## Introduction

In the world of Real Estate Syndications, there are a lot of complexities, but one that always baffles everyone the most is Waterfalls. You, as a passive investor, might hear about them in two separate situations: Distribution Waterfall and Profit Waterfall. They behave the same in spirit but are often hard to grasp. The main purpose of the waterfall is to push the Sponsor to perform better. A well-performing syndication can make a lot of money for the sponsor, so the push to ensure that they are delivering on their promised returns is real.

When you think about waterfalls, you are thinking about the big majestic, incredible creation of nature. We want you to imagine this:

than this:

The main reason is that we will discuss multi-layer structures, not a single one. To be fair, in real life, waterfalls do not result in less water at the end, but for now, use your imagination.

We will preface this with the following – every waterfall structure is usually different, and you, as the passive investor, really need to make sure to read the PPM (Private Placement Memorandum) thoroughly and make sure you understand the distribution structure.

## Distribution Waterfall

Let’s start simple – Distribution Waterfall. A common setup might be a simple distribution Waterfall in which the Investor gets 100% of the profits up to the Preferred Return, after which the split is 75/25. Or 75% of the profits are allocated to the investor and 25% to the Sponsor. In the above case, the 8% preferred return is also known as Hurdle Rate (this might be the first Hurdle Rate of multiple). So let’s view a few examples with an assumed investment of $100,000 and a single investor for simplicity:

Year 1 Available Distributions: **$8,000**

To Investor | To Sponsor | Total | |
---|---|---|---|

8% preferred Return | $8,000 | $0 | $8,000 |

Year 1 is easy – we only had $8,000 available for distributions, which is equal to the 8% preferred return. In this case, 100% of the distributions go to the Investor.

Let’s look at year 2:

Year 2 Available Distributions: **$10,000**

To Investor | To Sponsor | Total | |
---|---|---|---|

8% preferred Return | $8,000 | $0 | $8,000 |

75% Investor/25% Sponsor Split | $1,500 | $500 | $2,000 |

Total | $9,500 | $500 | $10,000 |

In this case we have an extra $2,000 for distribution. According to our agreement, the split is 75/25. Which, in this case, translates to 75% of the extra $2,000 (or $1,500) to the Investor and 25% of $2,000 (or $500) to the Sponsor. Let’s also visualize this:

## Sale Waterfall

To continue our example, let’s assume we are in year 3, and the Asset sells. The total profit on the sale is $50,000 ($150,000 distribution assuming $100,000 return of capital). Let’s say that our agreement with the sponsor was 100% to Investor up to 12% IRR, 70/30 split up to 18% IRR, and 50/50 above 18% IRR. What is IRR? Read our article IRR, AAR, Equity multiple, oh my! to learn more about this KPI. This is where we can see we have multiple Hurdle Rates. Disclaimer: This is for illustration purposes only and we by no means support this hurdle rate structure.

Our calculations have become a bit more complicated now, so we will round up the numbers a bit. For simplicity, we assume that we sold at the end of year 3, we got distributions once a year at the end of the year, and we round the numbers a bit. Here is what our hurdle IRRs look like, along with our realized $50,000 gain on sale (20% IRR):

12% IRR | 18% IRR | Total – 20% IRR | |
---|---|---|---|

Invested | -$100,000 | -$100,000 | -$100,000 |

Year 1 | $8,000 | $8,000 | $8,000 |

Year 2 | $9,500 | $9,500 | $9,500 |

Year 3 – Sale | $120,000 | $142,000 | $150,000 |

Based on the above table, those are the thresholds we need to worry about – $120K, $142K and $150K. So let’s see what our distributions will look like:

Year 3 Proceeds from Sale: **$150,000**

To Investor | To Sponsor | Total | |
---|---|---|---|

12% IRR | $120,000 ($100,000 is the return of capital) | $0 | $120,000 |

70% Investor/30% Sponsor Split | $15,400 ($142K-$120K)*0.7 | $6,600 | $22,000 |

50% Investor/50% Sponsor Split | $4,000 ($150K-$142K)*0.5 | $4,000 | $8,000 |

Total | $139,400 | $10,600 | $150,000 |

Let’s also visualize this:

The example above becomes more complicated, but hopefully, the illustration with numbers help. In this case, our first level of the waterfall is the 12% IRR hurdle, up to which the investor gets the full 100% of the return or $120,000. Then we move to the second hurdle – 18% IRR. In this case, our 18% IRR threshold is $142,000. So at this point, the Investor gets 70% of the return between 12% and 18% IRR, which is:

**($142,000 – $120,000) * 0.7** **= $15,400**

The Sponsor at this time received the remaining 30% or $6,600.

After our 18% IRR hurdle, the split moves to 50/50, so in this case, the Investor and the Sponsor will each split the remainder of the distribution or $4,000 each:

**($150,000 – $142,000) * 0.5 = $4,000**

All this makes the final IRR for the investor ~17.3%.

Investment | -$100,000 |

Year 1 Distribution | $8,000 |

Year 2 Distribution | $9,500 |

Proceed From Sale | $139,400 |

IRR | ~17.3% |

## A word of Warning!

The Waterfall structure can make this investment a great deal for both you, as the passive investor, and the sponsor. You do want the sponsor to have the incentive to over-perform; however, be very careful about how the waterfall is structured. The sponsor does not make it easy sometimes in the PPM, and reading the description of the splits can make you have multiple headaches before you can understand what they mean! Make sure you understand what is being promised to you clearly.

## Conclusion

We hope that this has helped clear up some of the waterfall confusion of the syndication process! In a very short example, we attempted to illustrate two examples of waterfall structures. These are only basic examples, and each waterfall with each investment will be different. Unfortunately, there is no shortcut to this, so grab a drink, your PPM, and Excel/Google Sheets!

Photo by Jeffrey Workman, Mike Lewis HeadSmart Media on Unsplash

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