Real Estate Waterfall

How Does the Real Estate Waterfall Work?

The real estate waterfall model is a tier-based system used to illustrate the hierarchy in priority and allocation of fund proceeds.

The real estate waterfall model establishes the order by which the distributable proceeds of a fund are issued to the investors of a fund (or limited partners).

In practice, the distribution waterfall schedule, or “equity waterfall”, serves as the standard tool to track the proper distribution of proceeds for the participants in an investment fund (i.e. the stakeholders).

The core mechanism of a real estate waterfall is structured to align the economic incentives of the general partner (GP) and limited partners (LPs) of an investment fund, like a real estate private equity (REPE) fund.

• General Partner (GP) → The general partner (GP), or “sponsor”, is the active manager of an investment fund responsible for deal origination (i.e. sourcing potential investments), performing diligence, and managing the properties post-acquisition.
• Limited Partners (LPs) → The limited partners (LPs) are the capital providers of the fund. By committing capital to the fund, the LPs are passive investors, for whom the GP is investing.

The underlying provisions of a distribution waterfall – formally stated in the Limited Partnership Agreement (LPA) of the specific fund – set the conditions that must be met for parties to be entitled to receive proceeds on an investment.

These provisions and clauses are what arrange the systematic distribution of fund proceeds, where each stakeholder with a vested interest in the performance of the fund collects their fair proportion of the profits earned.

The mechanics of a real estate waterfall structure can be perceived as a series of tiers (i.e. the “target hurdle rate”), wherein the distribution of proceeds is different per tier. In short, the payoff “stays within” the current tier until the target hurdle rate is met (and then “spills over” to the next tier).

For each subsequent tier, there is a new set of guidelines that dictate the allocation of fund profits.

What is the Preferred Return and Promote (Carried Interest)?

Two of the most common terms stated in the limited partnership agreement (LPA) are the “Preferred Return” and “Promote” (or “Carried Interest”).

• Preferred Return (“Pref”) → Once the limited partners (LPs) are “made whole” and recouped their original capital investment, the subsequent tier is the preferred return (or “Pref”). The preferred rate usually ranges between 6% to 8% on an annual basis, while based on the internal rate of return (IRR) accrued.
• Promote (Carried Interest) → The term “promote” refers to the disproportionate allocation of fund proceeds that flow to the general partner (GP) after reaching the target returns. Often used interchangeably with carried interest (or “carry”), the promote is a performance-based contingency payment and can be thought of as the reward earned by the general partner (GP) for meeting the pre-determined return target. The tier(s) with the promote provision, or carried interest, constitute the main source of returns for a sponsor (GP).

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What are the Components of Equity Waterfalls?

Catch-Up vs. Lookback Provision: What is the Difference?

The catch-up provision ensures that the investor receives 100% of all profit distributions until a predetermined rate of return is met. Subsequently, once the investor attains the required return, all distributable proceeds are allocated to the sponsor until the general partner (GP) reaches parity with the limited partners (LPs).

The investor (LP) receives a full share of the profit until a specified return is achieved under the catch-up provision, after which the sponsor (GP) receives a distribution.

The catch-up provision, akin to the lookback provision, shares many commonalities in terms of the objective. However, the distinction between the two is that the lookback provision necessitates the investor to request a payment from the sponsor on the date of closure.

Until the tier with the catch-up provision, the interests of the sponsor were subordinate to the investors (LPs). Therefore, the sponsor can now “catch up” to an equal footing since the target return was met.

The lookback provision is a clause that provides a fund’s limited partners (LPs) with the right to “look back” and retrieve distributed profits back from the general partner (GP), even if the proceeds were issued to the GP. The rationale for the inclusion of the provision is that if the general partner (GP) is unable to generate a predetermined return for the limited partners, the LPs have the right to collect more proceeds to improve their poor returns.

The lookback provision offers sponsors with the option to allocate funds on investments, even if those proceeds must be returned later – hence, general partners (GPs) tend to view them favorably. In contrast, limited partners (LPs) prefer the catch-up provision, considering the receipt of an upfront payment without the need to request reimbursement from the sponsor at a later date.

How to Build a Real Estate Waterfall Model

The step-by-step process to model a basic distribution waterfall is as follows.

• Step 1 → Quantify the Net Cash Flow (NCF) Available for Distribution (Sum of Levered Cash Flow, including the Purchase Outflow and Sale Proceeds)
• Step 2 → Solve for the Minimum Cash Required to Meet Each Hurdle (Delta Between the Current and Prior Hurdle)
• Step 3 → Input the Profit Split at Each Hurdle (Note: Profit Split ≠ Ownership Split)
• Step 4 → Calculate the Cash Flow Attributable to Each Partner (Including Promote) at Each Hurdle
• Step 5 → Multiply the Required Cash Balance at Each Hurdle by the Coinciding Profit Split
• Step 6 → Reduce Net Cash Flow (NCF) Available for Distribution by the Cash Flow at Each Hurdle

If the model is adjusted properly, there should be no cash remaining to distribute after reaching the final hurdle.