When investing as a passive partner in a real estate project, cash distributions are computed and made using a ‘waterfall,’ most of which are constructed according to somewhat uniform criteria, and some are more creative.
Real estate syndications use these “waterfalls” to set up and pay principals and investors. Once a developer sets up a waterfall that works for them, it rarely changes. However, there are many different ways to make a waterfall, and this article looks at some of the most common and some of the most complicated.
Simply put, a “waterfall” is how cash and profits from a project trickle down through a series of calculations to pay the project’s developer and investors in a way planned ahead of time.
Most of the time, the preferred return and the internal rate of return are used to determine how revenue and profit will be split. These two things can be used together to set up different breakpoints. As the sponsor meets certain return hurdles, as measured by the IRR, the proportional share of profits will change.
What is a “waterfall” in terms of how cash flows are shared?
A real estate waterfall is a way to show how different investors get their money back by getting a share of the cash flow. Think of a waterfall. Water flows down from the top until it reaches the next level, where it pools, then flows down to the next level, and so on.
The same is true of a real estate waterfall. Those who were promised a higher return will be paid back first, while other investors will be paid back later. As we’ll explain, these waterfalls can look very different and have many parts. Before the deal sponsor can start getting its share of the cash flow distributions, certain benchmarks need to be met. This keeps the sponsor motivated and ensures everyone’s interests are aligned throughout the project.
Common Components of Waterfall
Equity waterfalls are one of the most complicated ideas for real estate investors to understand. Part of this is that waterfalls can be built in different ways. The structure is mostly determined by the nature of the deal, such as how long it takes to invest and how many investors are involved. In the following sections, we talk about the most common parts of a waterfall.
Return Hurdle
In commercial real estate, a “return hurdle” refers to the rate of return that must be reached before cash flow distributions can go to the next level of investors in the equity waterfall. Most waterfalls have more than one way back. Most of the time, the return hurdles are based on reaching a predetermined internal rate of return (IRR) or equity multiple.
Return hurdles are significant because they are what cause profits to be split in different ways. They are designed to allow the deal sponsor to have a vested interest in seeing the project through to completion as effectively and profitably as possible. The sponsor stands to make a bigger share of the profits compared to what they put into the deal, the higher the return. For example, let’s say that the internal rate of return on a deal is expected to be 8%. Below that point, investors (80%) and the sponsor (20%) split the cash flows 80/20. Above that point, the sponsor gets a bigger share of the profits because the split changes to 70/30.
Preferred Return
Falls are another thing that uses the preferred return. It is the first claim on profits made by investors until a specific target return has been reached. It is also called “the pref.” It is paid similar to how a bank pays interest, but there are two significant differences. First, it can be paid either current or accrued, while a bank usually only pays current. Second, it is not guaranteed like a bank’s interest. Instead, investors get paid first as a “pref.” They will get a share of the profits as long as there are profits to share. Once the preferred return hurdle has been reached, any extra profits are split between the parties according to the deal’s terms. The preferred investors in each deal are made up of different people.
The Lookback Provision
When an equity waterfall gives out cash flow distributions before selling the asset, the deal usually has a “lookback provision.” This basically says that if the investor doesn’t get his expected (pre-agreed-upon) rate of return, the sponsor will have to give up some of the money they’ve already made to make up the difference. In other words, the sponsor has to pay the total amount of the agreed-upon return to the investors. This is usually done with the money from the sale of the asset. This is another rule that is meant to encourage the sponsor to do their job.
Catch-up Provision
The catch-up provision says that investors must get all the profits until the agreed-upon rate of return has been reached. Once the investor has made the required amount of money, all of the profits will go to the sponsor until they have made the same amount of money as the investors.
This rule is similar to the “lookback” rule and serves the same purpose. The primary distinction between the two is that with the lookback provision, the investor must return to the sponsor and request that they write a check at the end of the transaction. The catch-up provision gives the investor all the profits until the required return is met. Only then does the sponsor get a distribution.
Most sponsors like the “lookback” provision because it lets them use that money immediately, even if they have to pay it back to investors in the long run. On the other hand, investors like the catch-up provision because they get paid first and don’t have to find a sponsor to get paid if a deal doesn’t go as planned.
How Do You Calculate Waterfall Breakpoints?
Investor Management Services (IMS), the leader in investment management technology for commercial real estate, says that waterfalls usually offer an 8 percent preferred return and split the profits 90-10 or 80-20 between the investors and the developers.
Then, there may be a break where the split changes to 70/30 or 60/40 after investors get a specific internal rate of return (IRR), maybe 12 or 15% IRR.
The most common metric used to define the breakpoint in waterfalls is the internal rate of return (IRR).
IRR in a Waterfall Payment Model
IRR is the rate that shows how much the future returns will be worth in terms of the initial investment. This means that it predicts how much money you’ll make in the future based on how much money you invest now. In other words, it estimates how much investors will earn annually throughout the life of an agreement.
