What is a Waterfall in a Real Estate Syndication and Why is it Important?

In a typical real estate syndication, a waterfall structure allocates the profits or losses from the investment to the limited partners (LPs) and the general partner (GP). This is done according to a predetermined formula, or “waterfall,” and this formula is documented in detail in the partnership’s Operating Agreement.

The most obvious goal of a waterfall structure is to fairly distribute the profits or losses among the LPs and GP based on their respective contributions to the investment and their level of risk. The specific terms of the waterfall will vary depending on the investment and the parties involved, but the waterfall will typically include provisions for distributing cash flow, return of capital, and allocating residual profits or losses. It is less apparent, but no less important, that the waterfall should de-risk the investment for the LPs by prioritizing their returns over that of the GP, especially in the early years of the investment.

What is a Simple Example of a Waterfall?

As you will see, waterfall structures can vary widely, but a waterfall in a real estate syndication may include the following steps:

First, the LPs would receive a Preferred Return on their investment. This is typically a fixed percentage of between 6-8% per annum paid on an LP capital contribution. The purpose of the Preferred Return is to ensure that the LPs receive a minimum level of return on their investment before the GP begins to receive a share of the profits.

Second, after the LPs have received their Preferred Return, the LP and the GP will begin to split profits, with a disproportionate share of the profits still going to the LPs. Profit splits after the LP Preferred Return threshold has been met can range widely, but at this stage investors will most often see a split of 75/25 in favor of the LPs, up to another profit threshold, such as a 12% IRR or a 15% IRR.

The Details Are Important: Waterfalls Mitigate LP Risk

It is very important to recognize and appreciate that the waterfall structure is much more than a method to allocate profits and losses. It’s most important function is to de-risk the investment for the LPs. Since the GP is making most decisions but is typically not investing the majority of the equity, it is extremely important that the GP takes first loss risk and the LPs get their money out first. Moreover, the riskier the investment, the more robust this function must be.

There are additional nuances that are also extremely important. For example, is the Preferred Return calculated on a compounding basis, or is it calculated a cumulative basis? A compounding basis is much more favorable to the LPs, but it can also increase LP risk. On the other hand, in a transaction where the GP is not investing significant equity capital and/or where the GP is extracting substantial upfront fees, a compounding Preferred Return may be more appropriate, especially if the GP is doing this on an investment where the GP was simply the high bidder on a heavily marketed deal. 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.

What is “Death By Pref”?

It is extremely important to make sure the waterfall strikes the right balance between risk and reward for each constituency. Offering a compounding Preferred Return to LPs as described above could create an excessive financial burden on the GP if the economics of the underlying real estate do not support compounding. These types of Preferred Return structures are likely more suited to high-risk, high-reward investments involving ground-up development. However, if the asset is unlikely to ever support the Preferred Return, then the GP cannot ever share in any profits. This is called “Death By Pref” and it could result in the GP walking away from the asset. Such an outcome is not in the best interests of the LPs, as they often lack the local or asset-specific knowledge required to operate the asset.

Nevertheless, these burdensome compounding Preferred Return structures do get done. 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 with 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.

Larger LPs Often Negotiate the Waterfall Terms With the GP

These are examples of syndications involving only one asset, but you can see from these examples that waterfalls can be complex creatures even with one asset. Accordingly, the the waterfall deservedly receives high levels of visibility from all participants. Most larger LPs will attempt to negotiate the terms offered by the GP, and this usually involves shifting the profit splits back toward to the LPs, or adding additional profit hurdles to the waterfall, such that the initial split described in the first example above is revised to 80/20 in favor of the LPs (from 75/25), but if the GP is able to produce a 15% IRR, every dollar after the 15% would be split 60/40 in favor of the LPs (instead of 75/25). There could even be a third hurdle at a 20% IRR, where every dollar over the 20% IRR is split 50/50 instead of 75/25. This ensures that the GP is motivated to reach for the last dollar by operating efficiently and controlling costs.

LPs do not always attempt to shift the waterfall in their favor. We’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. This is a great example of how a waterfall can be a great tool for creating a strong alignment of interests between LPs and the GP.

Fund Waterfall Structures Need Additional Risk Mitigation Features

Waterfall structures involving funds with multiple assets are even more complex because they need to prevent the possibility of “stranded assets”. This arises from the fact that a fund has multiple assets, which could tempt the sponsor to sell the winners early on in order to earn a promote. In a stranded asset scenario, the remaining assets are held until they mature into profitable investments. But what if they don’t become profitable investments, and they are instead sold at a loss that eats into the LP profits from the earlier asset sales?

To prevent this scenario, most fund waterfall structures will include an “IRR lookback” feature for the entire fund portfolio. Under the “lookback” feature, the overall fund returns from all realizations combined must meet a minimum IRR threshold. If the minimum overall IRR threshold is not met, then there is a “clawback” feature where the GP is obligated to return all or a portion of its promote to the LPs. The clawback feature is common in “American Style” waterfall structures. However, “European Style” waterfall structures sidestep the entire issue by prioritizing LP returns until the fund is fully liquidated. In a European Style waterfall, 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.

We May Use a More Simple One or Two Step Waterfall More Often

We syndicate single asset offerings, and our philosophy on waterfalls is changing. In the past, we employed multiple hurdles to incentive operational efficiency during the hold period. We typically met the multiple hurdles we offered in our waterfalls, and our partners intuitively understood the “reach for the last dollar for our partners” justification this. Over the years, however, we have also learned that most investors also value simplicity. We believe we can offer more simplicity with one or two simple and fair hurdles, while maintaining control over our track record by outperforming for our investors on a net basis after fees and expenses.

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.