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Real Estate Syndication Waterfalls

By: Tilden Moschetti, Esq.

Many investors with experience in the property market suffer from not having enough capital to go after large-scale projects. As a result, they start wondering how to find investors for real estate that can bring the necessary capital to the table to meet the down payment requirements or buy an entire property.

The beauty of real estate investing is two-fold. On the one hand, it’s a powerful wealth-building industry. The other benefit is that certain methods can lower the investment entry barrier considerably. They can even allow someone to earn a share of the profits of an income-generating property without putting any of their own capital into the deal.

Such scenarios usually involve setting up a real estate syndication which is a partnership between a sponsor or general partner and passive investors, known as limited partners.

These legal entities often pool together the investors’ financial resources and knowledge of the sponsor to go after big real estate properties that can create substantial cash flow. The cash flow and profits are split between all parties in accordance with an agreed-upon payment structure – including rent, refinancing, or sale profits.

Similar to crowdfunded real estate, a syndicate enables a sponsor to get involved in a property without buying equity and earn rewards depending on how the asset performs.

The issue with doing these deals is that they can be structured in many ways, and this is where some sponsors get stuck. With that in mind, learning about real estate syndication waterfalls becomes mandatory to increase your chances of putting together a profitable and attractive deal for accredited investors.

Waterfall Cash Flow Distributions

Imagine an actual waterfall. Excess water flows over a ledge into another body of water. Once it reaches another threshold, the water can flow over a new ridge and pour into a new body of water.

Now picture water being the cash flow and the ledge what’s known as a hurdle rate.

The cash flow has to hit a certain threshold, after which the revenue gets distributed between the general partner or sponsor and the limited partners.

Up until reaching the hurdle rate, all partners take profits reflective of their stake in the investment. For example, if someone put up 90% of the money, they would be entitled to 80% of the profits. However, once the revenue meets the hurdle rate, the general partner is allowed to alter the distribution of the excess financial gains, such as claiming a percentage of profits the limited partners would make.

In a real estate syndication deal, waterfall cash flow distributions can get highly complex, even though the concept is simple enough to grasp.

Waterfall Components

One of the first elements you have to understand is the return hurdle. This term indicates the rate of return threshold required before the investors are entitled to cash flow distributions.

In most deals, waterfalls can feature multiple hurdles, essentially creating layers of reward tiers. Now, a return hurdle is usually based on reaching a set internal rate of return, and on some occasions a predefined equity multiple.

The hurdles are the triggers for a disproportionate distribution of profits. The way that they’re structured often provides the general partner or sponsor with added incentive to manage the investment property as efficiently as possible.

Sponsors make more money the higher the return on the property asset. Here’s an example of how this would work. Say a property has an IRR of 8%. The cash flow distribution has an 80/20 split between the limited partners and the general partner. Once reaching the hurdle, the split changes into a 70/30 distribution model, wherein the sponsor becomes entitled to a larger share of the profits.

Alongside other waterfall components, you’ll often hear the term preferred return. This is the initial claim on profits generated by the real estate asset by investors. The preferred return is a return on their investment that general partners distribute prior to reaching a particular target threshold.

In many ways, this is similar to how a bank pays interest. However, there are some differences. In real estate syndication, the preferred return can be current or accrued. Banks, on the other hand, typically pay current. Furthermore, the preferred return isn’t guaranteed. Investors get paid first, as long as there are profits to distribute.

Once the preferred return hurdle has been reached, any money generated over that by the property gets split between the general partner and limited partners.

Another common component of a waterfall cash flow distribution structure is the lookback provision. It happens when payouts occur before the asset’s disposition. These agreements usually state that sponsors have to relinquish a share of the distributed profits to make up for the difference between the pre-agreed upon rate of return, should investors not receive their entitled amount.

In most cases, this would force sponsors to meet the predetermined return, even if it would imply dipping into their own profits or proceeds of the sale. Lookback provisions are excellent motivators for general partners to perform their management duties.

