The Waterfall Model: Real Estate Cash Flow Distributions Defined

Are you looking at real estate as a way to diversify the cash returns from your investments?

Investments in real estate, both large and small, can reward you with significant cash flow. But understanding how this cash flow is distributed is key to planning your investment returns. The waterfall model is the most common method of distributing cash flows from an investment property.

The Waterfall Model defines the hierarchy of real estate investments, which allows all parties involved — including the operator and other investors —to remain on the same page when it comes to payments. This model also helps real estate operators plan their finances more accurately by determining when each investor will receive their returns.

In this blog post, we’ll discuss what exactly a real estate waterfall model is and why understanding this concept can help you make smart investment decisions.

What Is The Waterfall Model In Real Estate Investing?

The waterfall model in commercial real estate is a legally binding agreement between the operator and other investors. It describes how and when money gets paid to the investors and the hierarchy of investors. The waterfall model is also known as a “cash flow waterfall” or “equity waterfall”. This document is essential for all parties involved in a real estate investment.

Essentially, the real estate waterfall model states that when a real estate investment produces cash flow, each party receives its share in an orderly fashion.

This means that the investors are ranked and paid out in order of seniority. The most senior investors are paid first with any remaining money going to lower-ranking investors.

Many real estate investments don’t produce a large amount of cash flow initially. This is why it’s important to establish a real estate waterfall model that reflects the long-term nature of real estate investments. This way, all parties can be adequately rewarded for their contribution to the deal.

Who Uses The Waterfall Model?

The equity waterfall structure is used in commercial real estate investing. In particular, partnership, syndication, and crowdfunded investments typically use a waterfall as a way to both reward investors and incentivize sponsors.

This model is most useful when different classes of investors provide different investments or services for the property. The private equity waterfall allows these different investor classes to have different reward structures.

Typically, waterfall structures reward passive investors first through a preferred return because they are putting money at risk in the transaction. After the passive investors (or limited partners) gain some predefined reward level, the sponsor (or general partner) starts to receive some reward. This incentivizes the sponsor to manage the asset well and produce a high level of financial performance.

If you’re interested in learning more about how real estate syndication works, check out our resource on multifamily syndication.

How Does The Waterfall Model Work In Real Estate?

As mentioned previously, the waterfall model is intended to describe the order in which different classes of investors receive their payments from the cash flow generated by the investment.

Typically, a waterfall will first reward the passive investors (also called limited partners) for risking their capital. This is called a preferred return. Once the limited partners reach a certain level of return, the waterfall will start to reward the general partners who operate the asset. This structure of rewards places expectations of performance on the general partners.

For instance, limited partners might earn a 6% preferred return. This means the first 6% of the free cash flow gets distributed to the passive investors. Once the internal rate of return on the property exceeds 6%, the cash flow is then split between the general partners and the passive investors. This might be a 70/30 split with 30% of the cash flow being paid to the general partners and 70% to the limited partners.

Many real estate waterfall models feature multiple tiers which progressively favor payments to the general partners. The example above might feature an additional tier when the internal rate of return exceeds 15%. At this point, the distributions might be split 50/50.

All of these thresholds and percentages are up to the syndication to define in the operating agreement. And note that syndications may define “rate of return” or “performance” differently. You should read the operating agreement so you know what kind of return you should expect.

What Is A Good Return From An Equity Waterfall Based On Invested Capital?

Since each real estate partnership is different, “good” can be very subjective when discussing returns. However, real estate waterfalls that feature 6-8% preferred returns and 12% or more return on investment are good investment deals.

Another good way to look at it is to compare the real estate investment to an investment in the stock market. If you invested in the S&P500 index, you should expect around an 8% average annual return and a 1% dividend return. If you’re a savvy investor looking for cash flow to fund your expenses, this simply won’t cut it.

Investing in private equity real estate investments can yield significantly higher cash flow for you through the preferred return. And you’ll get appreciation as a bonus.

Check out our review of syndication platforms that can offer you the best returns if you’re ready to get started.

