Real Estate Waterfall Structure To Be Explored For the First Time: What Valuable Information Investors Need to Know

In commercial real estate, few concepts are more important—and misunderstood—than the real estate waterfall structure. In its simplest form, a waterfall defines how profits (and losses) are split between general partners (GPs) and limited partners (LPs). But as investors know, what sounds simple rarely is.

Essentially, the waterfall should be structured as a mechanism to de-risk the investment for the LPs. This is accomplished by prioritizing LP returns over that of the GP, especially in the early years of the investment.

What Is a Real Estate Waterfall Structure?

At its core, a real estate waterfall structure is a predetermined framework for distributing cash flow, return of capital, and residual profits or losses. It is structured to reflect risk, reward, and incentive alignment between the LP and GP. These rules are codified in the partnership’s Operating Agreement.

Most real estate waterfall structures follow a tiered or “hurdle” format (although the can vary widely):

  1. Preferred Return: LPs receive a fixed annual return (typically 6–8%) before the GP earns any promote.
  2. Return of Capital: LPs receive back their initial capital.
  3. Profit Splits: Once LPs are made whole, remaining profits are split—initially in favor of the LP, then increasingly in favor of the GP as return hurdles are exceeded (e.g., 75/25, then 60/40, then 50/50).

This tiered approach rewards the GP only if the investment outperforms, creating aligned incentives.

Compounding vs. Cumulative Preferred Return

One nuance with major implications: is the Preferred Return cumulative or compounding?

  • Cumulative means missed payments are accrued.
  • Compounding means missed payments earn interest.

From the LP perspective, compounding is more protective. But it can add pressure to the GP, particularly when fees are front-loaded or capital contribution is light.

Investment risk profiles obviously vary widely, so you need to focus on understanding and assessing the real estate risk, how much the GP is contributing to the capital stack in relation to the fees being charged, and then make sure the waterfall meets the moment.

“Death by Pref” — And Why Balance Matters

An overly aggressive waterfall can backfire. For example, if the waterfall offers an 8% compounding Preferred Return on a deal with limited upside, the GP may never participate in profits. This is often referred to as “Death by Pref.”

It’s important to remember that a real estate waterfall structure isn’t just a legal technicality—it’s a tool for aligning expectations, sharing risk, and driving outcomes. A poorly designed waterfall can discourage GP performance, delay asset exits, or cause GP disengagement altogether.

Example:

  • We are aware of one GP who agreed to this structure on the acquisition of an office property in Orange County, CA. The GP was investing no cash, and they were charging a 3% acquisition fee with minimal on-going asset management responsibilities going forward.
  • Their partner was a large institution that loved the asset, but they had no contractual rights to acquire it directly.
  • In this case, the institution could easily operate it without the GP in place, so the GP was quite pleased to take the 3% acquisition fee and walk away without a potential future residual.

Most passive investors would not be well served by this outcome, and this is a great example of how waterfall structures require careful attention to the risk/reward balance related to the business plan and the desired roles of the LPs and the GP.

Waterfall Terms Are Often Negotiated

Larger LPs often negotiate waterfall terms. They may:

  • Increase the LP share of profits (e.g., from 75/25 to 80/20)
  • Introduce additional hurdles (e.g., 15% IRR = 60/40; 20% IRR = 50/50)
  • Require compounding Preferred Returns for high-risk or fee-heavy deals

However, some LPs may concede terms to incentivize creative or complex business plans. e’ve had experience with a large and sophisticated LP that chose to concede the waterfall back to us as the GP. The reason was that our business plan was unusually creative and complex, and they wanted to be certain that we were adequately compensated for both elements.

These scenarios underscore how waterfalls reflect not just economics, but trust and deal-specific dynamics.

Waterfalls in Fund Structures: Lookbacks and Clawbacks

In multi-asset funds, waterfalls can become significantly more complex. The key risk? Sponsors may liquidate winners early to earn promote, while holding underperformers eating away at LP profits over time.

To mitigate this, funds may include:

  • IRR Lookbacks: Ensures total portfolio return meets a minimum hurdle.
  • Clawbacks: Requires GP to return promote if overall targets aren’t met.

The clawback feature is common in “American Style” waterfall structures.

In European-style waterfalls, GPs earn promote only after full fund liquidation—providing maximum LP protection. The GP would not share in any profits until 100% of LP capital has been returned, and the LPs have received an agreed upon minimum return on investment from the entire fund.

In this latter structure, because the GP must wait 7-10 years or more before sharing in any profits, the GP share of profits is typically higher than under an American Style waterfall.

Why Simplicity Is Gaining Favor in A Real Estate Waterfall Structure

At PRPI, we’ve traditionally used multi-tier waterfalls. Over time, we’ve shifted toward simpler, two-step structures. Why?

  • Investors value transparency
  • Simpler structures reduce confusion
  • Net performance after fees ultimately tells the story

Whether simple or complex, every real estate waterfall structure must reflect the risk, the relationship, and the business plan.

Regardless of how we or other GPs structure their waterfalls, waterfalls are extremely important tools for aligning interests, and all LPs should carefully review the terms of the waterfall and ensure that the waterfall is realistic and equitable.