When investors jump from residential to commercial real estate, they face a whole new – and often confusing – vocabulary. Many of these new terms revolve around commercial financing. In particular, the concept of equity waterfalls confuses many new investors. While these cash distribution structures can become complicated, their underlying purpose proves quite simple.
As such, we’ll use this article to provide an overview of equity waterfalls in commercial real estate. Specifically, we’ll cover the following topics:
- An Overview of Equity Waterfalls
- IRR vs. Cash-on-Cash Return
- A Basic Equity Waterfall Scenario
- Using the Waterfall to Define Deal Returns
- Adding Layers to an Equity Waterfall
- Final Thoughts
An Overview of Equity Waterfalls
Unfortunately, experienced commercial real estate investors have a way of overcomplicating industry concepts. And, equity waterfalls absolutely fall victim to this phenomenon. To novice investors, understanding these tools can seem like a daunting task.
Quite simply, an equity waterfall outlines how a deal’s cash flows will be distributed to investors. That’s it. Yes, how you structure a particular deal’s waterfall can become quite complicated, as you can distribute cash flows in countless ways. But, at a basic level, these tools just explain to investors how they will receive cash flows from a deal. Accordingly, a well-structured waterfall will attract investors to a deal. Conversely, a poorly structured one can dissuade potential investors.
In this article, our goal isn’t to provide a detailed explanation of how to build an equity waterfall. Instead, we will provide a general overview to arm investors with the knowledge to ask the right questions when analyzing a potential deal.
IRR vs. Cash-on-Cash Return
Before diving into equity waterfalls, we need to outline two related concepts: internal rates of return (IRR) and cash-on-cash return. Both serve as metrics for analyzing a deal’s performance, and either can be used in building an equity waterfall. Consequently, if investors don’t understand these concepts, they will struggle to properly interpret a proposed waterfall design.
Internal Rate of Return
IRR is the discount rate where the present value of all cash inflows equals the initial cash outflow (i.e. the initial investment). In other words, if you invest $100,000 in Year 0, it’s the discount rate where the sum of all future cash inflows – discounted to Year 0 – equals $100,000. The higher the IRR, the higher the return for investors.
This metric has the advantage of assessing a deal’s total cash flows. But, it has the associated disadvantage of being a slightly more complicated metric for potential investors to grasp when analyzing a deal.
Whereas IRR looks at total cash flows, cash-on-cash return looks solely at annual inflows. Continuing the above example, if an investor contributed $100,000 in Year 0 and received cash of $5,000 in Year 2, she would have a 5% Year 2 cash-on-cash return. The Year 3 return would ignore these results and focus only on Year 3 cash inflows relative to the initial investment.
Cash-on-cash return has the advantage of simplicity. But, it also has the disadvantage of ignoring overall investment performance – and exit cash flow upon selling a property.
A Basic Equity Waterfall Scenario
We’ll use the next two sections to provide a basic example of how an equity waterfall could be built. As stated, a given deal may have a far more complicated structure. But, this example will demonstrate the foundational concepts of equity waterfalls in commercial real estate.
Assume a commercial real estate developer approaches you with an investment opportunity. He wants to develop and operate an apartment building, and he will invest $250,000 of his own money in the project. But, with $4,000,000 in projected development costs and 75% loan-to-cost financing, he needs another $750,000 in equity to meet the $1,000,000 down payment requirement. Enter you as a potential investor.
In this particular deal, the developer will serve as the general partner (GP), develop the project, and operate the stabilized property. You will be a limited partner (LP), only investing money – not responsible for any development or operations tasks. Equity will be divided pro rata based on initial investments:
- LP: $750,000 investment for 75% stake in the deal.
- GP: $250,000 investment for 25% stake in the deal.
Using the Waterfall to Define Deal Returns
At this point, we have the basic equity structure of the deal. Now, we need to decide how the deal’s cash flows will be distributed to the GP and LP. That is, we need to build the equity waterfall. To reiterate, this example is just one way – not the only way – to structure a waterfall.
Assume you and the GP decide that IRR makes the most sense as a measure of deal performance. As a starting point, the GP will likely ask you what sort of IRR you would require for a deal of comparable risk and duration. You decide 10% is reasonable, and the developer agrees. 10% now serves as the first tier of the deal’s waterfall:
- Tier 1: Until the deal’s cash flows reach a 10% IRR, you and the developer will split cash flows based on contribution, that is, 75% to you and 25% to the GP.
But, in developing and operating the property, the GP also does essentially all of the work on the deal. As a result, he requires an additional return above yours. In commercial real estate terms, this extra cut is referred to as a deal’s promoted interest, and it serves as the equity waterfall’s second tier:
- Tier 2: Once cash flows exceed 10% IRR, the GP takes an extra 50% of your cash flows in addition to his original 25%. That is, for every dollar above the 10% IRR, the GP receives 62.5% (25% original split plus 50% times your 75% original split). You’ll receive the remaining 37.5% on every dollar received above the 10% IRR threshold.
In this example, the deal’s cash flows “waterfall” from the first tier to the second one. And, this multi-tiered system provides two related advantages. First, the promoted interest compensates the GP for the work he’ll put into developing and operating the project. Second, the additional tier further incentives the GP to efficiently and effectively manage the project, as he’ll receive amplified returns for increased performance.
Adding Layers to an Equity Waterfall
While we outlined a basic equity waterfall example above, many deals use a slightly more complicated, four-tier structure. However, it’s important to note that the below model simply builds upon the above foundation.
- Tier 1, Return of Capital: This tier allocates cash flows based on equity stake until all contributed capital has been returned. In the above example, the first $1,000,000 in cash flows would be divided 25% to the GP and 75% to you as the LP until you’ve both recouped your initial investments.
- Tier 2, Preferred Return: In this tier, you as the LP would receive all cash flows until meeting your required return on investment – 10% IRR using the above example.
- Tier 3, Catch-up: Frequently, deals have what’s known as a catch-up provision. In this tier, all cash flows go to the GP until he reaches a certain return.
- Tier 4, Carried Interest: In this final tier, the GP receives his promoted interest, that is, a larger percentage of all remaining cash flows. From the above example, this is the tier in which the GP would receive 62.5% of every dollar of cash flow, and you would receive the remaining 37.5%.
As a new investor, trying to understand equity waterfalls shouldn’t intimidate you. Yes, individual deals can have complicated structures. But, the underlying purpose of an equity waterfall never changes. It’s simply a means of defining how investors will receive cash flows from a given deal.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available real estate investment opportunities – and the associated equity waterfalls!