A Real Estate Investor’s Guide to the Equity Waterfall

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In the commercial real estate world, there are few concepts more baffling than the equity waterfall.

What Is the Equity Waterfall?

When someone refers to the equity waterfall in commercial real estate, they’re essentially talking about how cash flow from an asset will be distributed and when. There are countless ways to structure these distributions, which is what makes the equity waterfall concept so complex—and in practice, even harder to model.

A real estate equity waterfall, sometimes referred to as the distribution waterfall, follows an order of hierarchy from which to distribute funds to limited and general partners.

In this article, we provide the overarching framework for an investor interested in learning more about the specific components of the equity waterfall. Grasp the concepts below, and you’ll have mastered one of commercial real estate’s most intimidating pieces!

Understanding What’s Behind the Name

At first glance, the term “waterfall” might not be one you would expect to see applied in commercial real estate. But a deeper look behind the name reveals why this term is, indeed, quite appropriate.

The term “waterfall” stems from the idea that cash flow from commercial real estate projects flows to different parties in numerous ways. The profits gather in a “pool” until that pool is full, at which point the profits spill over to the next pool of investors in a tiered fashion.

It’s actually quite like when water gathers at the top of a waterfall and then, after reaching a certain threshold, spills over to a pool below—sometimes multiple times. Just as nature’s waterfalls can have numerous pools below, so too can real estate waterfalls.

In most equity waterfalls, the profits of a project are split unevenly amongst the project’s partners. Operating partners (e.g., the real estate developer) are given a disproportionately larger share of the profits if the project beats expectations.

This extra slice of the pie is referred to as the “promote.” Promotes are used as a bonus to incentivize the developer to exceed return projections.

Common Equity Waterfall Terms Explained

Before getting into an example, it’s helpful to understand a few terms that are often used when discussing commercial real estate equity waterfalls. These are all important features involved in the structure of a waterfall.

Understanding these terms will help you understand why certain tiers of a waterfall function the way they do.

• Return Hurdles: A return hurdle defines the rate of return that must be achieved before the cash flow can move on to the next tier of the equity waterfall process. Most waterfalls have multiple return hurdles. These return hurdles are often based on an internal rate of return (IRR) or equity multiple.
• Preferred Return: At the most basic level, the preferred return refers to the order in which partners are repaid their equity investment plus their share of the profits until a certain threshold has been met.
• Catchup Provisions: Whereas some equity waterfalls are structured to distribute cash flow to different parties during the course of the deal, other equity waterfalls are structured with what’s known as a “catchup provision.” A catchup provision stipulates that the limited partner will receive 100% of the investment’s preferred return, and after achieving that rate of return, all proceeds will then go to the general partner until they’ve received a specified rate of return.

Typical Equity Waterfall Structure

The most basic equity waterfall commonly has four tiers. As described above, the first tier is where the cash flow builds into a pool—and once that pool overflows, the profits flow down to the next tier. The tiers listed below are not a hard and fast rule and vary by investment.

• Tier I—Return of Capital: In this tier, 100% of cash flow distributions go straight to the LP.
• Tier II—Preferred Return: All cash flow is distributed to the LP again until a preferred return on their investment is achieved. The preferred return is sometimes referred to as the “hurdle rate” and can range from 7-10% or more.
• Tier III—Catch-Up: This is where the catch-up provision comes into play. All distributions in this tier go to the GP until they achieve a certain percentage of the profits.
• Tier IV—Carried Interest: At this point, the GP receives a disproportionately larger share of the cash flow distributions in the form of promotes until all cash flow is exhausted.

Sample Equity Waterfall

Equity waterfalls can be structured in many different ways. But for simplicity’s sake, we offer a very basic, five-tier example below. In this example, we’re assuming there is a single Sponsor (the GP) and single Investor (the LP).

The LP has invested $4 million (90% of total equity) and the GP has invested $400,000 (10%). Here’s how a basic water fall might be structured in this case:

	IRR		Distribution
Waterfall	From	Through	Investor (LP)	Sponsor (GP)
First Tier	0.0%	12.0%	90%	10%
Second Tier	12.0%	18.0%	80%	20%
Third Tier	18.0%	21.0%	70%	30%
Fourth Tier	21.0%	24.0%	60%	40%
Final Tier	24.0%	100.0%	50%	50%

And here is how that might take effect, in practice:

	IRR		Distribution		Cash Flow Distributions
Waterfall	From	Through	Investor (LP)	Sponsor (GP)	Investor (LP)	Sponsor (GP)	% Profit
First Tier	0.0%	12.0%	90%	10%	$5,599,799	$552,997	8.6%
Second Tier	12.0%	18.0%	80%	20%	$980,322	$245,081	13.8%
Third Tier	18.0%	21.0%	70%	30%	$551,404	$236,316	13.4%
Fourth Tier	21.0%	24.0%	60%	40%	$596,558	$397,705	22.5%
Final Tier	24.0%	100.0%	50%	50%	$737,660	$737,660	41.7%
TOTAL DISTRIBUTIONS					$8,465,723	$2,169,759
Investments					($4,000,000)	($400,000)
PROFIT					$4,465,723	$1,769,759	100%

As you can see in this example, the LP has more invested in the deal (financially) and therefore, experiences a preferred rate of return in advance of the GP earning a greater share of the profits.

And remember: what we’ve shown here is an extremely simple version of an equity waterfall. Equity waterfalls can become highly complex, particularly depending on the number of investors, lenders, and other partners involved in a deal.

Conclusion

Real estate equity waterfalls are not easy to grasp, even for those who have years of experience in the industry. They can be filled with complicated tiers, returns, and provisions that are all interconnected to support a structure of uneven distributions of profit from a specific project. In breaking down the different features of an equity waterfall, you can gain a clearer understanding of how a project’s returns will be distributed to whom and when.

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.