Real estate investment returns come in the form of free cash flow and value appreciation. Everyone understands how cash flow works – cash investment in, cash return out. However, you can only access value appreciation by recapitalizing or selling the asset.
Investors get paid from cash flow and value appreciation in different ways. Equity waterfall models defined in the venture operating agreement determines who gets what and when they get it.
Fundamentals
Let’s first define some terms.
Operating cash flow is the money that a property makes from operations. Investment cash flow starts with revenue, which is then reduced by operating expenses. Additional fixed expenses, like taxes and insurance, reduce that further, and finally, the lender gets her cut in the form of debt service.
Cash flow from capital events is cash that comes back to the investors from balance sheet manipulations. During the holding period, this may be a debt refinancing or equity recapitalization. At the end of the holding period, it’s a sale of the asset.
I focus on common equity in this article.
Common equity is the riskiest position in the capital stack that gets paid after debt and any preferred equity. However, it is the position that can realize the greatest upside.
How the Equity Waterfall Flows
Most investment waterfalls follow a similar structure that defines how and when to pay the different parties. Some equity waterfalls treat operating cash flow and cash flow from capital events differently. For simplicity, we’ll assume they’re treated the same.
First, all investors that put money into the deal get their pro-rata share of the cash flow. For example, if there’s $100,000 to distribute and you invested 10% of the money, you get $10,000.
You may hear this first tranche called a pari passu or preferred return.
The deal sponsor (aka general partner or GP) may or may not co-invest alongside limited partners (LPs). She gets paid on her co-investment the same way as anyone else. Otherwise, the sponsor must wait to get paid until later in the waterfall.
To simplify things, consider the sponsor’s co-investment an investment just like any other investor.
The next step is a return of capital, where all investors get their initial investment back.
In some cases, proceeds may not be enough to pay back all of the initial investment, but it will reduce your investment basis on which the preferred return will accrue. Just like the first tranche, this one is distributed pro-rata according to your initial investment.
Waterfalls vary widely beyond the return of capital stage, but they all start to deviate from the initial investment splits. This is where the sponsor’s position gets “promoted.”
A basic distribution waterfall may be expressed like this, “Preferred return to 8%, then return capital, then 80/20 to 15%, and 50/50 thereafter.”
We covered the first two stages, but it may start to get confusing after returning capital.
The 80/20 and 50/50 split are adjustments to the sponsor’s share. In these cases, we adjust the sponsor’s position and rights to the cash flow from 0% to 20% until all cash investors reach a 15% internal rate of return (IRR). That position is adjusted from 20% to 50% after that point.
Why Bother?
Equity waterfall models incentivize deal sponsors to go the extra mile.
Fees associated with a real estate investment keep the lights on. The sponsor doesn’t get rich on these until they reach a certain scale because the fixed costs of an investment operation are so high.
Deal sponsors rely on the promoted share (aka promote or carried interest) to build wealth in this industry. The size of that promote depends on how effective the sponsor is at hitting the target return hurdles. And, she usually only collects it upon sale of the asset.
Most traditional real estate investment structures target one important thing – alignment of interests.
As a passive investor, you want to know that the people driving profitability in your investment are incentivized to get the best result. A fair and balanced distribution waterfall evolved to be the most effective way to build that alignment.