IRR is also used to figure out how much money to put into a project and how much to invest. For example, a developer might need to reach a certain annual return goal before a deal can go through. Maybe they must make at least 10 or 15 percent a year on the money investors give them. The IRR helps predict a deal’s return in the future so that investors can compare one deal to another and their own goals for returns.
Remember that there is no “silver bullet” for waterfall structures, and each deal is different, as the offering documents explain. When it comes to waterfalls, there are a wide variety of options available to both sponsors and investors. Let’s take a look.
Vanilla Waterfall
In a vanilla waterfall, investors get a preferred return of 8%, the most common preferred return (it’s used in 40% of all projects), after payments have been made to senior lenders but before the sponsor gets an incentive payment. The investors will receive their money back in the next step of the waterfall, and only then will the sponsor receive payment in addition to their fees. This payment will be a share of the deal’s remaining profits. We call this the “promote.” Most of the time, these are set up so that the investors get 90%, the developer gets 10% or 80%, and the investors get 20%.
Some investors might want to get sponsors to do better by giving them better promotions once they’ve reached a certain level of return. To do this, a new layer is added to the scenario described above. For example, when investors get an IRR of 15%, the splits change to 70-30.
Two-Tiered Waterfall
The vanilla waterfall shows structures where a b applies to cash flow and any payouts from a capital event like a sale or refinance. Investor Management Services (IMS), the market leader in investment management technology for commercial real estate, says that these are the most common structures found in about 75% of all projects.
Sponsors of some projects like to split the waterfall into two separate waterfalls, each with its own set of rules. One waterfall only applies to operating cash flow, while the other only applies to capital events. About 24% of the time, these waterfalls have two sets of falls. The few exceptions have more than two sets of falls, but those are so rare that there is no pattern to how they are built.
Which waterfall option is better, vanilla or two-tiered? Each transaction is unique, and sponsors will select a waterfall based on their current needs and interests. Vanilla waterfalls are the most common and straightforward to create. Two-tier waterfalls and other types are used in more complicated situations. This is mostly because of the idea that they better align everyone’s interests. It can also be argued that when there are more tiers, there is a better alignment of interests and a stronger incentive for sponsors to do better than expected, which raises returns for everyone.
Common Waterfalls
IMS handles more than 7,000 projects on its platform. According to IMS, about three-quarters of all projects have two equity splits in their waterfall structures. They have found that a preferred return to a 90-10 and then a split to an 80-20 is the most common right now. The most common preferred return is 8%.
The 8% preferred return will be used in about 40% of projects. The next most common is 10 percent, used by about 30 percent of sponsors. Finally, the 7 percent preferred return is used in about 8 percent of project waterfalls. The next most common are 12 percent and 9 percent, and the rest range from 2 percent to 22 percent.
The IRR is by far the most common. About 80% to 85% of all hurdles used in the business world are IRRs. Other obstacles used are:
- Reaching a level of return that was agreed upon.
- Equity multiple.
- Amount of the money that was returned.
- How much of the pref has already been paid out.
When it comes to waterfalls that don’t happen very often, the differences are less about the math that goes into the formula for distributing cash flow, whether it’s operating cash flow or return of capital, and more about how the entities are set up.
There will be more than one entity in the org structure, making these waterfalls stand out and make them so complicated. Usually, there are General Partners (GP) and Limited Partners (LP). However, in more complex waterfalls, GPs and LPs can be broken up into many different entities and classes.
The waterfalls are made even more complicated by the fact that different classes may have other return metrics, such as different preferred-return levels, different hurdles, and many different splits, such as 90-10, 80-20, 70-30, 60-40, and 50-50. 40-60. In the most complex waterfalls, there might be anywhere from 7 to 10 layers of calculations.
For example, there might be three different types of investors: class A, class B, and class C.
- Class A investors may get a 10 percent pref and an 80 percent share of profits, giving the sponsor a 20 percent promotion.
- Class B investors may get an 8 percent pref and a 70 percent share of profits after that, giving the sponsor a 30 percent boost.
- Class C investors may get a 10% preference and 80% of the profits until they reach an IRR of 15%, at which point the profits are split 70:30, and then again at an IRR of 20%, when the profits are split 60:40.
Wacky Waterfalls
When the sponsor figures out the breakpoint based on what is “greater of something,” things start to get wacky. They might make the split depend on getting a 15 percent IRR or a 1.5x equity multiple, whichever comes first.
This means that before moving down to the next layer of the waterfall, you have to figure out which of these two is bigger at any given time.
To make things even more complicated, some organizational structures have more than one class, and the overall return metric for each class is different for each investor. This could be a preferred return, an equity multiple, the IRR, or some greater-of combination of these.
For instance, there may be not only different types of investors, as shown above, but also different types of investors within each entity. A sponsor may want to get money from many other places, such as foreign investors, a crowdfunding site, an investor group, and friends and family. To do this, more than one legal entity may invest in the deal. Every legal entity has its investors.
Side Letters
In waterfall structures, those with side letters between a sponsor and their investors in different classes are another thing that stands out. These side letters are only available to investors in this class, or maybe only to a certain number of investors in that class.
