decided up front and obviously it can be amended at at any point but it's usually decided up front or the investment doesn't go forward yeah no i think i think those are the two most critical decisions is disposition and placing debt on the property deciding to put debt additional debt or refinance debt on there those are the two most fundamental powerful decision making and and yeah you know there are some scenarios or partners that would have that right and i guarantee you a general partner doesn't want to give it to a limited partner but if they can if they can negotiate for it they'll get it do we want to talk a little bit about the waterfall you know we've got just a few more minutes here um let's talk about like an actual distribution um such as section 7 article 7 of the template um matt do you want to walk us through just just briefly you know we've got five different four different hurdles here do you wanna certainly yeah so again the way the number one thing to keep in mind when uh either constructing or modeling out and negotiating a waterfall is the alignment of interests here and so you know if the general partner thinks that this is a very very high potential return deal and they've worked really really hard on it obviously they want to get an outsized return and be compensated for all that that they that they put in on an active basis as opposed to a passive one yeah again again pet the lp the passive investors those are the ones that tend to be bigger you know with more capital um you know they're they're looking to get more of a of an insured return and so this is why in a waterfall structure um interests are aligned in the initial stages of it just to make sure that the lp is getting their preferred return so sorry initial stages you're talking about like operations um distributions from cash flow yeah okay because so if i'm looking at the limited partnership you know chapter seven section 7 uh a 7.1.1 a to all partners you know pro rada each distribution reaches the irr approved by by the partner that's what you're talking about in the initial period is distributions from cash flow yes but no but basically look the lp is going to want something consistent in a lower return but it but a more safe return every year and so this is why in the initial stages of the project this is kind of what i was getting at a minute ago in the initial stages um that's not usually when you get right into your promote it's usually toward you know the the end of the project you know as what if you're if you're renovating units if you're if it's if it's an office building like if you're re-tenanting it or retail if you're bringing in new tenants and so on and so forth and materially um increasing the value well only once you achieve that value are you really getting into the promote and getting the outside's return now how do you get those ad size returns this is this is the the the part that everyone loves to learn about so if the returns are up to seven percent the general partner and an lp in this case will share them equally yeah and then once you and so that seven percent that is the first quote unquote hurdle and then in between seven and i think ten percent then it will switch where anything and now first of all both parties are still getting are still splitting up to seven percent so this only kicks in when returns are in excess of seven percent so if returns are between any returns between seven and ten percent then uh ten percent of that goes to the general partner ninety percent of it goes to the limited partner and then over ten percent you might go 85 15 and then finally you know if it's a really a home run of a deal you say oh anything beyond you know 15 or 18 percent let's say it goes 50 50. and this one i think can be lucrative for the general partner it if if and only if they meet their financial projections basically right so in this template document that we have three hurdles we get to the peak of a 60 40 split that that is correct it's really useful to visualize this for me as a as a non-numbers person you know i was a philosophy major in undergrad the flow of profits it gets progressively larger towards the general partner as you hit as you cross all these hurdles the question is how evenly do you start that split do you start it earlier and do you make it go very wide or do you let it stay tighter you know within the normal bounds for a longer period of time and then you say returns above 30 i get 99 something like that i i haven't seen something that extreme but there are different contours to how do you shape these returns where beyond just the normal pyramid or you know i don't know what shape it is but it's kind of like mostly lp and then it progressively percentage increases towards gp well that's fine but you can have a narrow slope or a decreasing rate of return based on how you predict the the likely the likely return range to be you know we think it's going to be 15 to 19 or we think it could be 15 to 30. if that's the case model it out so if you get above 22 percent you get a lot of the reward because i think above that threshold a lot of partners are willing to give it to you correct and the old my only caveat on that statement would be that especially if you're starting out and um you know you really want to make a name for yourself obviously you know you're gonna you won't be able to have those kinds of terms initially but but um if you want to continue a relationship with a very very good and reliable equity partner um i and then this is just what i've heard within the industry i think they say it always makes sense to cap it at some point like you know at 50 50 or 60 40 or something like that so they're still you know get they feel like they're sharing in a lot of the games and that's especially true if you think you have a very very good business model that you want to replicate on other deals with that same equity partner and so 6040 is still in favor of the lp absolutely yeah see so i think that's that's really great insight um in terms of what the market bounds are and again the reason why we do this thing is because it's a partnership it's it's not a here let me borrow money from you and then i'm gonna make a bunch of money it's let's have a partnership we're risking capital together let's let's share the rewards together um versus i would say maybe the mentality of hey i'm putting 10 percent of the equity into this deal but between after we close i get eight percent of my equity back via fees so i've got really in reality two percent equity in the deal that does not create the same incentives um again coming full circle if you get all of your equity back off the table through fees it's not it's not an alignment of incentives you have de-leveraged yourself tremendously and again doesn't have to be the same but you're not aligned you know if i'm only two percent into a deal i'm gonna do some pretty risky things um because it's it's rolling the dice so yeah absolutely all right well again i you know again i want to thank matt it's really been insightful i learned a lot um i love talking to to my counterparts in the industry again what i work on is taking the client's interests and the clients goals and then transforming those into the legal documents and making sure that it reflects what they intend because a lot of legal documents do not match what you think it means but hopefully this was helpful check out the template um subscribe and we will have more content for you coming up next is actually a really exciting anchor tenant uh leasing so you'll wanna you'll wanna tune in for that one right thanks matt thank you very much for having me ron