What is an Equity Waterfall Structure in Real Estate?
What is a waterfall structure in real estate? In real estate, an equity waterfall structure refers to a method of distributing profits among the participants in a real estate syndication or partnership. It outlines the order and priority in which profits are distributed to the various parties involved. The waterfall structure is typically defined in the partnership agreement or operating agreement and serves as a framework for profit sharing.
Here’s a general overview of how a typical waterfall structure works:
Here’s an example of an equity waterfall structure using a 7% preferred return and a 70/30 split:
Assuming the initial capital invested by the investors is $1,000,000, and the project generates a total profit of $200,000.
Return of Capital: The initial capital of $1,000,000 is returned to the investors.
Preferred Return: Assuming the project took one year to generate the profits, the preferred return of 7% per annum on the invested capital would be $70,000 ($1,000,000 x 7%). This amount is distributed to the investors.
In this example, the investors receive their preferred return of $70,000 and an additional $91,000 as their share of the profit split, resulting in a total distribution of $161,000. The general partner receives $39,000 as their share of the profit split.
To calculate the Internal Rate of Return (IRR) for the given example, we need to consider the cash flows associated with the investment and solve for the discount rate that equates the present value of those cash flows to zero. Here’s how you can calculate the IRR:
Initial Investment: -$1,000,000 (negative value represents cash outflow)
Year 1: Preferred Return – $70,000
Year 1: Profit Distribution to Investors – $91,000
To calculate the IRR, we’ll input the cash flows into a financial calculator that has the IRR function. The IRR represents the annualized rate of return that makes the net present value (NPV) of all the cash flows equal to zero.
IRR = Calculate IRR(-$1,000,000, $70,000, $91,000)
The IRR indicates the average annual return that the investment is expected to generate over its holding period, taking into account the timing and magnitude of cash flows. In this case, the IRR suggests that the investment is expected to yield an average annual return of approximately 12.36% based on the cash flows provided.
It’s important to note that this is a simplified example, and in practice, the calculations and distribution may involve more complex factors, including the duration of the investment, additional fees, expenses, and potential hurdles or benchmarks that need to be met before profit distributions are made. The specific terms of the waterfall structure would be outlined in the partnership agreement, and it’s advisable to consult with legal and financial professionals to ensure accurate implementation and understanding.
Catch-Up Equity Waterfall Clause
In real estate syndication, a catch-up clause refers to a provision within the waterfall structure that allows the sponsor or general partner (GP) to receive a higher share of profits until they “catch up” or receive a predetermined percentage of the profits. It is typically used in situations where the GP receives a disproportionate share of profits in the early stages of the investment to compensate for their upfront costs and efforts, but then the profit distribution shifts to favor the limited partners (LPs) as the project progresses.
The catch-up clause ensures that once the LPs have received their preferred return or a certain level of profit, the GP’s share of profits is adjusted to align with the agreed-upon profit distribution. The GP will receive a greater share of profits until they reach their catch-up threshold, after which the profit distribution is typically adjusted to favor the LPs.
Here’s a simplified example to illustrate how a catch-up clause works in a real estate syndication equity waterfall structure:
Let’s say the equity waterfall structure is structured as follows:
Preferred Return: LPs receive an 8% annual return on their invested capital.
Catch-Up: Once LPs receive their 8% preferred return, the GP receives 30% of the remaining profits until they catch up to a cumulative total of 20% of the total profits.
After the Catch-Up: Once the GP has received its 20% catch-up share, the remaining profits are distributed between the GP and LPs, typically with a ratio of 70% to LPs and 30% to GP.
Suppose the project generates $1 million in profits. In the first year, the LPs would receive their 8% preferred return, which amounts to $80,000. The remaining profits are $920,000.
With the catch-up clause, the GP will receive 30% of the remaining profits until they catch up to 20% of the total profits. In this case, the GP would receive $276,000 (30% of $920,000) in addition to the preferred return, bringing their total share to $356,000.
After the catch-up threshold is reached, the remaining profits of $644,000 would be distributed between the LPs and GP according to the predetermined ratio (70% to LPs and 30% to GP). In this example, the LPs would receive $450,800 (70% of $644,000), and the GP would receive $193,200 (30% of $644,000).
Please note that the actual catch-up clause terms and percentages can vary depending on the specific agreement between the GP and LPs in a real estate syndication. It’s important to review the partnership agreement or offering documents for precise details on how the catch-up clause operates in a particular investment.
Tri-Land Properties is a commercial real estate developer that focuses on the redevelopment of grocery anchored real estate projects. We have been evaluating real estate projects and evaluating equity waterfall structure since 1978 for passive real estate investors. Accredited investors can have access to institutional grade grocery anchored real estate investments. To learn more, please contact RJ Johnson at Tri-Land Properties.