The catch-up provision is another potential component featured in real estate syndication waterfall payment structures. Under this condition, investors would be entitled to 100% of any profit distributions until they meet the predetermined rate of return as stipulated in the agreement.

Once investors reach their return levels, the profit distribution shifts to 100% in favor of the sponsor until they also get the same return as the limited partners. Naturally, most sponsors prefer agreeing to a lookback provision. It enables them to get a share of the profits faster, which means they can use that money to finance other deals. Investors tend to favor the catch-up provision as it prioritizes their payment.

Calculating Waterfall Breakpoints and IRR

Most waterfalls come with an offer of 8% preferred return followed by 90/10 or 80/20 splits between investors and general partners. However, hitting a certain internal rate of return can trigger different splits, such as going to 70/30 or 60/40, with each split earning the sponsor a higher share of the profits.

Commonly accepted internal rates of return fall within the 12% to 15% range. It’s worth noting that the IRR is the standard metric for measuring and creating waterfall breakpoints.

It is essential, therefore, to fully understand this component in order to structure a syndication waterfall deal with passive real estate investors.

The IRR generally likens future returns to the initial equity investment. It’s a project of potential returns based on how much cash is put into a deal. This calculation can tell partners how much money they can expect to make annually for the entire duration of the deal.

Furthermore, the IRR metric is featured in capital allocation calculations. Imagine having a target annual return threshold you have to meet before you can move forward with a deal. Say that means getting a 10% annualized return on the investor capital. Using the IRR, you can project and compare the potential return from multiple deals and compare your desired target returns.

Of course, no two real estate syndication waterfalls are the same. Every deal could have different provisions, thresholds, and cash flow distribution tiers. Understanding the fundamentals of a real estate syndication waterfall is enough to get you started. Yet, it’s good practice to also enlist the services of a qualified real estate syndication attorney when drafting the offering documents.

Waterfall Examples

To further clarify the structure and shine a light on its flexibility, here are a couple of examples of how waterfalls look in real estate syndication deals.

The Basics of Waterfall Structures

In around 75% of cases, most waterfall deals call for two equity splits. After meeting the preferred return requirements, profits will see a 90/10 division between investors and sponsors, followed by an additional 80/20 split upon reaching another threshold.

The dominant preferred return in the industry is 8%. However, other deals may offer a lower 7% return. It’s not likely to see rates over 10%, although some unique projects might go as high as 22% on the preferred return. These structures are usually reserved for costly deals with massive upside potential.

Within a waterfall structure, the IRR metric determines up to 85% of the hurdles in all real estate industry segments. That said, things like equity multiples, return capital percentages, and other hurdles could be used on a case-by-case basis. In any event, it’s important to understand that with rare waterfall models, or highly complex ones, sponsors put an emphasis on structure rather than calculations.

The organizational structure can have multiple entities, including a breakdown of general partners and limited partners into various classes. The waterfall structure can also see different distribution hurdles and splits. Although quite uncommon, plenty of waterfall structures can feature up to 10 layers of different calculations.

Similar to how some stocks have common and preferred stocks, a waterfall may have classes A, B, and C of investors.

For example, Class A investors may be entitled to a 10% preferred return and an 80/20 split of the profits after reaching a specific threshold.

Class B investors may only get an 8% preferred return and a 70% stake of the profits, thus bumping the sponsor’s promote reward to 30%.

With Class C investors, the distribution structure can look completely different. They could receive a 10% preferred return, 80% of profits, but only upon reaching a 15% IRR threshold. From there, a sponsor can change the split to 70/30 and add another one for achieving a 20% IRR where the general partner would receive 40% of the profits and the passive investors a 60% share.

Many factors play into the sponsor’s decision on how to structure a real estate syndication waterfall. Although a vanilla model is easier to implement and manage, some scenarios might call for a more complex approach.

