What Is a Commercial Real Estate Waterfall?

People fly across borders to stare at them. Tourists pay big money to fly over them in helicopters. And a few daring souls have even built tightropes to walk across them.

Waterfalls.

Honestly, I was a bit perplexed the first time I read about one in an investment context. Then I realized almost every commercial real estate and private equity deal out there has what's known as a waterfall structure.

If you’ve ever been similarly perplexed, you’re in the right place. We’re going to briefly explore this concept in this article. My goal is to give you an overview of the framework involved so you know what to look for when you encounter waterfalls in real estate and private equity investment offerings. We have reviewed hundreds of PPMs and operating agreements so we have a good idea of what’s normal and what’s not for waterfalls in the commercial real estate space.

The waterfall structure is a blueprint for the order and relative magnitude of returns of profit, initial capital invested, and effort in a commercial real estate deal.

The cash flow waterfall reflects waterfalls in nature in the sense that cash (like water) flows down from the source and fills numerous descending pools, each of varying size. Only when a pool is filled does cash spill over its banks and flow down to the next level. In the event that cash stops flowing before a lower pool is reached, or filled, the pools above it remain fully intact.

The waterfall structure describes how cash flows are distributed between the sponsor (aka operator or syndicator or general partner) and passive equity investors (limited partners). Equity investors have less knowledge of and relatively no control over the project. They are therefore typically favored in early cash flow and profits. Sponsors, who typically have more knowledge and control, are motivated to mitigate risk and maximize profits in order to fill the higher pools and enjoy the cash flow overflowing to lower pools.

The Importance of Understanding Waterfalls

If you’re passively investing with a sponsor in a commercial real estate or private equity deal, waterfall structure is one of the most important concepts to grasp. This is the heart of the offering, and one of the most critical items to utilize when evaluating a passive investment. And when comparing multiple offerings.

The waterfall defines how and when you (as a passive equity investor) will be paid relative to the sponsor. It defines the specific order of repayments and give you a roadmap for repayment of principal, profit from operations, refinance proceeds, and profit from the sale of an asset. The operating agreement and private placement memorandum outline the waterfall structure for each deal.

While many financial concepts are standardized across all operators and offerings, waterfalls are anything but standard. They can be quite confusing as a result.

Interest on a savings account, for example, is quite standard. A 1.2% annual interest rate compounded daily on your savings account results in the same sad accumulation of 1.2% annually in any bank from Kalamazoo to Katmandu. 

But if I told you your return on a passive real estate investment is 9%, how would you know if you are getting a fair deal? And how would you compare that to other offerings? Understanding the waterfall structure will help you evaluate this.

Please note that it is critical for you to understand the risk level for any investment you consider. Understanding the waterfall will not necessarily help you make that assessment. A 9% return on a savings account (haha!) would be completely different from a 9% projected return on a ground-up Chuck E. Cheese development in Cleveland.

Also note that the waterfall doesn’t necessarily speak to the sponsor’s fees. Common fees include acquisition fees, asset management fees, property management fees, administrative fees, loan fees, development fees, refinance fees, and disposition fees. They may be heavily skewed toward the syndicators or they may be more investor friendly. The amount of fees can reflect the skill and effort required to make this deal work, the track record of the sponsor, the financial climate, and much more. The fees may sometimes reflect the waterfall as we’ll see in one of the examples below.

Common Waterfall Terms

Let’s define some of the terms you may see in a typical operating agreement or private placement memorandum. This list is not exhaustive and exact definitions for each term will vary from deal to deal.

Preferred Return: The preferred return (aka “the pref”) is the percentage of profits (typically from operations) that goes to the equity investors before any cash flow is split with the sponsor. The range is typically between 5% and 10%, but development deals may have a pref as high as 12%. I wrote a separate article on this term which you can check out here.

Cumulative Preferred Return: This is typically part of the preferred return calculation. When the sponsor is offering equity investors the first X%, that hurdle typically accumulates over time. So, if the annual preferred return is 7%, and there were no payouts in the first three years, the equity investor is owed the first 21% of the profits at that point in time.

Split: When the preferred return is exceeded, cash flow above this level is often shared between the equity investors and the sponsor. The split can be all over the board. I’ve seen it as high as 90/10 in favor of equity investors and as low as 30/70 in favor of sponsors. Typical splits we see are 60/40 to 80/20 in favor of equity investors. Note that the split alone is not an indicator of a good or fair deal. Many other factors (including sponsor track record, project risk, projected returns, fees, etc.) are in play. Note that splits may change after different return metrics are achieved as you’ll see below.

