Equity waterfall models are one of the most difficult real estate finance concepts to understand. Since cash flow from your investment can be split in a multitude of ways, your waterfall may look different from your partners. However, there’s a general structure that stays consistent.
The waterfall model is a legal term found in an operating agreement that describes how, when, and to whom the money is paid. Both the distributions from cash flow and capital event of the investment property are allocated to the General Partners (GPs) and Limited Partners (LPs).
Think of the waterfall method as a series of pools that are slowly filled up with cash flow. Once one pool is full, it spills into the next. Investors may use this method to reward certain partners with an extra (disproportionate) share, also called a promotion, for motivational purposes.
The General Partner or operating partner has control over major investment decisions, such as when to sell and how much to spend on improvements. GPs expect to receive a promotion that takes their role into account but said promotion depends on the part they play in the transaction.
A GP may participate in finding the transaction, negotiating the transaction’s terms, looking for a loan, calculating the loan's borrowing cost, and managing all aspects of ownership after the fact.
A GP that takes on a significant amount of risk, cost, and time for the project should receive a generous promotion. You won’t do the same for a passive Limited Partner. However, the LP still receives a bigger share of the profits because they’re investing more cash into the project.
A sound commercial real estate investment strategy can pay off, but you need to know what you’re working with. The internal rate of return (IRR) will either be the deal level IRR or the net to the Limited Partner investor level IRR. The return net to the LP investor should take priority.
The deal level IRR calculates return based on inflows and outflows at the property level, but it can’t determine what the investor will receive or what is expected after subtracting fees. But the return net to the LP investor does account for what the LPs and the GPs are going to take.
It’s important to note that the internal rate of return method isn’t the only one used, but it is the most common (and will be used for this article). XIRR and the Equity Multiple are also used.
Most waterfall models will start with a sponsor who offers a preferred return and a skewed split. The sponsor is saying that they’ll offer the investors the pro-rata (proportional) share of the distributable cash flow from the commercial investment once they reach the preferred return.
Let’s assume that the preferred return is 7% and the split is 65/35. Once the investors have received 7% on their investment, the sponsor will receive 35% of the distributions (promote), and the LP will be offered the rest. The sponsor (GP) may be offered less if there are more LPs.
Remember that the terms of your agreement will change based on your operating agreement. For example, you can reset the preferred return percentage or accrue it to the next year.
Here are some other factors that may affect your operating agreement:
Since the waterfall method is difficult to describe in an operating agreement, ask the person writing it to offer a visual breakdown. That way, you’ll know precisely what you’ll potentially earn.