Promote crystallization
"Promote crystallization"
What is it? and how does it affect Real Estate developers/investors?
Developers work to earn a promote, which is a disproportionate share of profits distributed to the developer after a certain preferred return hurdle has been crossed.
Once the project is completed or "stabilized," the risky part of the business has been executed and the developer considers that they've earned their promote.
However, if the deal has a high preferred return, as most institutional deals do, the developer's promote will typically gradually get smaller due to the build-up of the preferred return or IRR hurdle that the developer has to clear, which eats away at the promote.
Limited partners (LPs) often want their capital invested for a longer period of time, but developers either want out or want the preferred return to go away. This creates tension and interests are not aligned, either until the developer is bought out, the deal is sold, or the promote is "crystallized" or "frozen."
If parties agree to a crystallization, the general partners (GPs) and LPs will run the deal through a hypothetical sale based upon an agreed fair market value (FMV). They will run everything through the agreed upon split/waterfall, and that will determine the net proceeds that each partner would receive if they had sold the project.
They then reset the percentage interest based on the allocation of these proceeds and the deal is "crystallized."
This is called a "crystallization." We learned this the hard way, where our investor didn't want to sell and we still had a preferred return ticking away at our share of the cash flow. We had equity but no cash flow. "You can't eat equity."
Make sure to negotiate a proper crystallization at stabilization or, alternatively, agree to drop the preferred return to the rate of the first mortgage. This solves the issue in a similar but not exact way.
When structuring such deals, please make sure you work with a qualified real estate attorney.
One of the most successful developers I know told me that when structuring deals, the worst thing you can do is have an attorney that is not on the same level as the attorney your investors are using.
Do not use a $200-$300 an hour lawyer to negotiate terms against a $1200 an hour lawyer. Don't let your attorney be outclassed. One word in the contract can change the terms, significantly. Your attorney and your CPA are two areas where you should not try to save money.
Additional:
As pointed out by @untrendedYOC "After crystallization, the sponsor would own X amount of the equity in the property straight up, and there would no longer be any promote. Any cash flow generated from the property now flows pro rata to each party’s share."