Vanilla Waterfall

One of the most common types of waterfall structures is the vanilla waterfall. Up to 40% of investments feature this cash flow distribution model in which investors are entitled to an 8% preferred return.

Distributions are given once senior lenders get paid and prior to sponsors receiving incentives. Going forward, the next tier covers the investors receiving their capital back, after which the general partner also gets a payment.

Within the vanilla model, syndication sponsor fees can be proportionate to the remaining profits. The usually agreed-upon structures call for a 90/10 or 80/20 split between limited partners and the sponsor. It’s common within this structure for investors to motivate sponsors to outperform in their management duties through generous promotions when hitting specific return hurdles.

The vanilla waterfall might get an additional distribution tier calculated on the IRR where sponsors receive 30% of the profits in such a scenario.

Tiered Waterfall

A more elaborate version of the vanilla waterfall is the two-tiered real estate syndication waterfall structure. Up to 75% of projects may see agreements featuring this model.

The implication is that sponsors can split profits by referring to two different sets of rules. One usually applies to the operating cash flow, and the other would account for various capital events.

Sponsors tend to choose a waterfall model based on their individual needs and interests. There’s no golden rule or clear indicator that one model works better than the other. However, vanilla waterfalls do win in popularity due to the model’s simplicity, which makes managing and forecasting a lot easier.

That said, it’s often believed that tiered waterfalls align the sponsor and investor’s interest better and can give the general partner more incentive to outperform, potentially increasing the returns for all partners.

The Wacky Waterfall

Another interesting model is created around sponsors calculating breakpoints using a greater than something formula or a multiple. Such structures would change the split based on meeting whatever result is best. For example, it can be a toss-up between meeting a 15% IRR or a 1.5x equity multiple.

Of course, this puts more strain on the sponsor as they have to keep track of two metrics and constantly compare them to figure out the cash flow distribution. A common trait of the wacky waterfall is to have multiple classes of investors.

Each class could be entitled to a specific payment in these scenarios after a combination of equity multiple, IRR, and preferred return thresholds are met. These things happen in situations where sponsors attempt to raise money from different sources such as crowdfunding platforms, investing groups, foreign entities, and so on.

Although complex, the wacky waterfall model is somewhat necessary to manage a real estate syndication involving various legal entities.

No-Preferred Return

The preferred return is one of the things that draw investors to real estate syndication projects. Yet it’s a common misconception that sponsors have to offer a preferred return. Some syndication structures don’t feature it at all.

It’s possible to see a simple 70/30 split for every dollar made by the income-generating property, whether from cash flow or following a liquidity event, as in selling the property or refinancing the project.

However, few investors would willingly agree to these terms. Thus, this waterfall structure is highly dependent on the relationship and trust between the sponsor and would-be investors. You’ll typically see this type of agreement when sponsors raise money from friends and family to finance real estate investment projects.

Such a structure might also imply that the sponsor won’t get any fees or only tiny amounts for their work. Instead, they split the profit with the investors upon selling a property.

Waterfall Outliers Worth Knowing About

When it comes to syndication, real estate offers tons of organizational structuring flexibility. Various outliers can influence particular splits and rewards for general partners and accredited investors.

One of these outliers is the side letter. Think of this as a stipulation that allows deviation from the standard agreement for specific classes of investors or small groups of investors within a category. As side letters occur, some investors might be treated differently regarding their returns.

What’s interesting here is that the deviations might not always be in the investor’s best interest. It’s possible that limited partners may see smaller returns than initially agreed-upon based on the stipulations in the side letter.

In any event, side letters can complicate things as they essentially mean adding a new layer of calculations. But some sponsors like using them as ways to reward loyal investors that perhaps follow the sponsor in multiple deals over the years.

In these scenarios, side letters allow deviations from the standard agreement that might give a loyal investor a higher share of the profits compared to others, even if they’re in the same class.

