The Basics of a Real Estate Equity Waterfall
In the real estate finance world, there are few concepts more difficult to understand than the almighty equity waterfall.
So…What Is the Equity Waterfall?
When someone refers to the equity waterfall in real estate, they’re essentially talking about how cash flow from an asset will be distributed and when. There are countless ways to structure these distributions, which is what makes the equity waterfall concept so complex—and in practice, even harder to model.
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.
In this post, 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’ll have mastered one of real estate’s most intimidating components!
Why Is It Called A Waterfall?
At first glance, the term “waterfall” might not be one you would expect to see applied in real estate, but a deeper look behind the name reveals why this term is, indeed, quite appropriate.
The term “waterfall” stems from the idea that cash flow from commercial real estate projects flows to different parties in numerous ways. The profits gather in a “pool” until that pool is full, at which point the profits spill over to the next pool of investors in a tiered fashion.
It’s actually quite similar to when water gathers at the top of a waterfall and then, after reaching a certain threshold, spills over to a pool below—sometimes multiple times. Just as nature’s waterfalls can have numerous pools below, so too can real estate waterfalls.
In most equity waterfalls, the profits of a project are split unevenly amongst the project’s partners. Operating partners (e.g., the sponsor or real estate developer) are given a disproportionately larger share of the profits if the project beats expectations.
This extra slice of the pie is referred to as the “promote.” Promotes are used as a bonus to incentivize the developer to exceed return projections.
Common Equity Waterfall Terms Explained
It’s helpful to understand a few terms that are often used when discussing real estate equity waterfalls. These are all important features involved in the structure of a waterfall. Understanding these terms will help you understand why certain tiers of a waterfall function the way they do.
Pari Passu: A Latin term used to describe the equal treatment of investors, returns or securities. In real estate, the term is commonly used in waterfall distribution models to reference the pro-rata distribution of profits based on each investor’s initial equity contribution percentage. In other words, if you invested 10% of the initial equity requirement, then you would be entitled to 10% of the cash available for distribution.
IRR: The internal rate of return on an investment is the annualized effective compounded return rate, or the rate of return that sets the net present value of all cash flows (both positive and negative) from the investment equal to zero. Equivalently, it is the interest rate at which the net present value of the future cash flows is equal to the initial investment, and it is also the interest rate at which the total present value of costs (negative cash flows) equals the total present value of the profits (positive cash flows). IRR also accounts for the time value of money and investments. A given return on investment received at a given time is worth more than the same return received at a later time, so the latter would yield a lower IRR than the former, if all other factors are equal.
Equity Multiple: In real estate, the equity multiple is defined as the total cash distributions received from an investment divided by the total equity invested. Essentially, it’s the multiple of how much money an investor could make on their initial investment. An equity multiple LESS than 1.0x means you are getting back less cash than you invested. An equity multiple GREATER than 1.0x means you are getting back more cash than you invested.
Return Hurdles: A return hurdle defines the rate of return that must be achieved before the cash flow can move on to the next tier of the equity waterfall process. Most waterfalls have multiple return hurdles. These return hurdles are often based on an internal rate of return (IRR) or equity multiple.
Preferred Return: At the most basic level, the preferred return refers to the order in which partners are repaid their equity investment plus their share of the profits until a certain return threshold has been met.
Catch-Up Provisions: Whereas some equity waterfalls are structured to distribute cash flows to different parties during the course of the deal, other equity waterfalls are structured with what’s known as a “catch-up provision.” A catch-up provision might stipulate that the limited partner will receive 100% of the investment’s preferred return, and after achieving that rate of return, all proceeds will then go to the general partner until they’ve received a specified rate of return.
A Typical Real Estate Equity Waterfall Structure
Many equity waterfalls in real estate commonly have four tiers. As described above, the first tier is where the cash flow builds into a pool—and once that pool overflows, the profits flow down to the next tier. The tiers listed below are just examples and can vary by investment.
Tier I—Return of Capital: In this tier, 100% of cash flow distributions go straight to the LP, or if distributions were being made “pari passu”, then each investor would be entitled to their share based on their portion of initial equity contribution.
Tier II—Preferred Return: All cash flow is distributed again until a preferred return on the initial investment is achieved, which can be all to limited partners, or “pari passu” depending on each party’s initial equity contribution. The preferred return is sometimes referred to as the “hurdle rate” and typically ranges from 6-10% or more.
Tier III—Catch-Up: Should there be one, this is where the catch-up provision comes into play. All distributions in this tier go to the GP until they achieve a certain percentage of the profits to “catch up” to the limited partners.
Tier IV—Carried Interest/Promote: At this point, the GP, or sponsor, receives a disproportionately larger share of the cash flow distributions in the form of promotes until all cash flow is exhausted.
Conclusion
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 profits from a specific project, and the above-mentioned provisions are just examples of how they could look. In breaking down the different features of an equity waterfall, you can gain a clearer understanding of how a project’s returns will be distributed to whom and when. Should you need guidance on understanding equity waterfalls, or what structure may be best for your project, contact Realty Capital Analytics for a complementary consultation call.
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