Beginner's Guide: Real Estate Waterfalls
A real estate waterfall is a term used to describe how real estate partners distribute cash flow.
The “waterfall” is a way of visualizing various “pools” in a real estate partnership. Cash flow fills up each pool in succession, which spills over into the next pool. Each step along the way, the waterfall flows based on an agreed-upon methodology for distributing the profits. Once a pool has filled, remaining cash flows to the next pool, divided per the terms of the partnership agreement between the general and limited partners.
What’s a General and Limited Partner?
A general partner (GP), often referred to as the manager or sponsor, is the partner that manages the day-to-day operations of the investment. Once limited partners (LPs), achieve a certain return on their investment, GPs receive their payment.
LPs don’t actively participate in managing the investment. The first step in the waterfall is typically to return the LPs capital investment plus a hurdle rate or preferred return.
What’s a Hurdle Rate?
A hurdle rate is an internal rate of return (IRR) that pays LPs up to a certain percentage before going to the GP. For example, a 10% hurdle rate means that the LPs get their capital returned plus 100% of the profits up to 10%. After that, the remaining profits split between the LP and GP. When meeting a hurdle, profit splits may change.
What’s a Preferred Return?
The preferred return — sometimes called the “pref” — is an alternative to the hurdle rate. The preferred return is an expected annual rate of return based on periodic payments (monthly, quarterly, etc.). For example, if the LP investors contribute $10 million to the deal with a 7% preferred return, the LPs would get $700,000 before the GP is allocated any profits. The preferred return is often cumulative. If the threshold isn’t met in a given period, the shortfall is added to the next scheduled payment.
What’s a Promote?
The "promote" is the GP’s share of the profits, which is only earned after the LPs’ hurdle or preferred return is met. The GP is “promoted” for achieving the LPs’ desired return, and thus begins to share in the profits. Usually, the further down the waterfall you travel, the more the GP benefits.
A “GP catch up” is a provision that allots profits to the GP to ensure the GP’s share equals the promote. This happens after meeting the initial hurdle or preferred return. A “lookback” is the opposite of the GP catch up, with money allocated back to LPs from the GP if the IRR falls below the target threshold.
Let’s look at an example, using the information we covered above. Below is a simple example showing how the cash flows might work in a real estate waterfall:
1st tier | 8% all to LP
2nd tier | 8%-12% - split 80/20 to the LP/GP
3rd tier | 12+% - split 50/50
Based on the above assumptions, assuming the return of the LP capital, if the partnership earned $1.4 million in profits (14%), the waterfall would break down as follows:
- 1st tier | LPs gets $800,000
- 2nd tier promote:
- LPs gets $320,000 ($10mm x 4% = $400k; $400k x 80% = $320k)
- GP gets $80,000 ($10mm x 4% = $400k; $400k x 20% = $80k)
- 2nd tier promote:
- LPs and GP get $100,000 each ($10mm x 2% - $200k; $200k x 50% = $100k each)
Pay close attention to the structure of a deal. Usually, GPs are more involved in the drafting of agreements. Make sure hurdle or preferred return rates are realistic. If the project fails to meet the rates, the GP loses incentive to perform well. The best waterfalls are those where both the LPs and GP have a good understanding of the structure of the deal and allocation of the profits (the waterfall). These deals can get complex and communication is vital to ensure there are no surprises. The key is to create a win-win situation for both the GP and LP.
If you need help, contact us online or call 800.899.4623.
Published on June 30, 2021