“Commercial real estate isn’t rocket science.” – You’ve heard it said a million times by industry experts. In some instances, this statement is true. However, when it comes to waterfall investments and equity waterfall structuring and modelling, they might not be as complicated as rocket science, but they are not so simple either.
In this post, we demystify waterfall investment in real estate. We tell you everything you need to know, so you will come away with a full and in-depth understanding of what a waterfall investment is and how equity is distributed in a waterfall.
What is a Waterfall Investment?
A real estate waterfall is a term that refers to how investors receive repayments for their investment. The waterfall is used as a way to describe the distribution of money in a visual way.
Visualize a waterfall. Water flows from the top to a lower level, and so on and so on until it reaches the bottom. This represents the flow of cash in a waterfall investment.
Investors who are in a position to earn a preferred return will be repaid first. Other investors are repaid later – when the water (cash) reaches their pool.
These waterfalls can get complex and take many forms but we will discuss this in greater detail later in the article.
How Do Real Estate Waterfalls Work?
Let’s say that you are a 27-year-old investor. You have some real estate experience and want to start building your commercial portfolio by investing in a multi-family project. You want to invest in an apartment project and have $50,000 to do so.
After searching for a great project, you find a good deal. At the asking price, you think you can hit a 16% IRR over a five-year hold period.
The problem is the project is listed for $3 million. Even if you were able to get 65% of the value of the deal from loans, you would still need around $1 million additional cash to close the deal.
You search for equity partners to fund the deal. You find a partner to invest $950,000 (+ your additional $50,000 making $1 million).
Let’s break down the numbers so far:
- Purchase Price: $3 million
- Assumed Debt: $2 million
- Assumed Equity: $1 million (You: $50,000 + Partner $950,000)
You are the person who is doing all of the work, – finding and managing the deal. You become what is known as the ‘Deal Sponsor’ or ‘General Partner’. Your investor is simply providing you with the capital you need to find the deal and will often be referred to as a ‘Limited Partner’.
You decide therefore to add a promoted interest. This means, for example, you might say:
For the first 8% IRR, we split profits 95/5. For all profits over 8% IRR however, you will take 30% of all profits that would otherwise go to your investor. This is a way to incentivize you to work harder and rewards you for putting your time and expertise into the deal.
This is where the waterfall investment comes into play.
Now you receive 30% of your investor’s profits (95%) over 8% IRR. It is important to note here, that this is not 30% of the total profit.
This works out to 28.5% (30% of 95%) of profits over 8% IRR. In addition, you will still receive your initial 5% from the equity you invested, giving you a grand total of 33.5%.
Let’s say after five years have passed, your project generated it’s aimed for 16% IRR. How will those profits be split?
Up to 8% IRR = $400,000
- Your share would equal: $20,000 (5%)
- The investors share would equal: $380,000 (95%)
Over 8% IRR = $600,000
- Your share would equal: $201,000 (33.5%)
- The investors share would equal: $399,000 (66.5%)
This is how the waterfall investment model works in commercial real estate. In this example, you would earn over 40% IRR from your initial $50,000 which is why this is such a popular option for commercial real estate investors.
It is important to note that this is only an example. These percentages can change and in many waterfall structures, you may have one percent for lower IRR (ie. 20% for anything over 8% up to 11%) and then another percent for higher IRR (ie. 30% for anything over 11% up to 15%).
Waterfall Investment FAQs for Commercial Real Estate
Now you understand how waterfall investment works. But maybe you still have a few questions. Hopefully, the following FAQ will answer them all and you will walk away as a waterfall investment pro.
Question 1
My preferred return is 8% IRR. In year 1, my cash-on-cash return is 10%. However, my calculations show that I don’t earn any promoted interest. Am I doing something wrong?
Short answer: No
Long answer:
Promoted interest won’t be earned in the first year with a 10% cash-on-cash return even with an 8% IRR.
This is because waterfall investment structures are IRR-based. Your promoted interest is based on an IRR metric rather than cash-on-cash.
These two metrics differ in many ways. However, the main difference is that you need a return of capital for the IRR to be a positive number. Even with a 10% cash-on-cash return in the first year, your 8% IRR hurdle would not even be close to being met.
Let’s take a look at an example.
If your initial investment is $100,000 and your first-year net cash flow is $10,000 this makes your cash-on-cash return 10%. However, because the net cash flow is only $10,000, you have still not made a return and your IRR is -90%. You would need to generate a $108,000 net profit in your first year to hit your 8% IRR. This is very unlikely without a sale.
Question 2
If my investor hits their preferred return before the sale of the property, is my promoted interest earned during normal operations?
This will be dependent on the language in your agreement with your investor. Your agreement will specify when promoted interest is earned.
In general, you will find that most agreements will specify that promoted interest is only earned after a ‘capital event.’ This often means the sale or refinance of the property.
As explained in the answer to question 1, you need a return of capital to hit your IRR and start earning invested interest, so in most cases, this problem will not come into play as the capital will not be returned until the sale of the property.
However, if you are planning to hold the property for a long time, this is something to be aware of when solidifying your agreement with your investor.
Question 3
I am analyzing a deal where the IRR is much higher than the preferred return but the investor and my return are both the same number in my waterfall investment. Why is that?
Cash-on-cash return is calculated by the net of the refinance and sale proceeds. This is the capital event that we referred to in the previous question.
Many waterfall investment structures call for a Parri Passu split until the return is made. What this means is that until the preferred return is hit, the investors will receive the percentage of cash flow that reflects their ownership in the deal.
Let’s say you have a $100,000 total investment to which you have contributed $10,000 and your investor $90,000. If you make $10,000 net profit in the first year, this would be split with you receiving $1,000 and your investor $9,000.
If we take a look at these numbers as a percentage of initial investment, both you and your investor are earning a 10% cash-on-cash return.
To Sum Up
Waterfall investments can appear complicated. But now you have read this post they should be clearer for you. If you are about to structure a waterfall investment for your next commercial property purchase, you have all the information you need to create a successful deal that should help you increase your wealth with the understanding of how cash from the deal will be distributed.
Looking to make a commercial real estate purchase in Colorado? U-Collective is an expert team of local real estate brokers who can help guide you. We have specialists in everything from hospitality to multifamily properties. Whatever type of property you are looking for, our team can help find it for you, and guide you through the research and purchasing process. Ready to grow your portfolio and purchase a new piece of commercial real estate? Get in touch with our team today.