Categories: Education

What is the Waterfall Model for
Commercial Real Estate Investing?

Introduction

Investing in private equity commercial real estate can be financially rewarding, especially when the right waterfall model is used for cash distributions. Although some models call for a pro rata share of the profits based on the equity invested, that is not necessarily the ideal way to structure a private equity investment.

With the right waterfall model for commercial real estate investing, passive investors may achieve returns on investment above and beyond the targeted ROI by building incentives into the model that rewards all partners when an investment overperforms.

Related: What Is Real Estate Syndication

What is the Waterfall Model?

The waterfall model in commercial real estate is used by private equity firms to describe the method of distributing cash flow returns among a group of investors in the project.

You may have seen a champagne waterfall at the last wedding you attended or cruise you took. The glasses are stacked in a pyramid shape, and as the glasses at the top are filled the champagne overflows and fills the glasses below, until the bubbly runs dry.

In commercial real estate, the waterfall model works in a similar way, except cash flow is used instead of champagne. In essence, the waterfall model details how profits from a private equity investment are distributed between the Limited Partners (LPs) and General Partners (GPs).

GPs are the investors who take on an active role in managing the day-to-day operations of the investment, while LPs are generally passive investors who are not responsible for the daily business operations.

The waterfall model in commercial real estate is used by private equity firms to describe the method of distributing cash flow returns among a group of investors in the project.

Because a General Partner is ultimately responsible for how successful the investment is, the commercial real estate waterfall model can also be designed to reward the GP with a bonus – also known as a “promote” or “carried interest” – to incentivize the GP to exceed the anticipated return from the investment.

Of course, the model of the waterfall structure also works both ways. If the project’s return exceeds expectations, the General Partner may receive a higher share of the profits. However, if the returns are lower than expected, then the GP will receive a lesser share of the profits.

Why it’s Important to Have an Owner’s Agreement

An Owner’s Agreement for a private equity real estate investment describes in detail how the cash will flow – or the profits will be shared – between the GP and the LP investors.

There can be quite a few variables in the way a waterfall model is structured. While there are common terms and sections, each model is constructed to meet the unique needs of the private equity investment, Limited Partners, and General Partner. So, it is important for potential investors to read and understand the owner’s agreement.

In most cases, the owner’s agreement will give LP investors a priority of cash flow distributions until the anticipated return has been reached. By putting the Limited Partners first in line to receive cash flows, the General Partner’s interest is better aligned with those of the Limited Partners, because the GP has more direct impact on the project’s success than the passive LP investors.

In most cases, a General Partner will expect to receive an extra share of any excess profits, as compensation for taking on the extra time, effort, expense, and managing potential risk that Limited Partners do not.

For example, a GP is actively involved in decisions such as locating the property, negotiating with the seller, performing due diligence, and structuring equity and debt financing.

Throughout the holding period until the time the property is sold or refinanced, the General Partner is also responsible for leasing the property up, determining what to spend on tenant improvements, the level of rent to charge, property management, when to refinance, and determining the exit strategy that will achieve and exceed the projected ROI of the investment.

Related Link: How to Recession-Proof Your Real Estate Portfolio

What are the Common Real Estate Waterfall Model Components?

The Preferred Return

Preferred return (or “pref”) is the order in which the Limited Partner investors and General Partner are repaid their initial investment, along with their corresponding share of the profits, until the target return has been reached.

Another way of thinking about preferred return is that LP preferred investors will receive their profit distributions before the other investors and the GP, because they are first in line. Once the return threshold has been met, excess profits will be distributed as agreed to in the owner’s agreement.

For example, assume the waterfall model for a private equity real estate investment offers a 10% preferred return and a 80%/20% split for returns above the 10% threshold.

That means Limited Partner preferred investors will receive their proportional share of the distributable cash flow until they have received a 10% ROI. After that, all equity investors will be repaid their initial investments in full. Once equity investors have received their capital back, 80% of any additional profits will be distributed to LP investors and 20% to the GP as a promote.

While the concept of preferred return is easy enough to understand, there are several questions investors should ask before committing money to a private equity real estate opportunity:

  • Does the preferred return apply to all equity investors or only certain equity investors, and can the GP also receive a preferred return on its capital invested?
  • If the 10% preferred return is not reached in a given year, will the shortfall be made up in subsequent years or does the preferred return calculation restart at the beginning of each year?
  • Is the preferred return compounded at the preferred rate of return, and what is the compounding period, such as monthly, quarterly, semi-annually, or annually?

The Return Hurdle

In track and field, hurdling is an event where a runner sprints over a series of obstacles that are a fixed distance apart. The return hurdle in private equity real estate works in a similar way.

