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What Are Waterfalls in Real Estate Syndication Deals?


Jun 19, 2020 by Brad Cartier

As real estate investors, we are always looking for ways to smartly grow and scale our investment portfolios. At times, this involves using OPM -- other people's money. One of the ways to do this is through real estate syndication and by offering what is called a waterfall return.

Waterfalls in real estate syndication deals can be simple or complex, but we are here to demystify this common OPM offering. Here's an overview of waterfalls in real estate, the pros and cons of different waterfall structures, and whether real estate investors should try to get in on the action.

What is a waterfall in real estate deals?

Simply put, waterfalls are a financial structure that dictates how returns on a real estate investment are distributed to investors. As a passive investor, your cash distributions will typically flow according to a waterfall distribution schedule.

This is a cascade of a series of payment events in a specific order. For example, passive investors (limited partners) may receive an 8% as first money out, meaning before anything else, investors in the deal are paid their 8%. After that, proceeds may be split 90-10, 80-20, 70-30, and so on, between the developer and passive investors respectively. This first money out is what is called a preferred return, and it's typical of many real estate deals that involve capital partners.

Waterfalls also often rely on the internal rate of return metric to trigger different payment scenarios. A profit split between investors and developers may change when certain IRR milestones are hit. This is because it incentivizes the developer (general partner) to produce better returns and rewards them for that.

In turn, passive investors know that a certain return is guaranteed, called a preferred return, no matter the performance of the asset. This gives passive investors some certainty that they will be first money out before returns go to anyone else.

How is a waterfall return structured?

The waterfall structure can be made in a number of different ways and depend on the legal language you use in your agreement. A waterfall distribution agreement can include any of the following provisions:

  • Preferred return: This is a preferred rate percentage that goes to the money partners before any other disbursements are made. This is typically in the range of 5% to 8%.
  • Split: After the preferred return is made, there is a split of the remaining returns between the developer (general partner) and the investors (limited partner). This can be 90/10, 80/20, 70/30, and so on and depends entirely on the waterfall structure of your real estate deal.
  • Promote: This is the term used to reflect the equity and cash returns received by the "promoter," also referred to as the general partner, developer, manager, etc.
  • IRR lookback: A waterfall model agreement can contain what's called an IRR lookback, XIRR, or IRR hurdle. In this model, a certain IRR hurdle or threshold must be met to trigger new profit-sharing arrangements. More on this below.
  • Simple split: In a less complicated waterfall model, you may see a simple split with no preferred return or IRR lookback. In this scenario, you'd simply split all proceeds between an equity investor and the general partner.
  • Catch-up provision: This is similar to the XIRR but requires that 100% of returns go to investors (limited partners) until a certain threshold is met, and then the remaining funds go to the general partner.
  • Return of capital: Provisions can be made to achieve a certain threshold of return of capital to an equity investor before a sponsor/developer receives their returns.
  • Capital event: There are provisions for when a capital event happens, such as a refinance or sale of a property. This can include a full return of capital provision as well as a different split than what any pre-capital events such as cash flow disbursements contain.
  • Tiers: There are examples of two-tiered waterfall agreements that contain different rules for cash flow disbursements as well as capital events. So you may get a simple split for cash flow, whereas a capital event may contain different rules.

What is a lookback provision?

An IRR lookback provision sets certain IRR milestones and return hurdles to incentivize the general partner (sponsor) to achieve higher equity and cash returns for capital investors. In these scenarios, once an IRR rate is achieved, meaning investors are getting better returns, the split between investors and sponsor changes to typically favor the sponsor.

For example, if the sponsor (general partner) can only achieve an 8% IRR, then the split may be 80/20, with 80% going to limited capital investors and 20% to the general partner. If the sponsor improves returns and achieves an IRR of 13%, then that split may move to 70/30 or 60/40, and so on.

The IRR lookback structure is limited only by the creativity of the sponsor and what capital investors are comfortable with. If sponsors can achieve a home-run IRR of 20%, then capital partners are already reaping the benefits of that through their regular returns, so sponsors typically then get a bigger slice of ongoing returns.

Keep in mind that the lookback provision means this amount isn't paid until end-of-year, hence the lookback, so the general partner would be holding onto these funds until your designated year-end.

Waterfall real estate calculation example

Let's take a quick look at some waterfall model structures using specific numbers and examples.

Example 1: Simple waterfall split with a preferred return:

  • The yearly cash flow of Development A is $100,000.
  • Capital investors, of which there are four, take 8% off the top. So $8,000 goes to those limited partner investors.
  • This leaves $92,000, to be disbursed along a 70/30 split between the investors and developer, respectively. In this case, the developer would take 30% and the investors 70% of the remaining $92,000.

Example 2: Waterfall split with a preferred return and XIRR:

  • The yearly cash flow of Development B is $50,000.
  • Capital investors, of which there are two, take 8% off the top. So $4,000 goes to those limited partner investors.
  • This leaves $46,000, to be disbursed along a 50/50 split between the investors and developer, respectively.
  • If the IRR amount for that given year exceeds 15%, then the remaining disbursement split after the preferred return changes to a 70/30 split, with the general partner getting 70% of the returns and limited partners getting 30%. If the IRR metric moves above 20%, this split again changes to 80/20, favoring the general partner.

The bottom line

Waterfalls in real estate deals are a sophisticated way to protect the capital of limited partners who provide the majority of the funds as well as incentivize the general partner to produce as high a return as possible. Waterfalls can be structured in a number of ways and are limited only by your creativity, as well as that of your legal representative who will draw up the agreement.

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