When side letters happen, they usually explain how they differ from the standard operating agreement by giving certain investors different treatment regarding how much money they get back. That doesn’t mean that the investor with that side letter automatically has better terms than the other investors in that class. They’re just different, and as a result, they bring another layer of complication to the equation, from the project level down to each of those investors.
Side letters are most often used to thank investors who have been with a sponsor for a long time and have invested in most or all of the deals the sponsor has to offer.
In these situations, the loyal investor might get a return similar to what they have been used to getting from the sponsor over the course of their relationship with the sponsor. For example, if an investor has been investing for a long time, including at the beginning of a cycle when returns are usually higher. In that case, sponsors can use side letters to prop up returns for loyal investors to keep their early-cycle return profile as the cycle nears its end and returns shrink.
Most of the time, this is done by giving the investor a higher preferred return or giving them a bigger share of a split as they move through the different hurdles. For instance, these loyal investors might get a 20/80 split while everyone else gets a 10/90 split.
The No-Preferred Return Waterfall
Sponsors don’t have to offer a preferred return, of course, and projects that don’t have them are very rare, but they do exist. Here are two real-life examples of deals.
One of the projects did not have a preferred return, but had a straight 70/30 split from the first dollar, that is, for all distributions from available cash flow and from a liquidity event like a refinance or sale.
In another real-life case, a $100 million multi-family office residential development project with a $35 million equity piece was involved. All distributions from cash flow were split 75:25 between investors and sponsors. Investor capital was paid first from the proceeds of a refinance or sale, and the 75:25 split was kept for all other cash flow income. In this case, the deal was a development project, so investors didn’t get any money until three years later when the project started making money through operations.
Because of this, investors got no cash flow and no return during the development period. Also, if there were a refinance, only the 70 percent of the invested capital that could be paid off by the refinance would be paid off before the 75-25 split went back into effect.
Even though there are real-life examples of waterfall structures without a preferred return, IMS, whose investor management software has more than $40 billion worth of equity positions on the platform, says these structures are the rarest.
Most of the time, these zero percent pref structures happen between the sponsor, their closest friends, and family. Most of the time, investors put up all the money for these deals, and the sponsor does all the work but gets very low or no fees. When a property sells, the sponsor and investors simply split the profits 50/50.
- All of the capital comes from investors.
- The sponsor does all the work and doesn’t get paid for it.
- Split the profit 50/50.
There is no link between investor returns and waterfall complexity.
Notably, a complicated waterfall doesn’t change a sponsor’s actual returns very much. In fact, if you put the same numbers through a common waterfall with 2–4 layers and compare it to one with 7–10 layers, you won’t notice much difference in how the numbers come back.
Still, it’s clear that sponsors see benefits in making complicated deal structures by separating different types of investors. However, sponsors’ returns don’t change much, and as deals get more complex, the risk of making a mistake in their calculations increases, and so does their liability if they do. Most sponsors do their waterfall calculations in Excel, but with so many layers, Excel is pushed to its limits, and this often means that some calculations aren’t done right.
Knowing how your waterfall compares to industry standards, which are now easier to see, is a great way to show investors why your value proposition is good.
To stand out from the crowd, you need to be able to explain the benefits of your waterfall to both keep your current investors interested and attract new ones. Today, it’s a must that you can do this digitally. Using social media and high-tech digital marketing to spread this message makes the whole thing easier and more effective.
If you want to see exactly how you can raise money online and use the structure of your waterfall to get more investors and get closer to the ones you already have, find out what the best practices in the industry are right now.
Outliers in the Waterfall
The third anomaly, which is slightly less prevalent, is where there is a desired return, but it begins to accumulate only when cash flow is generated at the property. Even though they are uncommon, when they do appear, they are in development or value-add deals. In these peculiar waterfalls, an investor puts their money in with the understanding that the clock on earning preferred return does not start ticking until there is actual cash flow at the site.
The third outlier, which is less typical, is that preferred return accrues from the start of the agreement but isn’t paid for a while; it just accumulates during the project’s non-cash flow period. In such instances, the GP frequently has a catch-up period before capital is returned to investors. Most of the time, the catch-up will be determined as follows. If the excess capital is split after the preferred return is 70-30, the sponsor will receive the same split as a percentage of the preferred return paid to investors.
Putting things into numerical terms. If the transaction structure is an 8% preferred return followed by a 70-30 split and an investor invests $1M, the returns after two years would be as follows, assuming there is adequate cash available for distribution:
- Investors would receive 8% compounded over two years on their $1 million investment, for a total of $160,000.
- The sponsor would then earn a 30% bonus on the accrued preferred return, so 30% of $160,000 equals $48,000.
- Following that would be either continuous cash distributions to preference or catch-up.
- Then comes the return of the original $1 million invested capital.
- Finally, all remaining distributions are 70-30.
Notably, in some of these circumstances, the preferred return may be higher than expected if the preference was paid current from the time of investment, whether monthly or quarterly. However, these scenarios are uncommon, and there is no link between having an unpaid accrued return and having a higher preferred return.
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