A waterfall is a key piece of any real estate investment as its “flow” determines how returns will be paid out.
The waterfall dictates the hierarchy of how returns are distributed to investors and the transaction’s sponsors. In this article, we’ll explain the roles in a private equity real estate deal, when a waterfall is used for returns, and how a waterfall works.
What Are The Roles in a Real Estate Deal?
There are two primary roles in a real estate deal:
- General Partner: The General Partner (GP) is responsible for day-to-day management decisions, property management, and overall investment strategy. Unlike LPs, GPs have more liability and therefore take on more risk in a deal.
- Limited Partner: A Limited Partner (LP) is an investor who provides capital to the partnership but does not actively manage the investment or the day-to-day operations of the real estate project. They are inactive except for major decisions such as the sale of the property, refinancing, or a change in property management.
What share of returns does each role get?
The General Partner and Limited Partner typically receive their share of sale proceeds based on a waterfall structure which we will explore in detail later. This waterfall structure introduces a variable percentage split based on IRR (internal rate of return) hurdles for a real estate deal. As the IRR increases, the GP will receive a larger share of the sale proceeds and the LP will receive a smaller share.
How is The Equity in a Real Estate Deal Structured?
There are two common forms of equity that Colony Hills Capital has offered in our multifamily real estate deals:
- Preferred Equity
- Pro Rata JV Equity
What is Preferred Equity?
In a deal with preferred equity, the preferred equity provider (the LP) usually provides 25-50% of the equity and they have a priority return of 6-8%, meaning any available cash flow the property produces goes towards paying the preferred equity provider 6-8% on their investment. Upon sale they get their initial contribution back, get caught up on any missing priority return, and an additional accrued interest of another 4-6% (for a total of 10-14%).
The benefit of preferred equity is that these investors are paid first. However, if the deal outperforms, investors with preferred equity do not get the benefit of any upside and are capped at a 10%-14% return.
What is JV Pro-Rata Equity?
Pro Rata is a Latin phrase meaning “in proportion” and deals structured this way will follow a waterfall structure where the GP and LP will receive a proportionate share of the returns based on their initial respective equity contributions. Waterfalls can be complicated though so we’ll walk through an example to demonstrate how these work.
What is a Waterfall in a Real Estate Deal?
The waterfall structure outlines a hierarchy or sequence in which returns are paid out. Returns will be split pro-rata until the deal hits an IRR hurdle, then the GP will earn a disproportionate share of the returns.
The concept is akin to water flowing down through a series of steps or tiers—only after filling one tier does the water (or in this case, the profit) flow down to the next.
- Return of Capital: The first tier usually ensures that both the GP and LP receive back their initial capital investment.
- Hurdle 1: The second tier often involves paying a predetermined rate of return (7%-9% IRR) that investors are promised before the GPs receive any share of the profits.
- Hurdle 2: This tier is where the GP begins to earn a disproportionate share of the upside. As the deal reaches new IRR hurdles the GP will earn a higher share of the returns.
- Hurdle 3: After the above tiers are satisfied, any remaining profits are split between the GPs and LPs according to a predetermined ratio. The GPs' share at this stage is often referred to as "carried interest" or "promote," and is meant to incentivize the GPs to exceed performance thresholds and maximize the project's profitability.
Example Of a Waterfall
To help illustrate this further, let’s explore a hypothetical scenario. Suppose that we have a total investment of $1,000,000 with the following breakdown:
- LP contribution: $800,000 (80%)
- GP contribution: $200,000 (20%)
Following the above series of tiers, here’s a potential split and series of tiers based on the deal reaching set IRR milestones:
Return of Capital: Before any profit split, both LPs and GPs receive their initial capital back.
First Tier (80-20 Split):
Up until the first IRR milestone the deal will be split pro-rata (proportionate to the investment) between the LP and GP.
- IRR Threshold: 7% - 9%
- Profits up to this IRR are distributed 80% to LPs and 20% to GPs (and Co-GPs).
Second Tier - Catch-Up Phase (70-30 Split):
If the GP outperforms and reaches a double-digit IRR, then the breakdown will shift giving the GP a larger percentage of return.
- IRR Threshold: 13% - 15%
- Profits are split 70% to LPs and 30% to GPs (and Co-GPs).
Third Tier - Promote (50-50 Split):
In this final tier, the GP is rewarded more with a 50-50 split for IRR figures above 15%.
- IRR Threshold: Above 15%
- Any profits exceeding the second threshold are distributed evenly, with 50% going to LPs and 50% to GPs (and Co-GPs).
While waterfalls can initially seem complex, when broken down they are simply a way of paying the returns. As a potential investor, it is important that you understand the terms and structure of the waterfall before investing.
Interested in Investing in Multifamily Real Estate? Browse our Current Offerings!
Now that you understand how a waterfall works, check out our latest multifamily offerings!
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