One of the most common ways to structure a side letter goes like this. Loyal investors retain an early-cycle return profile, regardless of where they are in the deal’s term. Other passive investors might go through different profit splits where the sponsor keeps taking a larger share. Therefore, the loyal, long-term partners wouldn’t be affected by reaching new IRR thresholds.

When discussing a profit distribution in real estate syndication companies, it’s worth noting that sometimes investors have to wait before receiving their preferred return. It can take years before it happens, depending on the nature of the project.

For instance, real estate development projects or value-add deals typically imply that the property asset isn’t capable of generating income upon closing the deal. The investors’ preferred return accrues when the property produces cash flow. Investors have to decide whether they’re content with putting money into a deal that could have them waiting three years to see some returns.

Another similar outlier can involve an agreed-upon delay for paying the preferred return. It can accrue after closing the deal, but it builds up in the initial non-cash flow period. Such scenarios see the general partner doing a catch-up before paying back investors.

Here’s an example.

Imagine a deal structure with an 8% preferred return and a 70/30 split where an investor puts $1 million into the project. After two years, the investor would be paid the 8% accrued for two years on their investment which would be $160,000.

From there, the sponsor will get their 30% promote based on the preferred return of $160,000, netting the general partner $48,000.

The structure would then call for continued distributions such as cash to preferred return and catch-up payments. Subsequently, the investor would receive the $1 million investment back, followed by a 70/30 split for whatever profits remain.

To make these structures more appealing to investors, sponsors generally offer a higher preferred return than the usual 8% to compensate for the delay in profit distributions.

Investor Returns vs. Waterfall Complexity

There’s some debate on how a complex real estate syndication waterfall may impact the returns of a sponsor compared to those of an accredited investor. But having two to four layers might not make a big difference compared to a structure layered in 10 ways.

The return profiles aren’t as different as some people might believe.

Sponsors tend to see benefits in outlining complex deal structures once they separate investor classes. However, there’s a very good reason why most projects feature a vanilla waterfall model.

Sponsor returns rarely change materially. But multiple layers raise the complexity of a deal which makes managing the daily operations and calculations harder. With each new tier of profit in distribution splits, the possibility of calculation errors increases. Therefore, the sponsor may face a higher liability.

To make matters worse, not having access to proper management software can overcomplicate things. It’s best to compare your vision of a waterfall structure to the standard industry norms before making a value proposition to potential accredited investors. This would enable you to get a clear picture of any benefits stemming from your framework so that you can properly communicate them to investors.

Keeping Things Simple Can Work in Your Favor

Once you get the hang of waterfall structures, it can be tempting to try experimenting with multiple layers in an attempt to create scenarios that might favor you and impact your share of the profits.

But sticking to a two-tiered waterfall is generally better for everyone involved, especially on short-term three to five-year deals. As a sponsor, you’re not putting your own money on the table.

However, to be entitled to any profit distribution you have to contribute by handling all the work. It starts with finding the property, raising funds, syndicating or crowdfunding, and setting up the operation to ensure good cash flow, as well as taking care of selling the asset after the term of the deal. Therefore, it’s essential to focus on managing the property as best as you can to guarantee it can be an income-generating real estate asset with enough cash flow to meet the agreed-upon returns.

While each new layer you add to the structure can include provisions that entitle you to a larger share of the profit, you also increase the complexity of the syndication cash flow distribution.

It can be an incentive to outperform expectations. That said, it can divide your attention and make you work extra hard to meet certain thresholds. Furthermore, creating the documentation and doing the calculations for complicated waterfalls is no easy task. When starting out, this can also work against you as you attempt to clarify the deal to a potential accredited investor and other would-be participants.

Waterfalls are great profit distribution structures because they offer flexibility. While you can complicate them with outliers as much as you want, you can choose to simplify them and make your life easier, thus having no issues with focusing on outperforming projected profits.

Make informed decisions about your syndication.

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