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.<\/p>\n
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\u2019ll have mastered one of commercial real estate\u2019s most intimidating pieces!<\/p>\n
Understanding What\u2019s Behind the Name<\/h3>\n
At first glance, the term \u201cwaterfall\u201d 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.<\/p>\n
The term \u201cwaterfall\u201d stems from the idea that cash flow from commercial real estate projects flows to different parties in numerous ways. The profits gather in a \u201cpool\u201d until that pool is full, at which point the profits spill over to the next pool of investors in a tiered fashion.<\/p>\n
It\u2019s 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\u2014sometimes multiple times. Just as nature\u2019s waterfalls can have numerous pools below, so too can real estate waterfalls.<\/p>\n
In most equity waterfalls, the profits of a project are split unevenly amongst the project\u2019s partners. Operating partners (e.g., the real estate developer) are given a disproportionately larger share of the profits if the project beats expectations.<\/p>\n
This extra slice of the pie is referred to as the \u201cpromote.\u201d Promotes<\/strong> are used as a bonus to incentivize the developer to exceed return projections.<\/p>\n Before getting into an example, it\u2019s 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.<\/p>\n Understanding these terms will help you understand why certain tiers of a waterfall function the way they do.<\/p>\n The most basic equity waterfall commonly has four tiers. As described above, the first tier is where the cash flow builds into a pool\u2014and 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.<\/p>\n Equity waterfalls can be structured in many different ways. But for simplicity\u2019s sake, we offer a very basic, five-tier example below. In this example, we\u2019re assuming there is a single Sponsor (the GP) and single Investor (the LP).<\/p>\n The LP has invested $4 million (90% of total equity) and the GP has invested $400,000 (10%). Here\u2019s how a basic water fall might be structured in this case:<\/p>\n And here is how that might take effect, in practice:<\/p>\n 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.<\/p>\n And remember: what we\u2019ve 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.<\/p>\n 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\u2019s returns will be distributed to whom and when.<\/p>\n![\"real_estate_math\"](\"https:\/\/www.biggerpockets.com\/blog\/wp-content\/uploads\/2015\/01\/real_estate_math.jpg\" "\\"\\"")
<\/p>\nCommon Equity Waterfall Terms Explained<\/h2>\n
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Typical Equity Waterfall Structure<\/h2>\n
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Sample Equity Waterfall<\/h2>\n
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\n \u00a0<\/strong><\/td>\n IRR<\/strong><\/td>\n Distribution<\/strong><\/td>\n<\/tr>\n \n Waterfall<\/strong><\/td>\n From<\/strong><\/td>\n Through<\/strong><\/td>\n Investor (LP)<\/strong><\/td>\n Sponsor (GP)<\/strong><\/td>\n<\/tr>\n \n First Tier<\/td>\n 0.0%<\/td>\n 12.0%<\/td>\n 90%<\/td>\n 10%<\/td>\n<\/tr>\n \n Second Tier<\/td>\n 12.0%<\/td>\n 18.0%<\/td>\n 80%<\/td>\n 20%<\/td>\n<\/tr>\n \n Third Tier<\/td>\n 18.0%<\/td>\n 21.0%<\/td>\n 70%<\/td>\n 30%<\/td>\n<\/tr>\n \n Fourth Tier<\/td>\n 21.0%<\/td>\n 24.0%<\/td>\n 60%<\/td>\n 40%<\/td>\n<\/tr>\n \n Final Tier<\/td>\n 24.0%<\/td>\n 100.0%<\/td>\n 50%<\/td>\n 50%<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n \n\n
\n \u00a0<\/strong><\/td>\n IRR<\/strong><\/td>\n Distribution<\/strong><\/td>\n Cash Flow Distributions<\/strong><\/td>\n \u00a0<\/strong><\/td>\n<\/tr>\n \n Waterfall<\/strong><\/td>\n From<\/strong><\/td>\n Through<\/strong><\/td>\n Investor (LP)<\/strong><\/td>\n Sponsor (GP)<\/strong><\/td>\n Investor
\n(LP)<\/strong><\/td>\nSponsor (GP)<\/strong><\/td>\n % Profit<\/strong><\/td>\n<\/tr>\n \n First Tier<\/td>\n 0.0%<\/td>\n 12.0%<\/td>\n 90%<\/td>\n 10%<\/td>\n $5,599,799<\/td>\n $552,997<\/td>\n 8.6%<\/td>\n<\/tr>\n \n Second Tier<\/td>\n 12.0%<\/td>\n 18.0%<\/td>\n 80%<\/td>\n 20%<\/td>\n $980,322<\/td>\n $245,081<\/td>\n 13.8%<\/td>\n<\/tr>\n \n Third Tier<\/td>\n 18.0%<\/td>\n 21.0%<\/td>\n 70%<\/td>\n 30%<\/td>\n $551,404<\/td>\n $236,316<\/td>\n 13.4%<\/td>\n<\/tr>\n \n Fourth Tier<\/td>\n 21.0%<\/td>\n 24.0%<\/td>\n 60%<\/td>\n 40%<\/td>\n $596,558<\/td>\n $397,705<\/td>\n 22.5%<\/td>\n<\/tr>\n \n Final Tier<\/td>\n 24.0%<\/td>\n 100.0%<\/td>\n 50%<\/td>\n 50%<\/td>\n $737,660<\/td>\n $737,660<\/td>\n 41.7%<\/td>\n<\/tr>\n \n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 TOTAL DISTRIBUTIONS<\/strong><\/td>\n $8,465,723<\/strong><\/td>\n $2,169,759<\/strong><\/td>\n <\/td>\n<\/tr>\n \n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 Investments<\/td>\n ($4,000,000)<\/td>\n ($400,000)<\/td>\n <\/td>\n<\/tr>\n \n \u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0\u00a0 PROFIT<\/strong><\/td>\n $4,465,723<\/strong><\/td>\n $1,769,759<\/strong><\/td>\n 100%<\/strong><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n Conclusion<\/h2>\n
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