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Real Estate Waterfall

Step-by-Step Guide to Understanding the Real Estate Waterfall Model (Fund Distribution)

Last Updated March 1, 2024

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Real Estate Waterfall

How Does the Real Estate Waterfall Work?

The real estate waterfall model is a tier-based system used to illustrate the hierarchy in priority and allocation of fund proceeds.

The real estate waterfall model establishes the order by which the distributable proceeds of a fund are issued to the investors of a fund (or limited partners).

In practice, the distribution waterfall schedule, or “equity waterfall”, serves as the standard tool to track the proper distribution of proceeds for the participants in an investment fund (i.e. the stakeholders).

The core mechanism of a real estate waterfall is structured to align the economic incentives of the general partner (GP) and limited partners (LPs) of an investment fund, like a real estate private equity (REPE) fund.

  • General Partner (GP) → The general partner (GP), or “sponsor”, is the active manager of an investment fund responsible for deal origination (i.e. sourcing potential investments), performing diligence, and managing the properties post-acquisition.
  • Limited Partners (LPs) → The limited partners (LPs) are the capital providers of the fund. By committing capital to the fund, the LPs are passive investors, for whom the GP is investing.

The underlying provisions of a distribution waterfall – formally stated in the Limited Partnership Agreement (LPA) of the specific fund – set the conditions that must be met for parties to be entitled to receive proceeds on an investment.

These provisions and clauses are what arrange the systematic distribution of fund proceeds, where each stakeholder with a vested interest in the performance of the fund collects their fair proportion of the profits earned.

The mechanics of a real estate waterfall structure can be perceived as a series of tiers (i.e. the “target hurdle rate”), wherein the distribution of proceeds is different per tier. In short, the payoff “stays within” the current tier until the target hurdle rate is met (and then “spills over” to the next tier).

For each subsequent tier, there is a new set of guidelines that dictate the allocation of fund profits.

What is the Principal-Agent Problem?

The necessity of avoiding the risk of a misalignment in incentives between parties pertains to the principal-agent problem, a theory that a principal (GP) is likely to serve their own interests rather than those of the agents (LPs) if the two were mutually exclusive decisions.

The construction of an equity waterfall model in a fair, transparent manner is integral to building long-term relationships with limited partners (LPs).

What is the Preferred Return and Promote (Carried Interest)?

Two of the most common terms stated in the limited partnership agreement (LPA) are the “Preferred Return” and “Promote” (or “Carried Interest”).

  • Preferred Return (“Pref”) → Once the limited partners (LPs) are “made whole” and recouped their original capital investment, the subsequent tier is the preferred return (or “Pref”). The preferred rate usually ranges between 6% to 8% on an annual basis, while based on the internal rate of return (IRR) accrued.
  • Promote (Carried Interest) → The term “promote” refers to the disproportionate allocation of fund proceeds that flow to the general partner (GP) after reaching the target returns. Often used interchangeably with carried interest (or “carry”), the promote is a performance-based contingency payment and can be thought of as the reward earned by the general partner (GP) for meeting the pre-determined return target. The tier(s) with the promote provision, or carried interest, constitute the main source of returns for a sponsor (GP).
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What are the Components of Equity Waterfalls?