Catchup Provision: Some offerings provide an opportunity for a sponsor to catch-up to equity investors at a certain point. For example, if the goal is to have an overall split of 70/30 in favor of equity investors, a 7% preferred return theoretically puts equity investors well ahead of the curve in early years of the project. Once cash flow exceeds the 7% cumulative return, the catch-up provision may pay the sponsor 100% of the proceeds until the net split is 70/30.

Return of Capital: As part of the waterfall, equity investors receive their original investment back. Some waterfalls state this comes first, and others leave this until the end. Some return capital as cash flow above the pref. Others return it only at refinance or sale.

Capital Event: The refinance or sale of the subject asset. This event may produce return of capital and profits and could trigger capital gains (or losses).  

Pari-Passu: A French term that designates that equity invested by the sponsor is treated the same as equity contributed by passive equity investors. This is pretty standard and if the sponsor’s “skin the game” isn’t treated the same as LP investors, it could be a cause for concern.

Lookback or Clawback Provision: At the end of the deal the sponsor does a calculation to determine the final profit achieved by equity investors. If the equity investor doesn’t receive a pre-determined profit, or if the final split is out of balance in favor of the sponsor, the sponsor is required to write a check to equity investors to bring the returns or ratio into balance.

European Waterfall: A structure that treats all cash flow as return of capital to equity investors until all of the initial investment is returned. Then preferred return (if any) is paid, then cash flow is split between equity investors and sponsor according to the split.

American Waterfall: A structure that treats initial cash flow as return on investment and thus part of the preferred return. Cash flow above the preferred return level is often treated as return of capital or return on investment and is split with the sponsor. The balance of the return of capital is paid to equity investors upon capital events.

Waterfall Examples

There is no end to the number and type of examples we could provide here. My goal is to provide a few sample waterfall strucutres for your consideration.

Typical American Waterfall Offering: Sponsor offers say an 8% preferred return and 70/30 split. Cash flow to equity investor is subject to split and considered a Return of Capital above preferred return level if the source is operations or refinance. All proceeds from a Capital Event are considered Return of Capital until all capital is returned and equity investor Pref is caught up. The balance of cash flow is split according to waterfall.

Typical European Waterfall Offering: Initial cash flow from operations and refinance (and Capital event if relevant) is all returned to equity investors until 100% of initial capital is returned. Then cash flow is paid to equity investors only until 100% of the accrued preferred return (say 7%) is paid. All cash flow after that is split at say 75/25 or according to waterfall.

Straight Split: There is no preferred return, and all cash flow is split say 80/20 according to waterfall. Return of Capital comes at the time of refinance and/or sale of asset. The goal is that all profit above the Return of Capital is split according to waterfall. This structure is typically viewed as not investor friendly.

Multi-Tiered Waterfall: In many cases a deal may strongly favor equity investors upfront and more heavily incentivize the sponsor later on. This is often the case in a development deal. An example may include a 12% preferred return then an 80/20 split up to a total return of 16% annually (4% on top of the preferred return). Above 16%, cash flow is split 60/40 until a 20% total return is reached. Above 20%, all cash flow is split 50/50 except for the Return of Capital, which all goes to equity investors.

No Fee Deal: Wellings Capital invested in two properties where the developer charged no acquisition fee and no asset management fee. He bore the expense of acquiring and operating the asset himself. He pays investors 100% of the cash flow until all capital is returned, and he expects that to happen in full by the time of refinance in about year four of five. After that, all cash flow is split 50/50 for the life of the deal. (Though it is only 50% to the equity investor, the sponsor is motivated to perform by returning money to investors before making a dime. This could be viewed as alignment with the passive investors.)

Reverse-Engineered Split: I’ve seen a few deals that have a non-cumulative preferred return and a 30/70 split. What was going on there? I asked the developer. He said most investors he speaks to wouldn’t believe the high projected profits those deals were creating. So, he started with the end in mind. In this case, he started by assuming equity investors would get a very conservative projected return of say 19% annually. (Conservative in the sense that he assumed low growth and high expenses. He reported the real returns could easily hit 25% or more.) Then he backed into the low preferred return and split that favored the sponsor. He reasoned that if he could give the investors a 19% or higher return, they wouldn’t care how much the sponsor made. Did this work? I saw one deal where he raised all he needed in days. Another didn’t go as well. I don’t recommend this if you’re a sponsor. 

Concluding Thoughts

There is much more we could say on this topic, but hopefully this has given you a good place to start. If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call.

Real estate investments and securities offerings are speculative and involve substantial risks. Please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.