The Excel spreadsheet is highly recognizable across the commercial real estate industry as the standard tool for imputing and solving complex calculations such as waterfall distributions. While Excel and other similar tools such as Google Sheets are indeed capable of handling complex formulas, 9 out of 10 spreadsheets contain at least one error.
Fortunately, due to the expansion of technology, CRE firms have access to software like IMS that can automate workflows and manual processes, reducing risk, increasing accuracy, and providing transparency for each investment deal. And with the ability to calculate distributions in minutes, there’s hours of time saved that can be dedicated back to the value-add work for the firm.
IMS recently partnered with Dr. Adam Gower of GowerCrowd.com to discuss best practices for getting out of Excel and instead leveraging today’s available technologies.
Common Spreadsheet Errors
Spreadsheet errors are often easier to make than they are to identify. Mistyped numbers, incorrect formulas, rounding mistakes, and incorrect cell references are among the most common errors that are made.
Human error is largely responsible for mistakes made on spreadsheets. Many firms have one person who is responsible for data entry. Typically, their completed work is then reviewed by one or two people who check and approve the spreadsheet to ensure accuracy. Reviewing multiple lines of data can easily become mundane, making mistakes more likely to slip through the cracks.
Waterfall distribution-specific spreadsheet errors are often attributed to a misinterpretation of commonly used terminology such as “actual/actual”, “actual/365”, and so on. A lack of a thorough understanding of these terms can lead to input errors, which ultimately can result in inaccurate distributions.
Risks of Distributions in Excel
Although some spreadsheet errors may be easily rectified, others are associated with more serious risks. One of the major risks of using spreadsheets is distributing an incorrect amount of funds to investors. Both over-distributing and under-distributing funds can lead to unresolvable issues such as a damaged reputation, impaired business relationships, and reduced credibility. IMS recently conducted a poll revealing that 74% of respondents are running waterfall rules and distributions in Excel or a spreadsheet and the other 26% are not running any type of waterfalls. With such a large percentage of people using spreadsheets, the number of potential errors floating around are likely to be significantly high.
Spreadsheets also run the risk of too many variations if at one time or another the original creator is no longer managing or overseeing them. Ron Rossi, Vice President of Business Development for IMS, mentioned how “individuals in commercial real estate tend to take one model from their current job onto the next job; [they] drag this model around and then share with another organization”. Waterfall automation tools help minimize the inevitable discrepancies that a traveling spreadsheet model can cause. According to Dr. Adam Gower of GowerCrowd.com, “differences and discrepancies can grow, especially if you’re managing large amounts of money, the delta over a couple of years can be a couple hundred thousands of dollars”.
Waterfall Best Practices
The Simpler the Better
When it comes to managing waterfall distributions, the phrase “the simpler the better” is a great method to apply. A simpler distribution provides benefits for both sponsors and investors. For example, a simple distribution makes it easier for investors to compare one deal to another. Simpler distributions can help them quickly determine when they should be receiving their returns and that the amount they are receiving is appropriate.
Know Your Operating Agreement
For a deal to be successful, it is important for both the business’ interests and waterfall rules to align with the spirit of the deal. One major reason that ensuring a sponsor’s approach and desired outcome of a deal is aligned with the operating agreement and the waterfall ruleset is because it is the backbone of the cash flow between sponsors and investors. It can become quite complicated to receive an operating agreement and then attempt to build mock waterfalls accordingly.
Although the expansion of CRE tech requires a fresh way of thinking, firms that adopt these new processes and technologies are able to see quantifiable results of growth, efficiency, and success. To learn more about tech adoption in CRE, read Tech Adoption in CRE: Misconceptions and Reality.