A return hurdle is the rate of return that must be crossed before the cash flow can run to the next hurdle in the waterfall. A waterfall model for commercial real estate investing may have multiple hurdles rates and are often measured based on internal rate of return (IRR) or Equity Multiple:

  • IRR is the percentage of interest earned on each dollar invested over the entire holding period. The IRR calculation is best for real estate investments held over the long term, because it provides a more precise picture of the returns a private equity opportunity will generate from beginning to end.
  • Equity Multiple is calculated by dividing the sum of equity investment plus all profits by the total amount of equity invested. As with IRR, the Equity Multiple ratio is especially useful for commercial real estate investments with longer holding periods because it provides a better understanding of total cash return over the entire holding period of the investment.

When analyzing a private equity real estate deal, an investor should understand from whose perspective the return hurdles will be measured. For example, the hurdle rate could be based on the entire project which may include both the General Partner and Limited Partner investor equity. Or, the return hurdle could be based on only the LP equity, or only the GP equity.

Understanding the net return to a Limited Partner is important, since it measures the anticipated inflows and outflows LP investors may potentially receive, including the returns and promote paid to the GP.

Catch Up Provision

Cash flow distributions in an equity waterfall can be structured to distribute cash flow as a simple split to Limited Partner investors and the General Partner, with a lookback provision, or with a catch-up provision.

A waterfall model with a catch-up provision requires that LP investors receive 100% of the property’s preferred return until the predetermined rate of return has been reached.

Once the preferred rate of return hurdle has been crossed, only then do proceeds begin flowing to the General Partner. Distributions to the GP continue up until the point where the General Partner has “caught up” or received its rate of return specified in the owner’s agreement.

Limited Partner investors typically prefer an equity waterfall with a catch-up provision, because they get paid first before the General Partner receives any returns. On the other hand, a General Partner may prefer a waterfall model with a lookback provision since they have use of the LPs’ money even if they have to give it back at the end of the period.

Lookback Provision

A lookback provision in a waterfall model for commercial real estate is used to incentivize the General Partner to outperform by generating larger equity and higher cash returns for the Limited Partner investors.

Referencing our previous example, if the GP was able to only achieve the targeted 10% IRR, then the split would remain at 80%/20%, with LP investors receiving 80% and the GP receiving 20%. However, the lookback provision can be structured to compensate the General Partner for overperforming on a private equity deal, in any manner that the Limited Partners and General Partner are comfortable with.

For example, if the GP was able to achieve an IRR of 12% in a given year, the split may change to 70%/30%. If the General Partner was really able to outperform and achieve an IRR of 15%, the split could change to 60%/40%, and so on. Although the split changes in favor of the GP for hitting a home run each year, LP investors are still getting better returns than originally anticipated.

Of course, the lookback provision can also work in reverse.

This occurs when the General Partner and Limited Partners lookback over the entire holding period. If the LP investors did not receive the promised rate of return, the GP would be required to return the portion of the profits needed to provide the Limited Partners with the predetermined rate of return.

Breaking Down a Waterfall Model

A typical waterfall model for commercial real estate may consist of four levels or hurdle rates:

  • Level 1: Return of capital with 100% of the distributed cash flow going to the Limited Partners.
  • Level 2: Preferred return hurdle rate with cash flow distributed to the LPs until the preferred rate of return on the investment is reached.
  • Level 3: Catch up provision where cash flow is distributed to the General Partner until the GP receives its predetermined percentage of the profits.
  • Level 4: Lookback provision with the GP receiving a disproportionate share of the distributions if the investment performs better than expected.

Waterfall models in private equity deals can be structured in a countless number of ways. For the sake of simplicity, here’s how a waterfall model for a private equity commercial real estate opportunity might be structured with an anticipated IRR of 10% and an 80%/20% split:

LevelIRRDistribution
1Up to 10%80% LP, 20% GP
210% – 12%70% LP, 30% GP
312% – 15%60% LP, 40% GP
415%50% LP, 50% GP

Under this waterfall hurdle structure, the LP investors would evenly share profits with the GP when the IRR is 15% or greater, regardless of the amount of equity the General Partner put into the deal. This is an example of the “promote” bonus to the GP discussed at the beginning of this article.

Final Thoughts on the Waterfall Model

Waterfall models in commercial real estate can be difficult to develop and understand, even for investors with years of experience.

For example, although retail, office, and hospitality projects may promise over-sized returns to the opportunistic investor, there is arguably a higher level of risk to investing in these asset classes. Minimizing risk and maximizing potential returns are two reasons why many investors choose to diversify their portfolios with private equity multifamily investments.

Investing in private equity commercial real estate can be financially rewarding, especially when the right waterfall model is used for cash distributions.

Determining partner profit distributions for a multifamily property is relatively straightforward, especially for a company like Smartland that understands how to uncover hidden value in ways that traditional investors do not.

With expert renovations and state-of-the-art Class A technologies going into Class B units, Smartland is able to generate higher rents and longer leases. In turn, this leads to a greater return of capital for the partners investing alongside Smartland, while building wealth today and for future generations to come.

Are you interested in learning more about Smartland’s investment strategy? Contact us today.

Related Link: The Ultimate Guide to Investing in Rental Properties


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