When investing in a real estate investment fund, one of the most common payment structures is what’s known as a real estate equity waterfall. Although it may sound daunting and can sometimes leave investors scratching their heads, a real estate equity waterfall is quite a simple model to guarantee cash flow and profits are distributed to all the invested parties of a real estate deal in a logical and incentivized way.
It ensures that all parties receive adequate returns for their roles in the fund through clearly defined financial thresholds. It is also a common practice in private equity funds. The real estate equity waterfall doesn’t have to be an intimidating step on your investment journey.
This blog will dive into why a real estate equity waterfall exists, the key players, and how it works in practice to help you fully understand this model.
What Is a Real Estate Equity Waterfall?
At its essence, a real estate equity waterfall is a model or payment structure used to determine at what time and in what percentages profits (returns) are allocated to the parties of a real estate fund deal. For example, the waterfall helps determine how much monthly rental profits or gains from selling a capital asset (e.g., selling real estate investments) are provided to shareholders, and what happens if the fund or investment under or over performs relative to a predetermined return rate.
The waterfall is named as such because of how the funds flow or trickle from pool to pool or, in our analogy, bucket to bucket (more on this below). The gains follow a cascading structure with different layers of requirements, also referred to as hurdles. These requirements are pre-arranged and follow a particular ranking correlated with the fund’s performance.
The structure is based on the idea that a real estate fund or asset has varying roles, from passive investors to hands-on management. The managers assume the risk, and their role includes property management, contractual negotiations, sourcing tenants, meeting commercial requirements, and so on, which is reflected in the equity waterfall.
Because of this, real estate equity waterfall models provide value to shareholders while incentivizing the general partners (or fund managers) to make the fund as profitable and successful as possible.
Who Are the Key Players in a Real Estate Equity Waterfall?
There are generally two critical players in a real estate equity waterfall structure, not including auxiliary individuals such as agents, tenants, lawyers, or others.
1. The General Partners (GPs)
The general partners, also called real estate sponsors, are the equity partners doing all the work. They’re in charge of everything from locating the properties to management duties and securing financing (plus a whole lot more). The general partners will also contribute to the general fund or asset investment relative to the overall capital requirements to make the purchases.
The general partners are commonly corporations or fund managers.
2. The Limited Partners (LPs)
The limited partners are passive investors who put money into the fund to fulfill equity requirements to purchase the properties. They are commonly accredited investors who invest and assume they will receive returns from the assets’ cash flow, similar to investing in the stock market.
How a Real Estate Equity Waterfall Works
Before beginning, it’s important to note that equity waterfall agreements are structured differently and will vary. There is no one set real estate equity waterfall for multifamily real estate investing. Instead, it refers to the general structuring of a deal in this tiered way.
Imagine that you have a set of buckets placed from top to bottom and filled from a waterfall above. The water will symbolize the profits from our multifamily real estate fund. In this analogy, one bucket cannot be filled without the previous one having been filled.
For a real estate equity waterfall, you need to have a preferred return or a percentage taken from the profits. These profits must be distributed to the LPs before reaching the next step or ‘bucket.’ You also have an equity split, for example, 30/70, with seventy percent going to the LPs and thirty to the GPs but only if specific requirements have been met. Finally, real estate equity waterfalls require a timeframe, so let’s say five years. These are the fundamentals of our example.
Keep these critical details in mind as we go through a scenario.
Bucket 1: Return On Capital
So, in the very first bucket, your LPs must get their return on capital investment back. The first round of profits goes toward paying back the money the LPs put into the deal, and once the target is reached, e.g., the bucket is nice and full, it starts flowing into the next one.
Bucket 2: Preferred Return
In the next bucket, you have the preferred return, which we decided was 7% (calculated by multiplying the equity from the LPs by the agreed-upon preferred rate).
In this bucket, the fund must pay the preferred monthly return of 7% to the LPs. It’s important to note that even after five years, the profits may not reach the 7% benchmark.
If returns are under 7%, all this profit below the 7% mark will go to the LPs no matter what percentage it is, and nothing will go to the GPs. So the 7% preferred return must be hit before we can trigger the equity split and move on to the next bucket.
If the 7% preferred return is hit, the water flows into the next bucket with the equity split inside.
Bucket 3: Equity Split
In this bucket, anything on top of the 7% preferred return is split between the LPS and GPs at the 70/30 (equity split) agreed-upon rate, respectively.
You might be thinking 30% is a lot for the GPs as they contributed a much smaller percentage to the deal. Still, this figure is not only based on capital investment but also on time, management, and quality investment managing performance.
It’s like saying we’ve done such a good job we deserve a raise, and we’ll keep working extra hard to bring in the profits for both of us. So this is the incentive component of the real estate equity waterfall.
Bucket 4: Second Equity Split
Additional buckets can be worked into this agreement type. For example, if the fund is performing exceptionally well, then there might be a hurdle at the 15% IRR (internal rate of return), which is the return rate on the investments.
If that bucket is filled, the remaining equity flows into another bucket divided at a different equity split, for example, 50/50, as the fund is performing well above the 7% margin.
Investing in Multifamily Real Estate Doesn’t Have to Be Intimidating
Investing in multifamily real estate doesn’t have to be as complicated or daunting as it may first seem. The real estate equity waterfall is a common and mutually beneficial structure to ensure everybody gets their fair share out of real estate funds or assets. It’s one we’ve had great success with through Viking Capital!
If you’re interested in learning more about our strategies or investment opportunities, reach out today to discover the power of multifamily property investment and how to get started!