Benefits Of Private Equity Waterfalls

Investing in private equity real estate has several benefits for investors. Every investor needs to look at their individual goals and investment strategy to decide if real estate investments fit in their portfolio.

Let’s take a look at some of the benefits of adding real estate waterfalls to your investment portfolio.

Diversification

One of the biggest benefits of investing in real estate is diversification. Real estate adds another asset class to most investors’ portfolios.

Beyond the diversification of asset classes, a distribution waterfall adds another return profile. While stock investments typically favor appreciation over cash flow, real estate waterfalls do the opposite and favor cash flow distributions. This can be a huge benefit for investors living off of their portfolios because it creates a reliable flow of income.

High Distribution Of Cash Flows

The cash flow distributions from an investment in a private equity fund or other waterfall structure are typically much higher than other asset classes.

Waterfall structures can yield from 6% up to 15% or more cash flow returns. Compare that to stock market dividends at 2-4% or bonds, which vary greatly over time, but often yield 5-7%.

Equity Increase

Because a real estate equity waterfall invests in real estate, it also features an aspect of equity increase. This comes through either debt paydown, or asset appreciation, or most times both.

Compared to an annuity that might have the same cash flow distributions, the real estate equity waterfall will add inflation protection through increases in equity.

Favorable Tax Treatment

Because most private equity waterfall structures are based on a partnership, the tax treatment of the business flows through the business and to the investors. This means investors in private equity real estate gain all of the tax benefits real estate has to offer.

Passive Real Estate Investment

Real estate is not a passive investment. Don’t let anyone tell you it is. Even if you have a property manager, you still need to manage them and make decisions for the property.

Private equity real estate limits that active investment to the general partners. The limited partners are simply passive investors. So, investing in a private equity waterfall will give you the exposure to and benefits of real estate without having to play an active role in the management of the asset.

Rewards Investors First

Almost every waterfall structure will provide distributions to the investors first. The investors have capital invested at risk so it makes sense for a real estate equity waterfall to reward them first. The sponsors don’t take on this same risk.

Incentivizes Sponsor Performance

One big concern for any managed investment is ensuring the managers do the best they can do for the investors.

In a real estate equity waterfall, this is done by creating a return hurdle that must be met before the sponsors get rewarded. This ensures the correct incentives to align the goals of the sponsor and investors.

Waterfall Terms In The Operating Agreement

Now that we’ve looked at what a private equity waterfall is, how it works, and its benefits, let’s take a look at some of the terms you’ll come across when evaluating your investment options.

Internal Rate Of Return

The internal rate of return is one way to measure the performance of an investment opportunity. In a private equity waterfall, this metric is often used to define the performance that must be met to move to the next tier of the waterfall structure.

The IRR calculation is complex and accounts for all types of return on investment including operating cash flow, refinance, and sale of a property.

Return Of Capital

Most waterfall structures feature a return of capital that ensures the investors eventually get their money back. Typically, through capital events such as refinancing or the sale of the property, a significant amount of capital is injected into the real estate.

At these times, the return of capital stipulates that, before any distributions are made, the investors must first be paid back their initial investment. Once the initial investment is repaid, the excess capital is split based on the terms of the waterfall structure.

Return Hurdle

The return hurdle is the performance that must be met for the waterfall to move into the next tier. The first return hurdle (also called the preferred return hurdle) is typically the preferred return rate, and further return hurdles can be at 10%, 15%, and 20% for example.

The return hurdle is completely up to the terms of the agreement and is different for every distribution waterfall. Most real estate syndications use IRR to measure the hurdle rate, but others use equity multiple hurdles.

Preferred Return

The preferred return is the cash-on-cash return enjoyed by the preferred investors. This is usually the first tier in any real estate waterfall model and ensures the investors who risk their capital are rewarded first. This will vary for different distribution waterfalls but often falls in the 5-8% range.

When operating profits come into the property, it is first paid to the real estate investors through the preferred return. Once the preferred return has been fully paid, excess cash flow will be distributed to the next bucket of the waterfall.

The Promote

The promote is the next bucket in preferred return waterfalls. This takes effect once the investors achieve the state rate of the preferred return.

