What Is a Real Estate Waterfall and How Does It Work?

Among Americans, owning real estate routinely ranks as the best investment prospect. Many real estate investors struggle because they lack the funding to pursue large-scale projects. Therefore, they start questioning how to locate real estate investors who can provide the required funding to satisfy the down payment criteria or purchase an entire property. But some techniques can significantly lessen the entrance barrier for investments. 

Even without investing any of their money, they can let someone partake in the rewards of an asset that generates income. One such method is the real estate waterfall technique. 

What is the method?

Individuals fund property purchases using a combination of financing and equity. The investors acquire a claim on the income and profits generated by the property in exchange for their equity investment. The provisions of the “waterfalls govern the distribution of income and profits between the individual and the investors.” Consider a natural fall where a ledge is crossed by extra water that spills into another body of water. The water can cross a new ridge and pour into a new body of water if it reaches a new threshold.

How does it work?

Imagine water as the cash flow and the ledge as what is referred to as a hurdle rate. The revenue is split between the general partner or sponsor and the limited partners whenever the cash flow reaches a predetermined threshold.

All partners take earnings proportionate to their investment stake until the hurdle rate is met. For instance, if someone contributed 90% of the capital, they would be eligible for 80% of the revenue. 

The general partner is permitted to change the distribution of the extra financial gains, such as by taking a portion of the profits the limited partners would otherwise make, after the income reaches the hurdle rate.

What are the types?

  1. Vanilla waterfall

It’s one of the most widespread forms of waterfall systems. This cash flow distribution mechanism, which may be found in up to 40% of assets and grants investors an 8% preferred return, is used. Distributions are made after senior lenders have been paid and before sponsors have compensated. The following layer will cover the investors’ capital returns, followed by a payment to the general partner.

 

  1. No-preferred Return

One factor that attracts investors to real estate projects is the preferred return. But a widespread misperception is that sponsors must provide the desired return. Some syndication models lack it entirely.

  1. The Wacky Waterfall

Another intriguing idea revolves around sponsors figuring out breakpoints using a greater than or multiple formulae. Such arrangements would alter the split to get the desired outcome. For instance, choosing between achieving a 15% IRR and a 1.5x equity multiple might be difficult.

  1. Tiered Waterfall

This structure is a more complex variation of the vanilla waterfall. This approach may be used in agreements for up to 75% of projects. The idea is that sponsors can divide earnings by citing two separate sets of regulations. The first pertains to operational cash flow, whereas the second considers different capital events.

Conclusion

One of the trickiest ideas in real estate financing is the equity waterfall model, which is used in commercial real estate projects. Real estate waterfall models can be difficult to understand since there are innumerable possible ways to divide the cash flow from a building or investment project. But still, many real estate ventures include the difficult but essential use of waterfall models. 

They give a precise mechanism to fairly distribute project profits when adequately organized, align incentives, and safeguard investors.