Equity Financings and Structures

Equity Financings and Structures November 2011

Table of Contents C:\Documents and Settings\friedara\Local Settings\Temporary Internet Files\OLK9E4\Equity Overview 11 14 11.ppt\A2XP\15 NOV 2011\9:27 AM\2 Section 1 Section 2 Section 3 What Is Equity Fund Level Equity vs. Project Level Equity Joint Venture Equity Structures 2

Section 1 What Is Equity 3

WHAT IS EQUITY What Is Equity? There are a wide variety of ways in invest indirectly in real estate Debt Next Seminar.. Real estate ownership is generally comprised of both Debt and Equity Equity maintains the direct ownership interests in the asset REITs/Public Companies Public Securities Ownership Provides liquidity, but investment is subject to public market investment correlation Real Estate Ownership Equity Direct Investment Direct Property Ownership Provides control and benefits of real estate diversification but precludes market and property type diversification Commingled Funds Limited Partnership interest in diversified portfolio Provides geographic and property type diversification but investor cedes control to General Partner 4

WHAT IS EQUITY Risk Reward Spectrum of Financing Alternatives Debt represents: Securities An obligation of the property owner to repay; obligation can be collateralized and secured by the asset or unsecured Equity represents: An ownership interest in the company / asset The fundamental difference between debt and equity is that debt holds a superior claim and is repaid first Secured Debt Unsecured Debt Convertible Debt Preferred Stock Convertible Preferred Common Equity Debt acts like a put option Equity is inherently riskier and is like a call option Increasing Degree of Security Increasing Level of Expected Return 5

Section 2 Fund Level Equity vs. Project Level Equity 6

FUND LEVEL EQUITY VS. PROJECT LEVEL EQUITY Direct Investment Generally GP Capital Advantage: Single Promote Disadvantage: Local Expertise Institutional Investors Managing Member 90-95% of Fund Equity 5-10% of Fund Equity Discretionary Real Estate Fund Project Equity 25-45% of Capitalization Real Estate 55-75% of Capitalization Debt 7

FUND LEVEL EQUITY VS. PROJECT LEVEL EQUITY Indirect Investment Generally LP Capital Advantages: Local Expertise Disadvantages: Double Promote Limited Partner General Partner 90-95% of Fund Equity 5-10% of Fund Equity Discretionary Real Estate Fund Raise a Fund 80-90% of Project Equity Sponsor/Operator 10-20% of Project Equity Real Estate 55-75% of Capitalization Project Finance Debt 8

FUND LEVEL EQUITY VS. PROJECT LEVEL EQUITY Real Estate Equity Alternatives Raise a Fund Fund Equity Project Finance Project Equity Advantages Raise a Fund Ability to Close Quickly Buying Power Through Downturns Project Finance Not Cross Collateralized Higher returns for strong deals Disadvantages Long Timeframe to Raise Money Best Deals when Money is Tight Deal Pressure Tougher to move quickly Typical Providers Penision Funds Comingled Funds Endowments Institutions Wealthy Individuals Wealthy Individuals Terminology Managing Member or General Partner Sponsor or General Partner Investor or Limited Partner Third Party Equity or Limited Partner Structure General Partner Contribution: 5-10% Management Fee: 1-1.5% Preferred Return: 9-11% Promoted Interest: Depends on Strategy Acquisition Period: 3 Years Disposition Period: 4 Years General Partner Contribution: 10-20% Development Fee: 3% of hard costs Asset Management Fee: Negotiated Preferred Return: 9-11% Promoted Interest: Depends on Strategy Investment Term: Varied Clawback: Cross-Collateralized 9

FUND LEVEL EQUITY VS. PROJECT LEVEL EQUITY Real Estate Fund Investment Parameters Opportunity Development and the highest risk Strategy: Ground Up Development, Buying Notes, etc. LP seeking 17-19% return Value Added Redevelopment/Repositioning moderate risk Strategy: Reposition, Renovate, etc. LP seeking 12-15% return Core Long term hold of stabilized asset low risk Strategy: Stabilized asset LP seeking 6-10% return 10

