When you commonly refer to a waterfall you might flash back to a past vacation (we could all use one of those right now). In the world of multifamily real estate and syndication this term has a bit more complicated connotation. It is an integral part of structuring equity returns in a deal. Depending on how favorable the structure is you may profit enough to book a trip to see your next real waterfall in person.
How are investors paid in a syndication?
A multifamily syndication is the partnering of passive and active investors for the purpose of acquiring, and managing multifamily assets. The majority of capital is invested by the passive investors (limited partners) while the managing of the asset and hands-on work is done by the active investors (general partners). The general partners get paid fees such as asset management fees as well as a share of the profit from the investment.
The passive investors get a percentage of the profit based on the amount they have invested and agreed equity splits. The structure of the deal should be reviewed to make sure there is alignment of interest between both general partners and limited partners.
What is a preferred return?
Preferred return refers to the limited partners getting priority to receive distributions from the profits generated by the syndication. Simply, they must earn this return first before the general partners can be paid. Limited partners invest with the goal of making a return. The preferred return increases the probability of this but does not guarantee it.
"The preferred return increases the probability of this but does not guarantee it. “
If a deal does poorly and there is no profit, the desired preferred return may not be achieved. Limited partners are incentivized to make the investment more profitable as they will not be compensated until their passive investors achieve the agreed preferred return.
Preferred return may be cumulative over the lifespan of the investment or annually depending on the type of multifamily syndication you are partaking in.
What is an Equity Split?
Equity split refers to how profits are split. If a syndication is structured with a preferred return, the equity split would refer to whatever profits are earned after the preferred return is achieved.
If there is no preferred return, the equity split refers to how any profit generated by the investment is split. Profits are typically split 80/20, 70/30 up to 50/50 with the smaller number referring to the percentage given to the active investors.
Active investors typically invest a smaller percentage of capital than passive investors. Because the equity is split based on the agreed equity split rather than the amount of capital invested, the active investors may receive a disproportionate percentage of the profit relative to the amount hey invested.
For example, the active investor may invest 10% of the capital but get 20% of the profit. This additional 10% profit is called a promote. This incentivizes active investors to make the investment more profitable because the more profit that is generated, the greater the promote.
What is a Waterfall?
The equity split ratios can change throughout the timeline of the investment depending on if specific hurdles are achieved. Hurdles refer to specific financial benchmarks, most often a specific IRR. Other benchmarks may be a percentage of capital returned on refinance or a predetermined profit on sale. Waterfall refers to the way the equity splits, hurdles and preferred returns are structured.
Imagine you have an empty treasure chest and you filled it with the profits from an investment. At some point this treasure chest will be full and the profits would have to be distributed elsewhere. The next treasure chest may be able to hold a different amount than the first. This is what happens when you hit a hurdle. There can be many hurdles in a given investment depending on if you are investing in a fund or a private placement real estate syndication.
Passive investors need to understand and review waterfall structures to ensure an investment has alignment of interest between general and limited partners. While profits are not always divided evenly, this structure determines if profits are divided fairly.
“Waterfalls determine if profits are divided fairly, not evenly”
Lets look at an example:
We have a multifamily syndication with an 8% preferred return, with a 80/20 equity split up to a cumulative 15%IRR then a 70/30 split there after.
The first 8% of cashflow or profit each year would go to the limited partners. Once this 8% of profit has been maxed out the remaining profit is split with 80% going to the limited partners and 20% going to the active investors. As the investment performs better it eventually hits a 15% IRR for the passive investor. Any profits made after this point would be spilt with 70% going to limited partners and 30% going to active investors.
The general partners are incentivized to work hard because the more profits they earn for the limited partners, the more favorable the returns become for them. This is a win-win for both partners in the syndication.
Now that you have a better understanding of equity splits and waterfalls you can structure your next deal to maximize returns for you and your partners or analyze a deal that is presented to you to make sure you understand how your profits will be split.