This bucket in the waterfall is intended to incentivize and reward the operating partner in the deal. In this bucket, excess cash flows are split between the passive real estate investors and the operating partner. The percentage split varies across real estate deals with a range of 20% to 50% awarded to the operator.

Loopback Provision

The loopback provision helps real estate investors keep the operator accountable for maintaining high returns. In effect, the loopback provision requires the operator to pay back returns they have received if the IRR drops below a certain threshold.

Catch-up Provision

The catch-up provision favors the general partner as it allows the general partner to “catch up” to the returns earned by the passive real estate investors after the preferred return has been met.

What this means is that the passive investors will get 100% of the returns until the preferred return is met. After this, the general partner will receive 100% of the returns until they have received the same returns as the limited partners.

This provision creates a tier in the waterfall model right after the first, preferred return tier. Not all waterfall models feature this provision, but beware if you see it, because it heavily favors the operator.

Clawback Provision

The clawback provision allows passive investors to reclaim any fees collected by the sponsor that were charged in error. Whether the error was intentional or not doesn’t matter; this provision simply states the requirement that the sponsor must pay them back to the investors.

Capital Event

A capital event is anything that injects capital into the real estate deal. The two most common capital events in real estate investing are cash-out refinancing and the sale of the investment property. When these events occur, a significant amount of cash comes into the balance sheet. The operating agreement should clearly define what happens in these situations.

Cumulative And Non-Cumulative Returns

What happens if the cash flows from the property don’t support paying the preferred returns in full? This is a common occurrence, especially in the early phases before the real estate project has completed the changes required to generate its targetted returns.

The question to ask is whether the returns are cumulative or non-cumulative. If the returns are cumulative, preferred returns that cannot be paid immediately are still owed to the investors. Once the real estate project is generating enough operating cash flow, these returns will be repaid from the excess profits.

In contrast, non-cumulative returns will not be paid back to the investors. If the preferred return hurdle can’t be met, the investors simply don’t receive the payment.

Different Investor Classes

One big feature of the waterfall model in real estate investing is the different classes of investors. Different classes define how different investors get rewarded.

Having different investor classes allows the waterfall to handle cash flow splits unequally for the different sets of investors involved. Investors receive rewards and incentives based on their type of activity or investment in the real estate project.

Let’s dive into the most common classes of investors in real estate waterfalls.

General Partner

The general partner is an active member of a waterfall. They handle everything from the acquisition, financing, operation, distribution of available cash flow, and sale of the property. In larger deals, there is often more than one general partner due to the amount of work involved in managing larger assets. General partners are often referred to as operators or sponsors in the deal.

The general partners are incentivized to create a high level of financial performance for the investment property. This is done by weighting their rewards to higher tiers of the waterfall. The investment must reach a certain return hurdle before these partners start collecting performance-based rewards.

Limited Partners

Limited partners, on the other hand, are passive investors in the deal. This class of investors provides a large majority of the initial equity investment to fund the deal and does not have any requirements to operate or manage the property.

Each syndication can have 10s, 100s, or 1000s of limited partners funding the investment property. If you’re investing in real estate through a crowdfunding platform, you are most likely to be part of this investor class.

Other Investor Classes

In addition to the first two investor classes, some real estate projects have more investment tiers. These can be in the form of debt investments, as a means to introduce non-accredited investors, or as a way to reward investors who provide large amounts of capital to the project.

The definition and handling of each investor class is completely up to the syndication. Keep in mind that the only money that can be paid out is from the remaining cash flow after all operating expenses have been paid. There may be some cases where the available cash flow isn’t sufficient to pay all investors, so you’ll want to read the terms carefully to know where your tier stands in relation to all the other investors.

Cash Flow Distribution

The primary purpose of a waterfall in real estate investing is to determine how to distribute excess cash flow to the investors.

You can think of the waterfall model as a series of buckets. Cash flows into the first bucket until it is filled, then it starts to fill the next bucket. Buckets get filled progressively after filling the previous bucket until all of the excess cash flow is depleted.

