Commercial Real Estate Waterfall Models for Private Placement Offerings


Originally Posted July 2019
Edited April 2024

A waterfall, also known as distributions, is a legal term used in an Operating Agreement that describes how money is paid, when it is paid, and to whom it is paid in commercial real estate equity investments. Distributions from cash flow and distributions from a capital event (i.e. a refinance or sale) of the investment property are allocated to the General Partners (GPs) and Limited Partners (LPs), primarily based upon the roles they play in a real estate transaction. These distributions are important because the waterfall may be determined based upon different methodologies that impact the net returns to investors, and the terms offered may change for different investments.

The General Partner’s Role

The General Partner is also called the “sponsor” or the “manager” or the “operating partner” because it generally has control over most decisions, including major ones like how much to spend on improvements, what rents to charge, and when to refinance or sell the property. Investors should be aware that many GPs expect to receive a promote, or outsized profit share, also sometimes called a carried interest. The promote is specific to their role in finding the transaction, negotiating the offer terms with the seller, performing due diligence, securing and signing onto the debt, and managing all aspects of ownership including any proposed renovations until disposition. The promote is meant to reflect the additional amount of time, effort, cost and risk that a GP takes on, while the potential return offered to passive LP investors does not. By giving LP investors a priority of cash flows, the GP is taking on more risk and aligning its upside with the eventual success of the project, since the GP has a more direct ability to impact that outcome than an LP.

Understanding IRR (Internal Rate of Return)

When first analyzing commercial real estate investment opportunities, it is important to determine whether the target internal rate of return (IRR) proposed described by the sponsor in their offering materials is the deal level IRR or the net to LP investors level IRR.

The deal level IRR is the return based upon the inflows and outflows at the property level. While the deal level IRR may look good to an investor, it does not reflect the actual return that the investor receives or is expected to receive because it does not reflect the fees and the priorities of payment in the waterfall.

Rather, the return net to the LP investors is very important and more informative, as it reflects the actual projected inflows and outflows that the LP investors are underwritten to potentially receive, including the promote that the GP is proposing to take.

Breaking down a Waterfall

An example of a simple waterfall model may be a sponsor who offers an 8% preferred return and then a 70%/30% split. The sponsor here is telling investors that they should expect to receive their pro rata share of the distributable cash flow from a transaction until they have received an 8% return on their investment. Then all distributions will be paid to equity holders until initial investments have been fully returned. After that, the LP will receive 70% of the distributions, with the remaining 30% distributed to the sponsor as a “promote.”

From here there are a few questions that may arise:

  • If the 8% isn’t reached in a particular year, does it carry over (accrue) to the next year or does the preferred return reset each year into the project? This would be determined by the terms of the operating agreement.
  • Is the preferred return compounded? When a preferred return is carried over to the following year (accrues), it is either compounding or non-compounding. For a compounding return, the preferred return rate (e.g. 8%) is applied to the accrued interest. So, if $10,000 carried over, $10,800 would be owed the following year.
  • Does the sponsor get the preferred return and Limited Partner returns on their capital invested? Often yes, the sponsor’s capital is treated pari-passu (meaning, on the same terms) as other capital unless negotiated otherwise.
  • Are all Waterfalls the same? No, each sponsor offers their own structure and it may be negotiated by investors with sufficient negotiating power (i.e., capital) to make sure the offered terms are reasonable compared to other like investments in the market and the belief that the project could reasonably reach a return that the investor deems is a good risk-adjusted return relative to other like projects in the market.
  • What happens if the preferred return is not reached? Investors take on the risk that a project may not reach the preferred return offered by the Sponsor, but if that occurs the Sponsor will also not achieve its promote. The purpose of the preferred return is to put the investor first for distributions since it is the investor’s capital at risk.
  • Do all transactions offer a preferred return? No, some projects do not offer a preferred return. There are several ways to structure a waterfall, which are described below.

The following describes the most common types of waterfalls available to investors:

1. IRR Lookback or “XIRR method”

The first method of determining the waterfall model for a project is the Internal Rate of Return (IRR) lookback or XIRR method. The IRR is a time value calculation of all inflows and outflows of capital, from the outflow of the investment at the time the transaction closes, to inflows of cash from the operations of the property during the hold period, and finally, the inflow of capital to investors upon sale of the property, hopefully with a profit. “XIRR” is the function used in Microsoft Excel that allows for distributions at different time periods. A positive IRR cannot be calculated until initial capital invested is returned to investors, so this methodology contemplates a full return of the investor’s initial investment, or principal, before the sponsor gets paid any promote.

