Guest Author: Adam Gower PH.D., GowerCrowd
Real estate syndications use what are called ‘waterfalls’ to structure and compensate principals and investors, and these are seldom altered once a developer creates a structure that works for them. There are, however, a vast array of ways in which waterfalls are designed and this article examines the most common, as well as looking at some of the most complex.
Simply stated a waterfall describes the way cash available for distribution and profits in a project cascades through a series of calculations to make payments to the developer and their investors in a pre-arranged hierarchical fashion.
The most common tools used to define how revenue and profit splits are made include the preferred return and the internal rate of return. These can be used in unison to create different breakpoints where, as certain return hurdles are achieved by the sponsor as measured by the IRR, the proportional share of profits will be adjusted.
The Vanilla Waterfall
A vanilla waterfall is where investors receive a preferred return of 8%, the most common preferred return (40% of all projects) after payments to senior lenders have been made, and before the sponsor receives any incentive payment. The next layer in the waterfall will see the investors receiving their invested capital back, and only then will the sponsor receive a payment, beyond their fees, that will be a proportion of the remaining profits of the deal. This is called the ‘promote’ and in the most common structures these provide for either a 90-10 or 80-20 split to the investors and developer respectively.
Some investors might like to motivate sponsors to outperform by offering more generous promotes once certain return hurdles to themselves have been reached. To do this, another layer is added to the scenario described above where the splits go to 70-30 once investors have received a 15% IRR, for example.
The Two-Tiered Waterfall
The vanilla waterfall describes structures where there is just one ruleset that applies to cash flow as well as any distributions coming from a capital event like a refinance or a sale. According to Investor Management Services (IMS), the industry-leading investment management technology company for commercial real estate, these are the most frequently seen structures and occur in around 75% of all projects.
In some projects, sponsors like to split the waterfall using two separate rulesets where one applies only to operating cash flow, and another separate waterfall applies to capital events. These two-tiered waterfalls occur in approximately 24% of cases, and the outliers have more than two waterfall sets though they are so rare there is no pattern to how those are structured.
IMS, who handles in excess of 7,000 projects on their platform, reports that roughly three-quarters of all projects run two equity splits within their waterfall structures. They have found that currently the most typical would be a preferred return to a 90-10 and then a split to an 80-20, where the most common preferred return is 8 percent.
The 8 percent preferred return is used in approx. 40 percent of projects, followed by 10 percent as the next most common used by approx. 30 percent of sponsors, and finally 7 percent is used in around 8 percent of project waterfalls, with 12 percent and 9 percent prefs the next most common, and the remainder ranging between 2 percent and 22 percent on the extremes.
The IRR, which accounts for approximately 80 to 85 percent of all hurdles used industry-wide, is by far the most common. Other hurdles used include:
- – reaching an agreed level of preferred return
- – equity multiple
- – percentage of the returned capital
- – percentage of the pref that’s been paid out
When it comes to the rarer waterfalls the outliers are less about the arithmetic that goes into the formula for distributing cash flow – whether it’s operating or return of capital – and more about the way the entities are structured.
What makes for these outliers, the especially complicated waterfalls, is there’ll be multiple entities within the org structure. There are the usual General Partners (GP) and Limited Partners (LP), but in the more complicated waterfalls, both the GP and LPs can be broken out into a lot of different entities, as well as a lot of different classes.
Further complicating the waterfalls are that the different classes might have differing return metrics that include different preferred-return levels, different hurdles and lots of different splits; 90-10, 80-20, 70-30, 60-40, 50-50 40-60. The most complicated waterfalls can have 7 to 10 layers of calculations.
Returns Not Correlated to Complexity
Notably, however, a complicated waterfall doesn’t make a lot of difference to the actual returns a sponsor receives. Indeed, running the same numbers through a common waterfall with 2 to 4 layers and comparing them with those that have 7 to 10 layers, the different return profiles between the two is de minimis.
That said, clearly sponsors see benefits in creating complicated deal structures by separating out different classes of investors, but while the returns to sponsors don’t change materially, as the deals become more complicated, the higher the risk of making a calculation error, and the higher the resulting liability. Most sponsors run their waterfall calculations in Excel, and with all those different layers, Excel is stretched to its limit, and in many cases this means that there are some calculations that are not done properly.
Working with a robust, easy to use waterfall tool such as the one embedded in the IMS software, provides sponsors with numerous benefits.
- – No need to use Excel and run the risk of miscalculation
- – Simplify the entire waterfall calculation process
- – Automate distributions
- – Simplify investor management through dashboard controls
- – Provide investors with an on-demand, easy to access portal
This post was created in cooperation with the GowerCrowd. Adam Gower is a 30+ year veteran real estate investment and finance professional. He expands investor networks for real estate developers by implementing best-of-class digital marketing programs.