Term Definition
Preferred Return (“Hurdle Rate”)
  • The minimum rate of return received by the limited partners (LPs) before the distribution of carried interest to the general partner (GP) is permitted.
Carried Interest (“Carry”)
  • The disproportionate share of the fund’s profits to the general partner (GP) once the agreed-upon threshold in returns is met.
Clawback Provision
  • The carried interest received by the General Partner (GP) that must be returned to the Limited Partners (LPs) from not meeting the minimum hurdle rate.
Contribution
  • The distribution of capital by the Limited Partners (LPs) of the fund to fulfill a capital call request by the General Partner (GP) to fund an investment.
General Partner (GP)
  • The sponsor responsible for managing the fund’s investment strategy, capital deployment, and monitoring the performance of each holding.
Limited Partner (LP)
  • The investor that contributed capital to the fund – most profit-sharing partnerships in real estate are structured as a joint venture (JV).
American Waterfall (“Deal-by-Deal”)
  • The general partner (GP) receives carried interest on a per-investment basis, irrespective of the fund’s performance as a whole (or individual performance of other holdings).
European Waterfall (“Whole Fund”)
  • The general partner (GP) collects carried interest only after the requirement for the original capital contributions, inclusive of fund fees and expenses, are returned in full to the limited partners (LPs) is met.
Limited Partnership Agreement (LPA)
  • The contract between the general partner (GP) and limited partner (LP) to formalize the terms of the agreement, namely the profit share structure.
Management Fee
  • The periodic payment paid to the general partner (GP) by the limited partners (LPs) to cover the costs of managing the fund, such as administrative expenses and overhead.

Catch-Up vs. Lookback Provision: What is the Difference?

The catch-up provision ensures that the investor receives 100% of all profit distributions until a predetermined rate of return is met. Subsequently, once the investor attains the required return, all distributable proceeds are allocated to the sponsor until the general partner (GP) reaches parity with the limited partners (LPs).

The investor (LP) receives a full share of the profit until a specified return is achieved under the catch-up provision, after which the sponsor (GP) receives a distribution.

The catch-up provision, akin to the lookback provision, shares many commonalities in terms of the objective. However, the distinction between the two is that the lookback provision necessitates the investor to request a payment from the sponsor on the date of closure.

Until the tier with the catch-up provision, the interests of the sponsor were subordinate to the investors (LPs). Therefore, the sponsor can now “catch up” to an equal footing since the target return was met.

The lookback provision is a clause that provides a fund’s limited partners (LPs) with the right to “look back” and retrieve distributed profits back from the general partner (GP), even if the proceeds were issued to the GP. The rationale for the inclusion of the provision is that if the general partner (GP) is unable to generate a predetermined return for the limited partners, the LPs have the right to collect more proceeds to improve their poor returns.

The lookback provision offers sponsors with the option to allocate funds on investments, even if those proceeds must be returned later – hence, general partners (GPs) tend to view them favorably. In contrast, limited partners (LPs) prefer the catch-up provision, considering the receipt of an upfront payment without the need to request reimbursement from the sponsor at a later date.

How to Build a Real Estate Waterfall Model

The step-by-step process to model a basic distribution waterfall is as follows.

  • Step 1 → Quantify the Net Cash Flow (NCF) Available for Distribution (Sum of Levered Cash Flow, including the Purchase Outflow and Sale Proceeds)
  • Step 2 → Solve for the Minimum Cash Required to Meet Each Hurdle (Delta Between the Current and Prior Hurdle)
  • Step 3 → Input the Profit Split at Each Hurdle (Note: Profit Split ≠ Ownership Split)
  • Step 4 → Calculate the Cash Flow Attributable to Each Partner (Including Promote) at Each Hurdle
  • Step 5 → Multiply the Required Cash Balance at Each Hurdle by the Coinciding Profit Split
  • Step 6 → Reduce Net Cash Flow (NCF) Available for Distribution by the Cash Flow at Each Hurdle

If the model is adjusted properly, there should be no cash remaining to distribute after reaching the final hurdle.

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European vs. American Waterfall: What is the Difference?

Generally speaking, distribution waterfalls can be placed into two categories:

  • European Equity Waterfall → Under the European waterfall structure, sponsors are not entitled to receive carried interest (or “carry”) until the limited partners (LPs) are made whole (i.e. full recovery of the original capital contribution, often inclusive of a predefined preferred return). The distributions are issued on a pro-rata basis, so the payoff is in proportion to each investor’s stake, or initial contribution to the fund, to ensure each LP is compensated fairly.
  • American Equity Waterfall → The American equity waterfall model is often referred to as the deal-by-deal approach. The fundamental distinction between American and European waterfalls is the treatment of carried interest. Under the American waterfall structure, sponsors are entitled to receive carried interest on a deal-by-deal basis, i.e. individual fund investments before the LPs are “made whole”.