For this methodology, a series of target IRRs may be set by the sponsor, and each “hurdle,” or return threshold, must be met before the sponsor can take an increasingly larger portion of the profits. For example, a sponsor offers an 8% IRR and then an 80%/20% split to a 16% IRR, then a 70%/30% split to an 18% IRR and a 60%/40% split thereafter. The sponsor is offering that all investors will receive the available cash flow (pro rata according to each investor’s initial contribution) until an 8% IRR, without any outsized profit given to the sponsor. Once an 8% IRR is reached, potential distributions will go through a second hurdle where investors receive 80% of the cash flow until they reach a 16% IRR. Once the investors achieve a 16% IRR, the investor will then receive 70% of the potential cash flow until an 18% IRR is reached. If the deal performs above an 18% IRR, investors would receive 60% of the proceeds thereafter. The purpose of this structure is to incentivize the sponsor to outperform.

To determine the IRR at each stage, Microsoft Excel takes aggregate capital invested and compounds it at the annual rate to calculate the amount of cash flow and return of capital to at least achieve the targeted IRR.

2. Preferred Return Promote Methodology

The second methodology for determining waterfalls is the preferred return promote methodology, which can be broken up into two main sub-categories; the first prioritizes a return of capital and the second allows profit from cash flow.

  • Return of Capital

In the first type of preferred return waterfall model, the sponsor prioritizes returning the investor’s capital investment before the sponsor receives its promote. The preferred return promote offers investors a preferred return (which may or may not compound), then a return of capital and only then will the sponsor receive its promote, generally at the time of sale. The preferred return can either be calculated off the original amount invested or the balance of invested capital (aka based on a declining principal amount).

Below is an example which shows:

  • An 8% preferred return calculated on capital invested and noncompounding;
  • Then, a return of capital;
  • Thereafter, a 70/30 split:
Waterfalls - Return of Capital

Because the investor’s return of capital occurs before the sponsor’s promote, this is a more favorable structure to investors than a cash flow promote.

In the example above, the 8% preferred return accrues (but does not compound), which means if it is not paid in full in any given year, it carries forward and is paid in future years. At sale or refinance, the proceeds first pay off the senior lender’s debt, then any accrued and unpaid 8% preferred return ($20,000), then return the investor’s capital investment ($900k to LPs and $100k to GP), and then 70% to investors (90% of 70%, or $617,400, to LPs and 10% of 70%, or $69k, to GPs), and the 30% promote ($294k) just to the GP. Investors should always work with their sponsor and CPA to determine how and when to report the return of capital on their taxes for a given investment opportunity.

  • Promote off of Cash Flow

In the second type of preferred return waterfall model, the sponsor prioritizes reaching the promote by taking a promoted interest from annual cash flow before the investors receive their full return of capital. In this waterfall structure, investors first get a preferred return, then there is a split of any excess cash flows – some % to the sponsor and some % to investors. Initial capital is typically returned at the time of sale or refinance.

Below is an example which shows:

  • An 8% preferred return calculated on capital invested and non-compounding;
  • Thereafter, a 70/30 split (with the caveat that upon a capital event, a return of capital comes before any promote):
Waterfalls - Promote off Cash Flow

Because the sponsor’s promote occurs before the investor’s return of capital, this is a more favorable structure to sponsors, but it may be more appropriate for transactions that have a long hold period. In the example above, the 8% preferred return on the initial capital invested accrues, which means if it is not paid in full in any given year it carries forward and is paid in future years. In year one, only $70,000 is distributed, so $10,000 is carried forward to year two. In year two, the $80,000 preferred return plus the $10,000 carried forward preferred return are combined and paid out pro rata, but because there is an extra $10,000 above the 8% return, the investor gets 90% of 70% and the sponsor gets 10% of 70% (as an investor) and 30% promote. At sale or refinance, the purchase price proceeds first pay off the senior lender’s debt, then any accrued and unpaid 8% preferred return (none in the example), then returns the investor’s capital investment ($900k to LPs and $100k to GP), and then 70% to investors (90% of 70%, or $1.53M, to LPs and 10% of 70%, or $70k, to GPs), and the 30% ($300k) just to the GP.

3. Simple Split

The final method of determining a waterfall model is the simple split, which may not have any preferred return to the investors. An example might be 50% of all cash flow and profit is paid to investors and 50% of all cash flow is paid to the GP/sponsor. This is common in transactions where there may not be a high level of sophistication or lots of expenses, and the intent is to keep distributions very simple. An investor should ask in such instances if the sponsor is putting any capital into the transaction, whether the sponsor is contributing “sweat equity” (work as opposed to capital), and, if the sponsor is contributing capital, whether the sponsor is to receive its pro rata share of the investor portion of the distribution.

In Summary

Waterfalls are often not easy to model or to describe in operating agreements, so they should be done carefully and reviewed by professionals with years of experience. The success of an investment from an investor’s return perspective may depend upon well-defined distributions that are appropriately allocated to the proper parties during the hold period of the investment.

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