Equity Waterfalls Simplified | What You Need to Know as an Investor

Equity waterfalls represent one of the most daunting elements of commercial real estate to new investors.  And, if you ask an experienced investor to explain it to you, he or she will typically way overcomplicate the concept. 

Understanding equity waterfalls does not need to be an insurmountable obstacle, and I’ll use this article to provide a simplified overview of how waterfalls work. 

Equity Waterfall Overview

In simplest terms, a deal’s equity waterfall defines how its cash flows will be distributed to investors. 

That’s it. 

While the actual structure of an equity waterfall can become complicated, the underlying purpose is this straightforward.  It just serves as a tool to outline exactly how cash flows will be distributed.  And, as such, a well-structured equity waterfall can be used to make a deal attractive to investors. 

Feel free to drop us a note if you need help understanding or structuring a specific equity waterfall.  This can seem challenging, and we’re happy to help!

Basic Equity Waterfall Example

To better understand how equity waterfalls actually work, I’ll use the next two sections to provide a basic example.

Assume you’re a commercial real estate investor looking for a multifamily property, and you have $100,000 in capital.  After analyzing a deal, you determine it meets all of your underwriting requirements.  But, priced at $4,000,000, you’ll need to come up with $1,000,000 total for a 75% loan-to-value mortgage.

With $100,000, you need another $900,000 in investment capital to pursue the deal.  You pitch the deal to friends and family, asking them to invest money as limited partners (you’ll serve as the deal’s general partner and handle all operations).    

After pitching the deal to some family members, your aunt agrees to invest $900,000 as a limited partner.  This serves as the foundation for the equity waterfall:

●      You, the general partner (GP), invest $100,000 for a 10% stake in the deal.

●      Your aunt, as the limited partner (LP), invests $900,000 for a 90% stake in the deal. 

With this structure, you’ll control a $4,000,000 asset for only $100,000 of contributed capital.  Not bad.

Structuring Returns in the Equity Waterfall - Continuing the Example

Now that you’ve built the foundation of the equity waterfall, you need to structure investment returns to build the waterfall, itself. 

NOTE: This is a basic example - not the only way to structure an equity waterfall.

First, you ask your aunt, the LP, what she’d require in returns for a comparable investment.  Assume she says 7%.  This required return provides you the first tier of the equity waterfall:

●      Tier 1: Until the deal’s cash flows hit a 7% internal rate of return (IRR), the GP and LP split cash flows based on contribution (10% / 90%). 

As the GP, you do all the work.  As a result, you want to take an extra cut to further incentivize performance in the deal.  This is known as the “promoted interest” (sometimes just “promotes”), and represents the second tier of the equity waterfall:

●      Tier 2: For all cash flows above a 7% IRR, the GP takes an extra 30% of the LP’s cash flow, in addition to his or her original 10%.

This means that, for every dollar received above 7% IRR, the GP receives 37% of that dollar (10% original plus 30% x 90%). 

In this two-tiered example, cash flows “waterfall” from the first to second tiers.  Once the 7% IRR tier “fills up,” the remaining cash flows are distributed according to the second tier’s structure. 

Common Equity Waterfall Structure

Here’s a slightly more intricate equity waterfall structure.  It’s a common real-world structure using four tiers, and it simply builds on the above concepts:

●      Tier 1 - return of capital: Cash flows are allocated directly to the GP and LP based on equity stake until all contributed capital has been returned.

●      Tier 2 - preferred return: All cash flows here are distributed to the LP until he or she achieves a preferred - or required - return on investment.

●      Tier 3 - catch-up: Many deals have a catch-up provision, and distributions in this tier go directly to the GP until he or she achieves a certain return. 

●      Tier 4 - carried interest: This is where the GP receives the “promotes.”  He or she receives a disproportionately larger percentage of distributions until all cash flows have been exhausted. 

Commercial real estate professionals can help you identify common equity waterfall structures for your market and unique situation.  Need help connecting with reliable ones? Drop us a note!

Final Thoughts

An equity waterfall can be as simple or complicated as a given commercial real estate deal requires.  But, remember that it is nothing more than a tool to structure the deal’s cash flow distributions to investors. 

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We recognize that, even after outlining the above information, tackling the challenges of structuring commercial real estate equity waterfalls can seem daunting.   

That’s why we’re here to help.  The Pocket Broker team lives and breathes commercial real estate, so drop us a note to see how we can help you achieve your unique objectives!