The American waterfall is perceived as more favorable to sponsors and is thus the preferred fund structure for most GPs.

On the other hand, the European waterfall is considered to prioritize the interests of the limited partners (LPs) more – in particular, reducing the downside risk – since the GP is prohibited from receiving carried interest until certain conditions are met.

Real Estate Waterfall Calculator – Excel Template

We’ll now move on to a modeling exercise, which you can access by filling out the form below.

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Real Estate Distribution Waterfall Tutorial

Suppose we’re tasked with building a distribution waterfall model for a real estate private equity (REPE) fund given the following transaction assumptions and promote structure.

Transaction Assumptions

  • LP Equity Contribution = $7.6 million (95% of Total)
  • GP Equity Contribution = $400k (5% of Total)
  • Total Equity Contribution = $7.6 million + $400k = $8 million
  • Hold Period = 5 Years

Promote Structure

  • Tier 1 → 8% IRR Hurdle (Return of Capital + Preferred Return)
  • Tier 2 → 10% Promote Up to 10% IRR Hurdle
  • Tier 3 → 20% Promote Up to 12% IRR Hurdle
  • Tier 4 → 40% Promote Up to 25% IRR Hurdle

Tier 1. Return of Capital + Preferred Return (Pref)

Starting with the first hurdle, we are provided with the following assumptions for the cash flow available for distribution of the real estate fund.

  • Year 0 = ($8 million)
  • Year 1 = $800k
  • Year 2 = $1 million
  • Year 3 = $1.2 million
  • Year 4 = $1.25 million
  • Year 5 = $12 million

The net cash flow (NCF) available for distribution, similar to the levered cash flow metric, is expressed on a post-financing basis.

The distinction is that the net cash flow available for distribution is adjusted for the closing costs incurred from the purchase and sale of the property investment, including the outflow from the acquisition itself (Year 0) and the sale proceeds (Year 5).

However, the formula can differ per transaction, so we recommend confirming the aforementioned statement.

The parameters around each tier are stated in the profit-sharing agreement.

The first tier of a real estate waterfall is more often than not, set based on the return of capital (i.e. recoup the original investment) and/or a preferred return.

But in either case, the limited partners (LPs) of the fund are the priority is the distribution of funds. In effect, the initial tier ensures the LP’s original capital contribution is secure.

For subsequent hurdles thereafter, the remaining cash flow after the prior hurdle will flow downward until the balance is zero.

Tier 1 of the distribution waterfall is the return of capital to the limited partners (LPs), plus a preferred return to compensate them for taking on the risk.

Since the preferred return, or “pref”, is 8.0%, we’ll multiply the preferred rate by the beginning balance.

Preferred Return ($) = Beginning Balance × (1 + Preferred Rate) – Beginning Balance

While technically not relevant here, considering our model is on an annual basis – as a general best practice for modeling on the job, we recommend becoming accustomed to raising the (1 + Preferred Rate) to the difference between the current and prior period, and dividing by 365 days.

Why? Most real estate models forecast the performance of the underlying fund on a monthly basis, whereas our model is on an annual basis for illustrative purposes.

The distribution to the LPs is determined using the following formula:

=-MAX(MIN(SUM(Beginning Balance, Preferred Return), Cash Flow Available for Distribution),0)

The ending balance of the capital account roll-forward is equal to the sum of the beginning balance, preferred return, prior distribution, and equity contribution (funding).

Capital Account, Ending Balance = Beginning Balance + Preferred Return + Prior Distribution + Equity Contribution

Note that the distribution line item is a negative figure, so it is important to confirm that the intended effect is occurring – otherwise, the model will not flow properly (i.e. cash outflow).

