How do waterfalls work in a syndication? That’s what we’re going to be talking about right now. My name is Tilden Moschetti, I am a syndication attorney with the Moschetti Syndication Law Group.

You may be wondering to yourself exactly how distributions are going to happen, what are these things called waterfalls that you hear about, what are preferred returns? How does it all fit together? That’s what we’re going to be discussing now. Let’s go to our whiteboard and take a look at a very simple scenario so that we can better understand.

Let’s say we have a property that we bought for $5 million, all cash. We raised that $5 million entirely from investors just for the ease of doing the analysis. Out of that $5 million, it pays rents. That’s how most properties operate. They pay rents, and then there’s some sort of appreciation that gets distributed at the end.

Let’s say we’ve told our investors, “Hey, look, investor, we’re going to give you this deal. We’re going to give you a preferred return, also called a pref, of 7%. Any money that comes after that preferred return of 7%, we are going to split 70/30 – 70% to you, investor, and 30% to me as the syndicator.”

Now, let’s look at it from the investor’s point of view and the sponsor’s. Let’s say those rents are being collected, and we’re getting about $550,000 annually on that investment. First, we take that $550,000, and we need to give that preferred return, this pref, to the investors first. That’s the first thing that happens on all those cash flows.

They first get 7%, which equals $350,000. Why $350,000? Well, it’s 7% of $5 million, which we paid for the property. So that is their annual preferred return amount that they’re getting.

On top of that, there’s still this amount of money, $200,000. The $550,000 minus the $350,000 is $200,000, which still needs to be divided between investors and the sponsors. That $200,000 is split 70/30. So the investors get another $140,000 (70% of $200,000). The sponsor gets 30% of that $200,000 leftover, so they get $60,000.

Out of those cash flows, you as a sponsor are getting $60,000 every year. This is after fees have already been taken into account. The investor is getting $350,000 plus $140,000, so they’re getting $490,000 paid out to them every year as part of their investment. Pretty good deal. That’s a nice return.

Now, let’s say you’ve decided to sell the property in year five. You are able to sell the property for $6,500,000. How do we divide up that amount of money? First, we have to return to investors their principal. How much they initially gave you was $5 million, remember?

After the payment of their principal, we then need to pay them the preferred return. But actually, we don’t. Let’s say that sale is paid at the end of year five, and we’ve been paying regularly those preferred returns at that 7%. So at the end of year five, on December 31, that preferred return has already been paid.

So now there’s just the division of the assets that are remaining. We have to return their capital, which leaves us with $1.5 million to divide between the investor and the sponsor. 70% of that return belongs to the investor, which is $1,050,000. The remaining $450,000 gets paid out to the sponsor.

So now the investor gets $6,050,000 at the end of the investment. How do we figure out what the internal rate of return is? For this, you’re going to need a calculator. We draw what’s called a T-bar. A T-bar says we start at time zero, where they paid out $5 million. And then we held that for one year, two years, three years, four years, and five years. Remember, in those years, we were making payments of $490,000.

Then we also have this payment of $6,050,000. So that total is $6,540,000. What you do is you select this entire range, put it in Excel, and it tells you what the answer is. It’s been a 13% annualized return that the investor has gotten. Not bad. So the IRR is 13%.

Hope that explains a little bit on how you do these waterfalls, how you do those preferred return payments, and how you split out the cash for typically a real estate investment, but really any kind of syndication. This is how the water flows.

If I can be of any assistance to you, my name is Tilden Moschetti. I’m a syndication attorney with the Moschetti Syndication Law Group. We specialize in Regulation D Rule 506b and 506c syndications and funds.