Section 3 Joint Venture Equity Structures 11

JOINT VENTURE EQUITY STRUCTURES The Role of Capital Partners and Operating Partners Alignment of Interest Capital / Limited Partners Share the same investment philosophy as the sponsor Institutional Investors or High Net worth individuals Typically provide 80%+ of equity Typically do not sign recourse guarantees Approve all major decisions (Design changes and all capital transactions) Operating / General Partners National, Regional or Local Operators Manage day-to-day operations of the project Provide recourse guarantees to the lender Provide all reporting to capital partner If a project sells for an IRR greater than the preferred return, the sponsor gets a promoted interest. 12

JOINT VENTURE EQUITY STRUCTURES Joint Venture Economics Structure of hurdles and promotes can be dependent on the following: Asset type / inherent risk Leverage Operating experience of partner Market competitive dynamics Operating partners are paid through promoted interests (i.e, dilution of Capital Partner position) and management fees Sample JV terms: 95% / 5% deal to a 12% return for Capital Partner 75% / 25% deal to a 18% return for Capital Partner (Operator receives a 20% promoted interest on top of their 5% initial contribution) Hurdles are based on IRR of one cash flow stream (generally that of the Capital Partner) Short term investments may have an equity multiple hurdle as well 13

JOINT VENTURE EQUITY STRUCTURES Capital Contributions / Distributions & Fees Distributions Distributions come from Net Cash Flow and/or Capital Proceeds Net Cash Flow is cash flow from operations (less debt service & expenses) Capital Proceeds are from sales or refinancings Capital contributions Mandatory / Required Capital Fees Capital for initial investment, necessary to make expenditures going forward, shortfalls on debt service / operations Acquisition fees, asset management fees, guaranty fees 14

JOINT VENTURE EQUITY STRUCTURES Joint Venture Structures Management & Control is governed by an operating agreement on how to make major decisions Typical Major Decisions: Sales, financings & refinancings, leases, budgets / approvals of expenditures, additional capital contributions, litigation / bankruptcy, any matters outside ordinary course of business Generally for 90+% partners, most major decisions are unilateral (vs. unanimous) Other key management issues: Key Man provisions Duties of the operating member (general partner) Non-compete Breach of other key management issues can result in removal / forfeiture events (loss of promote, punitive dilution, etc) 15

JOINT VENTURE EQUITY STRUCTURES Joint Venture Sample Term Sheet 16

November 15, 2010 Mr. Apartment Developer ABC Development Group Any Street Any City, Any State 12345 RE: TERM SHEET CLASS A APARTMENT COMMUNITY Dear Apartment Developer: The purpose of this letter is to evidence our mutual intent to form a limited partnership (the Partnership ) between a ABC DEVELOPMENT GROUP entity ( ABC ) and an affiliate of PRIVATE EQUITY GROUP ( PE ) for the purpose of acquiring a 100 unit apartment community located in ANY CITY, USA. The parties hereto agree to negotiate in good faith and proceed with due diligence to convert this agreement (the Term Sheet ) into an acceptable partnership agreement. Below we have outlined how our company would like to structure the investment. Philosophy ABC and PE will form a partnership, which will have as its purpose the acquisition, renovation, and sale of an 100- unit apartment community. PE will structure its position in the partnership as a Limited Partner. The partners agree that the goal of the Partnership is to maximize investment returns and sell the project as quickly as possible for the highest achievable price. Capitalization - We assume a total project cost of approximately $20,000,000, and a loan for $15,000,000, leaving an equity requirement of $5,000,000. PE will contribute 90% or $4,500,000 of cash equity to the joint venture. ABC will contribute the remaining 10% of cash equity required or $500,000. Preferred Returns - The PE and ABC cash equity contributions will be treated equally, and both will earn a preferred interest rate of 10% beginning with PE s first equity contribution. The preferred returns will accrue and be payable from project cash flow. All preferred interest will compound annually. Payments to ABC - ABC will be paid an acquisition fee of 1% of the Total Budget (exclusive of the fee itself). The acquisition fee shall be paid upon acquisition of the project. 17

