by The Affordable Oracle
In the last couple of weeks at least two properties have come to market that had just been purchased less than a year ago: 205 Montague Avenue in Brooklyn is a office building just came to market with an asking price of $49m, the seller purchased the building for $33m just six months ago. 20 West 40th Street is a development site in Manhattan diagonal from Bryant Park that is on the market for $85m, the seller purchased the site 7 months ago for $46m.
Buying and selling a property to realize quick profit is known as a “flip” and one of the reasons for the existence of a flip is the incentive structure built into a traditional real estate investment partnership.
In the most common structure the owner entity is a LLC with a general partner (Managing Member) and investor (Member). The profit splitting arrangement typically calls for a preferred return (hurdle rate) to the investor and a split of the returns (between the investor and general partner) above the hurdle rate. The return that is split is known as carried interest.
This arrangement motivates the managing member to sell quickly and lock in his carried interest in circumstances where there is a spike in the investments value in the early stages of the investment. This allows the managing member to take a higher percentage of the total investment returns than if he were to sell it later.
Lets go through a simple illustration.
Lets say we formed an investment partnership to buy the Bryant Park site for $30m and as the Managing Member we contributed 10% of the equity with the remaining 90% coming from our investors (Members). The investment was structured with a 10% hurdle rate followed by a 20%/80% split.
Lets say the returns (appreciation as this is land only) were as follows:
Year 1 – 40% market rebounds
Year 2 – 12%
Year 3 – 12%
Year 4 – 10%
Year 5 – 5%
The worksheet below illustrates the return waterfall and eventually highlights the variation in the percentage of total returns between the investor and the managing member depending on which year the property is sold. Note this percentage does not account for the time value of money and simply calculates the percentage of the total return to the investor versus the managing member. Adjusting for time value of money would only exacerbate the point. As you can see the managing member’s share of the return pie decreases the later he sells the investment. This causes the investor and the managing member’s interest to be unaligned as the managing member is attempting to capture more of the investment return pie. But generally speaking a spike in investment value is a happy time for the investor so it is unlikely that he will want to raise a conflict with his general partner who picked the investment in the first place.
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