Waterfall models are a complex but integral part of many real estate investments. When structured correctly, they align incentives, protect investors, and provide a transparent way to fairly divide profits from a project.
On the downside, they are complicated to model, difficult to understand, and, when not properly designed, can result in unfair outcomes for all parties. After having been involved in many such deals myself, the goal of this article is to impart my knowledge in this area in order to mitigate these downsides.
How Do Waterfalls Work?
A waterfall structure can be thought of as a series of pools where cash flows from an asset fill a single section, before spilling over into the next one. Each pool represents an agreement on how the asset’s cash proceeds will be distributed. Below is an example of how a waterfall model looks visually in action.
Example of a Real Estate Cash Flow Waterfall Model
Returning to the concept of pools, to provide an example, the first pool might divide profits between the investor and the sponsor 90%/10%, while the second pool may favor the sponsor with a 50:50 split. This kind of graduated profit-sharing splits incentivize the sponsor to outperform in order to chase the more lucrative pools. The details of the profit-sharing agreements of the different pools are called the “promote structure.”
How do you know when the sponsor should get promoted? Well, it depends on the type of waterfall structure that is used. There are essentially two main types of waterfall structures that are used in real estate investments. The first is based on returning all capital to investors + an expected return (aka the “hurdle rate”); the second is based on a preferred rate of return (aka “the pref”) on a periodic basis.
The Hurdle Rate
Hurdle rates are usually based on IRR. Once a target IRR is reached, the sponsor gets “promoted” and begins to receive a more preferential rate of return. Although two-tier promote structures are the simplest to understand, I tend to see three-tier structures as the most common in the work I do. With a hurdle rate, the investor must receive all their initial capital before the first promote happens.
The promote structure in a three-tier model might look something like this:
Under this kind of structure, the sponsor receives none of the profits until the investor is paid out in full. Oftentimes, however, the sponsor may also be participating as an investor in the structure too. In a typical LP (limited partnership) structure, this means the sponsor would hold both LP and GP (general partner) shares, and their LP shares would be treated just like any other investor (often called pari passu, which is just Latin for “on equal footing”). GPs investing in their own funds can arise from a number of scenarios, most commonly when they are obliged to foot a commitment in order to demonstrate “skin in the game” to external investors.
With a hurdle rate, the investor receives all of their initial capital and a minimum rate of return before the promote can occur. This works well for projects such as developments where large cash flows are expected at one time, which can pay out investors in full.
Most commonly, though, real estate deals return smaller cash flows over a long period of time before a sale concludes the investment. In these situations, waterfall structures are typically set up with a pref.
The pref specifies a rate of return that the investor can expect annually based on periodic payments. Let’s say the investor puts up $1 million and the pref is 8% annually. Assuming a single dividend per year, the investor will get the first $80,000 before the sponsor gets to share in any profits.
After the pref the rest of the money is split based on the promote, which in our example is 50:50. In this example, if the dividend were $100,000, the investor would get $80,000 (for the pref) + $10,000 (based on the promote), for a total of $90,000. The sponsor would then receive the remaining $10,000.
Example Allocation of $100,000 of Profit in an 8% Pref, 50:50 Promote Structure
Other Terms Included in Waterfalls
If this were all there was to know about waterfall structures, the financial world would be a far simpler place. Waterfall structures often have additional complexities built into them, and realistically, you can add anything you want to the structure. I’ve seen some very complicated mechanisms added on to what appears to be a simple model. Here are some of the more common additional terms you might come across:
A catchup provision favors the GP by ensuring all the cash flows (after the hurdle rate is met) are allocated to the GP, until the GP’s share of the profits is equal to the promote. If we assume a $100-million one-year investment with a 12% hurdle and a 20% promote, the following outcome will transpire if a $15-million profit is achieved:
|Allocation of Profits||Without Catchup Provision||With Catchup Provision|
|Investor||$12m + 80% * $3m = $14.4m (96%)||$12m (80%)|
|GP||20% * $3m = $0.6m (4%)||$3m (20%)|
Hurdle Rate High-Water Mark
Sometimes, if there is time between large cash flows, the IRR could dip below a hurdle rate causing a “demote” of the sponsor. Sometimes, waterfall agreements will have a term called a “high-water mark” that states that once promoted, the sponsor cannot subsequently be demoted. To move to the next tier though, the returns would still have to reach the target IRR for the tier in question. This provision favors the sponsor.
On the other side of the coin, investors will often ask for a “lookback.” If the IRR dips below the promote threshold, the sponsor may have to pay back any of the money they have received, until the IRR threshold is reached.
If the pref rate isn’t met, typically it will not affect any future payments. With a cumulative pref provision, the balance from the unmet portion is added to the next pref threshold.
Cumulative and Compounding Prefs
When the pref is cumulative (but not compounding), the pref is just added on top of the required return for the next period. With a compounding pref, the remaining amount is both added and multiplied by the preferred rate before the promote.
Common Mistakes Made in Waterfall Structures
1. The Hurdle Rate Is Too High
If the hurdle rate is too high, then the sponsor may never reach it. As soon as the sponsor realizes the hurdle rate is impossible to reach, they can become disincentivized (and likely demotivated) to complete the project.
This happens frequently when there are unforeseen delays - a zoning problem, a temporary market downturn, or just adverse weather conditions - which delay a project for a year or more. With the effect of compound interest, a 12% IRR over a five-year project becomes 15% over four years or 20% over three years.
Annual Returns Required to Reach a 12% IRR Depending on Project Length
Often, a sponsor will try to renegotiate but the investor (for good reason) can be unwilling. Unfortunately, there is no easy solution to this common problem except to work with good partners on both sides and undertake thorough pre-deal risk assessments.
Frugal investors may push for such structures to try and maximize their returns, but it’s a very shortsighted approach to follow. Aligned investor-to-sponsor structures will ensure that absolute profits are higher to investors, even if it appears that they are giving away concessions in the terms.
2. Not Treating Investors Equally, with Transparency
Some investors end up getting higher prefs because of their bargaining power. Although this may be acceptable and necessary to get the deal done, problems arise when other investors aren’t informed in advance.
I often include a provision stating that if any investor is to receive a better deal, then all the other investors must be informed and have the right of first refusal. This avoids any hurt feelings on any side and keeps things fair for all parties.
3. Not Clearly Articulating the Waterfall Structure to Investors
Waterfalls can be complicated to model and even more complicated to describe in a document. Having a clearly written investor agreement and making sure every investor fully understands the structure can make future discussions much easier. In negotiations, a clear diagram that visualizes the waterfall can achieve the “a picture is worth a thousand words” effect, rather than assuming that all investors can piece together the scenarios from a verbose term sheet.
When hurdles are reached, it’s often a good idea to re-explain the model, in case anyone’s forgotten the finer details.
There Is No One-Size-Fits-All Approach to Waterfalls
In the end, there’s no one-size-fits-all approach for waterfall structures. Some factors that go into the design of a waterfall structure are easy. If it’s a development with some big cashflow events, use a hurdle; if it’s more of a long-term rental play, use a pref. But the rest is often dependent on several factors including market conditions and the sophistication and knowledge of all parties involved.
Waterfalls are a perfect example of how to mitigate agency effects of investing and create incentive structures to ensure that all parties are in sync toward making a deal run successfully.
Understanding the basics
A waterfall structure can be thought of as a series of pools where cash flows from an asset fill a single pool, before spilling over into the next one. Each pool represents an agreement on how the asset’s cash proceeds will be distributed.