When most people hear “waterfall,” they think of cascading streams of water in a tranquil setting. But in real estate investing, the term refers to how profits are distributed between the limited partners (LPs) and general partners (GPs) in a deal.
The waterfall structure is a critical concept for passive real estate investors to understand. It lays out the rules for how returns are divided, ensuring fairness and aligning incentives for both the investors and the deal sponsors. If you’re considering investing in a multifamily development or any other real estate syndication, understanding the waterfall is essential for evaluating the potential returns and risks of a project.
A waterfall in real estate defines the hierarchy of payments between LPs and GPs. The structure is designed to prioritize the LPs (who provide the capital) while also rewarding the GPs (who manage the deal) for strong performance.
Essentially, the waterfall creates different “tiers” or “levels” of profit distribution. At each level, specific rules dictate how returns are split.
Here’s how a typical real estate waterfall works:
The preferred return is the first tier of the waterfall. It ensures that LPs receive a minimum return on their investment before the GP takes any share of the profits.
• What is it? A fixed percentage, usually between 6% and 7%, paid on the LP’s invested capital.
• Why is it important? It provides a level of security for LPs, as they are first in line to receive returns.
• How does it work? If the project generates enough profit, the LPs are paid their preferred return. If not, the shortfall may carry forward to future periods.
For example, if an LP invests $100,000 in a deal with an 8% preferred return, they are entitled to $8,000 annually before any profits are split with the GP.
Once the preferred return has been satisfied, the remaining profits are split between LPs and GPs according to a pre-determined ratio.
• Common Splits: Ratios like 70/30 or 80/20 are typical, where the LPs receive the larger portion.
• Why it matters: This split ensures that LPs, as the capital providers, receive a significant share of the profits.
• What to watch for: These splits can vary depending on the deal structure, risk profile, and market conditions.
For example, if $50,000 remains after the preferred return is paid, and the split is 70/30, the LPs would receive $35,000, while the GP would take $15,000.
Some deals include additional tiers or thresholds, often called ‘hurdles’, in the waterfall that reward GPs for delivering exceptional performance. For example, if the project achieves a certain internal rate of return (IRR) or equity multiple, the split may adjust to give the GP a larger share of profits.
• How it works: A split might start at 70/30 but adjust to 50/50 once an 18% IRR is achieved.
• Why it’s used: This structure incentivizes GPs to exceed the project’s baseline expectations.
• What to consider: Understand at what point these adjustments occur and how they affect your returns.
It’s important to understand that the preferred return does not equate to the cash flow distributions you’ll receive annually. For example, an 7% preferred return means that you are owed 7% on your invested capital each year, but this doesn’t guarantee that you’ll receive the full amount of that 7% in cash distributions during that period. In some cases, especially with multifamily developments, there may be little to no cash flow during the early stages, such as during construction or lease-up.
This is normal with almost all real estate deals. Just because the cash flow distributions do not meet or exceed the preferred return amount, does not mean the deal is bad or something is wrong.
Any unpaid portion of the preferred return accrues, meaning it carries over to the next year and is still owed to limited partners. This accrued amount is prioritized and paid out before profits are split between the LPs and GPs, ensuring investors are made whole for the promised return. Understanding this distinction is key to setting realistic expectations as a passive investor.
Again, this is normal with almost all real estate deals and does not mean it’s a bad investment. The cash flow distributions are paid out based on what the project can support. If any amount of the preferred return falls short in that given year, it accrues and carries over to the next year.
Imagine you invest $100,000 in a multifamily development project with a 7% preferred return and a 70/30 split, in favor of investors, between the investors and developer. Here’s a typical scenario you could expect.
Year 1: During construction, there is no cash flow. The 7% preferred return ($7,000) accrues.
Year 2: The project begins to lease up but only generates enough cash flow to pay 4% of the preferred return ($4,000). The remaining 3% ($3,000) accrues, adding to the unpaid balance from Year 1.
Year 3: The project is sold. At the sale, all accrued preferred returns from Years 1 and 2 are paid first. For example, the $10,000 accrued from Years 1 and 2, plus the $7,000 from Year 3, is paid to the LPs before any profit splits occur.
Once the preferred return is fully paid, any remaining profits are split between the LPs and GPs according to the pre-determined split ratio (e.g., 70/30).
This structure ensures LPs are compensated first, even if the initial years of the project generate little to no cash flow.
For passive investors, the waterfall structure is crucial because it dictates how and when you’ll be paid. A well-structured waterfall ensures that your investment is protected and that the sponsor is motivated to maximize the project’s success.
Here are a few reasons why waterfalls are important:
• Transparency: A clear waterfall structure outlines exactly how returns will be distributed.
• Fairness: The preferred return prioritizes the LPs, ensuring they are compensated before the GP takes profits.
• Alignment: Performance-based tiers motivate the GP to achieve strong results, benefiting both parties.
Not all waterfalls are created equal. As a passive investor, you should carefully evaluate the terms of the deal to ensure they align with your goals and risk tolerance.
Here are a few key questions to ask:
A properly structured waterfall creates a win-win situation:
• LPs are compensated first, reducing their risk.
• GPs are incentivized to maximize returns for all parties.
• Both sides share in the upside of a successful project.
Understanding the waterfall structure is essential for evaluating real estate syndication opportunities. It provides a roadmap for how profits are distributed and ensures that both LPs and GPs are fairly compensated.
As a passive investor, your goal is to partner with a sponsor who uses a transparent and balanced waterfall structure. By doing so, you can confidently invest your capital, knowing that your interests are aligned with the GP.
If you’re considering investing in a multifamily development or another real estate deal, take the time to review the waterfall structure. It’s one of the best ways to ensure you’re making a smart, informed investment decision.
Want to learn more about how to evaluate real estate investments? Reach out, and let’s discuss how you can start building wealth through passive real estate investing.
A waterfall is the structure that determines how profits are distributed between the limited partners (LPs) and general partners (GPs) in a real estate deal. It’s called a “waterfall” because the profits flow through tiers or levels. Each tier outlines the priority and percentage of profits each party receives, based on pre-agreed conditions.
For example, LPs may receive a preferred return first, ensuring they get paid before profits are split between the LPs and GPs. Once the preferred return is met, the remaining profits are divided according to the agreed-upon split (e.g., 70/30).
No, waterfall structures can vary significantly depending on the sponsor and the specifics of the deal. It’s important to review the investment summary and subscription agreements to understand exactly how the waterfall works in the specific deal you are considering.
A preferred return is a priority payment to LPs, typically expressed as a percentage of their initial investment. It ensures LPs receive a minimum return on their investment before any profits are shared with the GPs. The preferred return is not a promised or guarantee, but it simply states what return LPs will receive before the GPs take a penny of the profits.
If any amount of the preferred return falls short in that given year, it accrues and carries over to the next year. Any unpaid preferred return amount can be ‘caught up’ at the sale. The cash flow distributions are paid out based on what the project can support. It is not uncommon for annual cash flow distributions to be less than the preferred return amount. This does not mean it’s a bad investment.
No, the waterfall structure is the same for all LPs in a specific deal. Each investor’s return is calculated based on their individual contribution to the deal, but the order of payments and profit splits remain the same.
Speaking only for the projects from Goodin Development, yes, investors receive a preferred return on every project we do. The preferred return starts accruing the day of closing. There is no cash flow distributions paid during the construction period, but investors start accruing their preferred return from Day 1.
