If you’ve decided that incorporating real estate into your investment portfolio is a no-brainer and realize that you don’t have the time or desire to be an active investor (another great choice!), then investing in a no-hassle, hands-off, Real Estate Syndication is the best option. These investments enable multiple participants to pool capital together to purchase a real estate property that delivers passive income and appreciation to the investor.
Today we will be exploring one of the most important concepts for passive real estate investors to understand: Equity Waterfall.
What is an Equity Waterfall?
When someone refers to the equity waterfall in a real estate investment, they’re essentially talking about how cash flow/profits from an asset will be distributed and when.
The term “waterfall” stems from the idea that cash flow from commercial real estate projects flows to different parties in numerous ways. The profits gather in a “pool” until that pool is full, at which point the profits spill over to the next pool of investors in a tiered fashion.
It’s similar to water gathering at the top of a waterfall and then, after reaching a certain threshold, spills over to a pool below—sometimes multiple times. Just as nature’s waterfalls can have numerous pools below, so too can real estate waterfalls.
How are Passive Investors Protected in an Equity Waterfall?
The structure is based on the idea that a real estate fund or asset has varying roles, from passive investors (Limited Partners) to hands-on sponsors/operators (General Partners). The GP’s assume the risk, and their role includes property management, making value-add improvement, sourcing tenants, meeting commercial requirements, and so on, which is reflected in the equity waterfall.
Sponsors use the equity waterfall structure to ensure passive investors meet certain return benchmarks before the sponsor receives any share of the cash flow distributions. This keeps the sponsor motivated and ensures that interests are aligned through the duration of the project.
The two most common ways this is accomplished is via:
Preferred Return:
Also known as "the pref," it refers to the first claim on profits earned by investors until a specified target return has been completed. It is paid rather like a bank pays interest with two major distinctions; one, it can be paid either current or accrued whereas a bank usually pays only current, and two, it is not guaranteed like a bank but rather investors are the first to get paid, in the form of the pref. They will receive a distribution of profits provided there is profit to be distributed. After the preferred return hurdle has been met, any excess profits are split between the parties as stipulated in the terms of the deal.
Return Hurdle:
A return hurdle defines the rate of return that must be achieved before the cash flow can move on to the next tier of the equity waterfall process. Most waterfalls have multiple return hurdles. These return hurdles are often based on an internal rate of return (IRR) or equity multiple.
Equity Waterfall Example
Equity waterfalls can be structured in many different ways but here’s an example of a common structure:
Tier 1 - Return on Capital:
In the first bucket, 100% of cash flow distributions goes toward paying back the money the passive investors (LPs) put into the deal.
Tier 2 - Preferred Return:
Once the LPs have received their return on capital, the profits are paid to the LPs based on the preferred monthly return of 7%
Tier 3 - Return Hurdle #1:
After the 7% ‘pref’ has been met, the LPs and GPs split the profits 70/30 with the LPs receiving 70% and the GPs receiving 30% until a 20% IRR has been met
Tier 4 - Return Hurdle #2:
When the profits exceed a 20% IRR, the profits are then split 50/50 between the GPs and LPs
Conclusion
When investing in a real estate syndication, it is important to keep incentives and interests aligned between the LPs and GPs. An equity waterfall does this by dividing cash flow/equity according to pre-set hurdles and specific return benchmarks.
The process of evaluating a real estate syndication equity waterfall can be complex but our team here at Limitless Investing can guide you every step of the way and help identify investment opportunities that meet your specific criteria.
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