Let’s take a look at some common tiers that are featured in most investment waterfalls.

Preferred Return

Often the first bucket in a waterfall, the preferred return tier is intended to first reward passive investors for risking their invested capital. This tier typically pays the investors between 5-8% return of the first operating profits.

In this tier, the managing partners don’t receive any compensation from cash flows.

The Promote From Excess Cash Flow

Once the preferred return hurdle is met, additional cash flow gets divided between the different classes of investors. The sponsor will receive anywhere from 10% to 50% of the excess cash flow. The remaining operating profits are distributed to the passive partners based on equity share.

The money allocated to the sponsor is called the promote. It is intended to incentivize the sponsor to achieve a high level of return by delaying compensation until that return hurdle is met.

Multi-tiered Equity Waterfalls

Larger real estate deals, or a real estate portfolio deal may introduce multiple tiers in the waterfall. They still feature the preferred return hurdles as any other deal, but progressively award more to the sponsor as the return increases.

For instance, the first tier after the preferred return of 5% may award 20% to the sponsor. Once the return increases to 10%, the sponsor may receive 30% of the remaining cash flow. After a 15% return, this may increase again to 40%.

There is no specific template for the thresholds or allocation; this is up to the syndication to decide.

Real Estate Waterfall Model Examples

Let’s apply what we’ve covered and see some waterfall models in action. We’ll examine a simple two-tiered waterfall and a progressive, multi-tiered waterfall below.

Simple Two-Tiered Waterfall Example

For the first example, let’s look at a simple two-tiered waterfall. This structure is more common in smaller real estate deals. Often these are done with family and friends, or a small group of investors.

In this example scenario, let’s say a property was purchased for $2,000,000 with a 75% loan. The investors contribute $500,000. The agreement features an 8% return hurdle with a 70/30 equity split.

In the first year, the property brings in $35,000 in profits. Since this is less than the 8% return hurdle of $40,000, the profits get split fully among the investors based on their equity share.

The property performs much better in the second year bringing in $50,000 in profit. Because this exceeds the return hurdle, the remaining $10,000 is split between the investors and the sponsor.

Let’s assume the $500,000 investment was made with 4 investors. One investor contributes $250,000, two investors contribute $100,000 each, and the last investor contributes $50,000. Here’s what the payout for each investor looks like.

Multi-Tiered Waterfall Example

Now let’s look at a little more complicated example featuring multiple return hurdles. You’ll likely encounter these in large investment deals. With this arrangement, the sponsor earns a progressively larger portion of the total cash flows as the return increases.

For this example, we’ll set the return hurdles at 6%, 8%, and 12%. After reaching the 6% hurdle, the sponsor will earn 20% of the return. After 8%, they earn 30%, and after 12% they earn 50%.

This is a larger deal than the previous example, so let’s say the property costs $50,000,000. Investors contribute $12,500,000 towards the purchase of the investment property.

The first year, the property brings in $500,000 profit followed by $900,000 the second year and $1,750,000 the third year.

Multi-Tiered Waterfall Example With Cumulative Returns

Since the first year didn’t reach the initial return hurdle, the investors didn’t receive their full 6% returns in the previous example. This shows non-cumulative returns.

If the operating agreement features cumulative returns, profits from the second year would be owed to the investors for the difference between the return hurdle and the actual returns in the first year.

Here’s what that looks like.

Comparing the income split between the examples with and without cumulative returns is interesting. Over 3 years, investors without cumulative returns earned $2,795,000 while investors with cumulative returns earned $2,875,000. We can see in these examples that cumulative returns benefit investors.

Summary

The real estate waterfall model is a powerful tool for real estate investors, developers, and operators to structure their deals. It ensures that the proper returns are distributed among all parties involved equitably.

Whether you’re investing in a simple two-tiered deal or something more complicated with multiple tiers and cumulative returns or catch-up provisions, it’s important to understand how these models work before getting into any real estate investment agreement.

With this knowledge of real estate waterfalls under your belt, you’ll be better equipped to make smart investment decisions.