PE Equity Fee Simultaneously with the acquisition of the project, PRIVATE EQUITY GROUP shall be paid, an equity fee of 1% of total project cost exclusive of the fee itself. This amount shall not be treated as a return on or return of the PE capital, or as any other capital contribution to the Partnership. Distribution Priority - Any ordinary cash flow remaining after payment of debt service on the Loan and establishment of a $300 per unit per year replacement reserve fund ( Net Cash Flow ) and any extraordinary cash flow proceeds from the sale, refinance or other liquidation of the property after full payment of the first mortgage loan ( Extraordinary Proceeds ) will be distributed as follows: First, repayment of loans or excess capital contributions made by partners, plus a return. Second, to the Partners, pari passu, in payment of each Partner s accrued, but unpaid, 10% preferred return on initial cash investments. Third, to the Partners, pari passu, to return their initial cash investment. Fourth, to each Partner, as set forth in the Ownership Section below. Ownership - After distributions are made in accordance with the distribution priority section above, all Net Cash Flow and all Extraordinary Proceeds will be distributed 75% to PE and 25% to ABC until PE has achieved an 18% IRR. Distributions above an 18% IRR and up to a 22% IRR shall be distributed 60% to PE and 40% to ABC. Returns above a 22% IRR shall be split 50% to PE and 50% to ABC. IRR Calculation The IRR is calculated using the = IRR function in a Microsoft Excel spreadsheet applied to a schedule of the actual monthly cash contributions and distributions for PE. All contributions and distributions are assumed to be made on the first of the month nearest the actual date made. The resulting monthly percentage calculated by the = IRR function is then multiplied by twelve to arrive at an annual percentage. Major Decisions - PE will leave day-to-day management of the partnership to ABC. PE will retain the right to approve all major decisions, including those decisions that affect the design and specifications of the project, as well as those that involve any capital transactions, including a sale or refinance. Defaulting and disabling Events - The partnership agreement will include definitions of defaulting and disabling events, such as failure to honor the guaranty of non-recourse carve-outs under the mortgage loan, misappropriation of Partnership funds, withholding distributable cash flow, bankruptcy of a partner or guarantor, the transfer of a partner's interest or withdrawal of a partner from the Partnership in violation of the partnership agreement. 18

Upon the occurrence of a defaulting event by ABC, all fees payable to ABC will cease, PE may elect to terminate any ABC affiliate contract, and PE will have the following rights listed below: Key Personnel Default If there is a change in control of the General Partner or if the persons in control of the General Partner cease having direct or indirect control of the General Partner or withdraw as members or partners of the General Partner, PE will have the right to replace ABC as the General Partner and to convert the interest of ABC to that of a limited partner without any decision making rights. Bankruptcy If ABC or any of the Guarantors files for bankruptcy, then PE will have the right to replace ABC as General Partner and to convert the interest of ABC to that of a silent limited partner without any decision making or voting rights. Fraud and other bad boy acts - Misappropriation of Partnership funds, withholding distributable cash flow, violations of Partnership transfer restrictions, and other willful misconduct or gross negligence by the General Partner will result in a termination of the General Partner s interest in the Partnership, and such right to terminate for bad boy acts will be secured by a pledge of the General Partner s interest in the Partnership. ABC agrees that until this Term Sheet is terminated by mutual agreement of the parties hereto, ABC will not conduct negotiation with any other potential investors regarding the transaction described in this Term Sheet and will terminate any current negotiations with respect thereto; provided, however, that the foregoing covenant by ABC shall terminate and the provisions of this term sheet shall automatically expire in the event the parties have not executed a Partnership Agreement by December 15, 2011. Please note that PE will require final Advisory Board Approval for this proposed joint venture. We understand ABC s approval is subject to its own process as well. This Term Sheet is not intended to constitute a legally binding contract between the two parties and the terms contained are subject to the satisfactory completion of our due diligence including, but not limited to, receipt and approval of: Engineering and environmental reports; A copy of the purchase contract; A copy of the partnership agreement and all related documents; Copies of all due diligence materials provided by the seller; A detailed marketing and leasing plan for the project; Plans and specifications including the community amenities, unit amenities, clubhouse interior design and FFE; Construction capabilities audit to be performed by PE s Construction Management Team; All loan, bond, title, and other related documents. 19

We look forward to finalizing this proposal with you. Sincerely yours, PRIVATE EQUITY GROUP By: Date: Mr. Capital Partner Managing Director This Letter of Intent offer is accepted by Sponsor: ABC DEVELOPMENT GROUP By: Date: 20

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