The “LP Cash Flow” and “GP Cash Flow” are each calculated by multiplying the initial equity contribution percentage by the sum of the prior distribution and equity contribution.

LP/GP Cash Flow = (Prior Distribution + Equity Contribution) × Equity Stake (%)

Using the XIRR function in Excel, the internal rate of return (IRR) can be calculated for the LP and GP, which comes out to 8% for both parties.

=XIRR (Array of Cash Flows, Corresponding Array of Dates)

Distribution Waterfall Calculator

Tier 2. 10% Promote Up to 10% IRR Hurdle

The second hurdle, or Tier 2, is a 10% promote, up to a 10% IRR.

The modeling mechanics for the roll-forward schedule are relatively the same as the prior tier, however, the prior distribution will link to the distribution paid in the preceding period, as opposed to net distributable cash flow.

Like before, the preferred return (or minimum hurdle rate now), is calculated using the same formula, except the rate is now higher (8% → 10%).

The LP and GP cash flow sections are a bit more complicated here, as the “Tier 2 Cash Flow” is the lesser value between the two.

  • Beginning Balance + Preferred Return + Prior Distribution
  • (1 – Promote) ^ Remaining Cash Flow

The new line item – “Promote Tier 2 Cash Flow” – is calculated using the following formula:

=MAX(SUM(LP Tier 2 Cash Flow, GP Tier 2 Cash Flow)/(1 – Promote) * Promote,0)

Furthermore, the “Promote Cash Flow” will simply link to that cell.

Using the XIRR function, we can confirm that the internal rate of return (IRR) of the LP Cash Flow and GP Cash Flow equals 10%.

To wrap up the second hurdle, the “Remaining Cash Flow” is calculated by deducting the sum of the LP, GP, and promote cash flow from the cash available for distribution line item at the top.

Remaining Cash Flow = Cash Available for Distribution – (LP Cash Flow + GP Cash Flow + Promote Cash Flow)

Waterfall Schedule Calculation Example

Tier 3. 20% Promote Up to 12% IRR Hurdle

For Tier 3, the promote is 20% up to a 12% IRR, so the process is identical to the previous step, aside from the increased hurdle rate and promote.

By the end of Year 5, we can see there is approximately $3.1 million left in remaining cash flow.

The internal rate of return (IRR) on the LP and GP cash flow (excluding the promote cash flow) is 12%.

Therefore, the equity waterfall schedule is allocating funds fairly, in proportion to the equity stake, i.e. the purpose for which the model was designed.

Distribution Waterfall Promote Example

Tier 4. 40% Promote Up to 25% IRR Hurdle

In the final section, the effects of the promote cash flow will be observed, as well as the internal rate of return (IRR) and equity multiple at the end of the hold period.

For Tier 4, the set conditions are a 40% promote up to a 25% IRR hurdle rate.

The same steps can be repeated as the prior two sections to complete the roll-forward schedule.

The notable distinction here is the “Remaining Cash Flow” line item, which has been wound down to zero.

Equity Waterfall Schedule in Excel

In closing, we’ll calculate the IRR and equity multiple for our hypothetical real estate private equity (REPE) fund in our real estate waterfall model.

  • LP Cash Flow = 15.4% IRR and 1.8x Equity Multiple
  • GP Cash Flow (Pre-Promote) = 15.4% IRR and 1.8x Equity Multiple
  • GP Cash Flow (Post-Promote) = 46.2% IRR and 5.8x Equity Multiple

Therefore, the general partner (GP) of the fund achieved the target return for the limited partners (LPs).

While the return might seem outsized because of the promote, the target return was met and the LPs of the fund are more likely to continue the partnership with the GP given the fund’s positive performance.

If the GP were to have underperformed, the provisions set by the distribution waterfall (or more specifically, the fund documentation) would have prevented the general partner (GP) from profiting from the investment fund.

But since the incentives were aligned and the real estate fund performed well, all stakeholders collectively received their fair share of the profits.

Real Estate Waterfall Return Schedule

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