Understanding of Equity Waterfalls
When investors go from residential to commercial real estate, they are confronted with a whole new and sometimes perplexing lexicon. The majority of this new terminology pertains to commercial lending. The notion of equity waterfalls, in particular, confuses many novice investors. Despite the complexity of these currency distribution schemes, their core aim is relatively straightforward.
This essay will thus offer an overview of equity waterfalls in commercial real estate. Specifically, the following themes will be discussed:
- An Introduction to Equity Waterfalls
- IRR compared to Cash-on-Cash Return
- A Standard Equity Waterfall Situation
- Using Waterfall to Define Transaction Returns
- Including Tiers in an Equity Waterfall
- Final Reflections
An Introduction to Equity Waterfalls
Unfortunately, experienced investors in commercial real estate tend to overcomplicate business ideas. And equity waterfalls are unquestionably susceptible to this occurrence. For inexperienced investors, comprehending these instruments might seem difficult.
Simply put, an equity waterfall illustrates the distribution of a transaction’s cash flows to investors. That is all. As there are many methods to disperse cash flows, structuring the cascade of a specific transaction may become pretty complex. However, these instruments explain how investors will get cash flows from an investment. A well-structured waterfall will thus entice investors to a venture. In contrast, a poorly constructed one might deter prospective investors.
This essay does not thoroughly explain how to construct an equity waterfall. Instead, we will present a broad perspective to provide investors with the information necessary to ask the appropriate questions when reviewing a possible acquisition.
IRR Compared To Cash-On-Cash Return
Internal rates of return (IRR) and cash-on-cash returns must be defined before delving into equity waterfalls. In constructing an equity waterfall, one might be utilized to assess a transaction’s success. Investors who do not comprehend these principles will struggle to interpret a suggested waterfall design correctly.
Rate of Internal Return
When all cash inflows and outflows are discounted at the same rate, the internal rate of return (IRR) is reached (i.e., the initial investment). Alternatively, if you invest $100,000 in Year 0, the optimal dividend yield is the valuation method at which the sum of all discounted future cash flows equals $100,000. The higher the IRR, the greater the investor’s return.
This statistic provides the benefit of evaluating a transaction’s entire cash flow. However, it is a little more difficult for prospective investors to comprehend when reviewing a transaction.
Cash-on-Cash Yield
In contrast to IRR, cash-on-cash return focuses entirely on yearly cash inflows. Continuing with the preceding example, if an investor contributed $100,000 in Year 0 and got $5,000 in cash in Year 2, her cash-on-cash return for Year 2 would be 5%. The return for Year 3 would disregard these outcomes and just consider Year 3 cash inflows compared to the starting investment.
The benefit of cash-on-cash return is its simplicity. In addition, it disregards overall investment performance and exit cash flow following the sale of a property.
A Standard Equity Waterfall Situation
The following two parts offer a rudimentary illustration of how an equity waterfall may be constructed. As said, a particular transaction may have a far more complex structure. This example, however, will illustrate the fundamental principles of equity waterfalls in commercial real estate.
Consider that a commercial real estate developer approaches you with an investment offer. He will spend $250,000 on a proposal to create and run an apartment complex. However, with $4,000,000 in anticipated construction expenses and 75% loan-to-cost financing, he needs an additional $750,000 in equity to achieve the $1,000,000 down payment requirement. You are listed as a possible investor.
In this transaction, the developer will act as a general partner (GP), build the project, and manage the stabilized property. As a limited partner (LP), you will just contribute capital and will not be accountable for any development or operational activities. Equity will be distributed proportionally according to the first investments:
- LP: $750,000 investment for a 75% share in the transaction.
- GP: $250,000 investment for a 25% share in the transaction.
Using Waterfall to Define Transaction Returns
We now know the fundamental equity structure of the transaction. We must determine how the GP and LP allocate the trade cash flows. In other words, we must construct the equity waterfall. This example is merely one method to organize a waterfall; it is not the only one.
Assume you and the GP determine that IRR is the best appropriate performance metric for the transaction. The GP will likely inquire about the IRR you expect for trade with similar risk and duration as a starting point. You determine that ten percent is appropriate, and the developer concurs. 10 percent is currently the first rung of the deal’s waterfall structure:
- Tier 1:
Until the deal’s cash flows achieve an IRR of 10%, you and the developer will divide cash flows according to the contribution, with 75% to you and 25% to the GP.
In developing and running the property, however, the GP does almost all of the deal’s labor. As a consequence, he demands a higher return than yours. In commercial real estate parlance, this additional cut is known as a deal’s promoted interest, and it represents the second layer of the equity waterfall:
- Tier 2:
Once cash flows reach a 10% IRR, the GP gets 50% of your cash flows in addition to his initial 25%. Thus, for each dollar over the 10% IRR, the GP earns 62.5 percent (25 percent original split plus 50 percent times your 75 percent original split). You will make the remaining 37.5% on each dollar received over the IRR threshold of 10%.
In this example, the transaction’s cash flows “waterfall” from the first to the second layer. Moreover, this multi-tiered approach offers two associated benefits. First, the promoted interest rewards the general partner for the effort he will invest in establishing and running the enterprise. Second, the second tier significantly incentivizes the GP to manage the project efficiently and successfully since he will earn more significant rewards for improved performance.
Including Tiers in an Equity Waterfall
While we previously provided an example of a straightforward equity waterfall structure, many transactions use a more complex, four-tier system. However, it is essential to highlight that the next model just expands upon the preceding basis.
- Tier 1, Return of Capital:
Until all contributed money has been refunded, this layer distributes cash flows based on equity holding. In the above scenario, the first $1,000,000 in cash flows would be shared as follows: 25% to the general partner and 75% to you, the limited partner, until both parties had recouped their original contributions.
- Tier 2, Favorable Return:
In this tier, as the limited partner, you would get all cash flows until you reach your desired return on investment, which in the previous example was 10% IRR.
- Tier 3, Make-up:
Frequently, contracts include what is known as a catch-up clause. In this tier, the GP receives all cash flows until he obtains an inevitable return.
- Tier 4, Interest Carried:
In this third stage, the GP gets his promoted interest, representing a more significant proportion of all remaining cash flows. This is the tier in which the general partner would earn 62.5 percent of each dollar of cash flow, and you would obtain the remaining 37.5 percent.
Final Reflections
Attempting to comprehend equity waterfalls as a novice investor should not terrify you. Yes, individual transactions may have intricate arrangements. However, the fundamental objective of an equity waterfall never changes. It only specifies how investors will get cash flows from a particular transaction.
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