The investment in commercial real estate always warrants careful consideration of a variety of factors. As one of the most confusing of all commercial real estate investment strategies, the equity waterfall model may be one of the most important methods to truly understand. There are numerous ways cash flow from a project can be split, and that is what makes this real estate waterfall method so complex overall.
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What is a Real Estate Waterfall Model?
The real estate waterfall model is a structured method used to demonstrate how to allocate each investor’s cash flow and returns on invested capital. This model aims to ensure that distributions are made fairly and transparently, which is ultimately critical in building long-term relationships with business partners and ensuring future ventures.
The commercial real estate waterfall model is often used for both profit distribution and creating a clear framework for how cash flow distributions will occur within the venture. It aims to ensure that each investor who puts money into the venture receives the funds in a specific order. This order is determined based on various factors, including the amount of risk and each investor’s investment level in the property.
As a waterfall flows, this method of cash distribution flows from the top down, moving through several tiers of investors as it does. The movement is outlined in the rules that investors take on early on in their venture, with each investor prioritizing distribution based on what is agreed upon within the original rules.
Among other things, this method will determine how investment decisions are made. It will determine when and how profits will be split among investors. It also provides a picture of those potential returns and how cash will flow to them.
How Does the Waterfall Model Work in Commercial Real Estate?
One of the factors to consider about the real estate waterfall method is that it is very much pre-determined and can follow a variety of methods depending on the goals of the investment. However, what makes it the waterfall method is that it has a staged approach to the distribution of all profits and returns.
Within this method, the investors receive their investment back when various benchmarks (all of which are pre-determined) occur. This ultimately will determine the subsequent payouts required as well.
Most of the time, the first stage focuses on getting the investors back their initial capital investment – the amount they put into the transaction. This ensures that their capital is secure. Once the capital is returned back to all investors, the structured model then follows a new set of guidelines to determine how the profits will be shared from the transaction. It focuses first on preferred return, which is a fixed percentage that all investors agree on before heading into the transaction.
The profits are then paid out into additional tiers as defined by the actual waterfall model created. The more profits that come in, the more complex the tier network becomes. At each tier, there are various risk levels and rewards involved, and those factors are ultimately what define how profits are paid out. The key to success is ensuring that all members of the investment group fully understand the waterfall structure and how project performance will impact it.
Components of Real Estate Waterfall Model
To be successful, the real estate waterfall model has several core components. These define how the investments and profits are structured. Here are some of those components:
Though there is some leeway for specifications, the preferred return is usually between 6 and 12 percent based on the project specifics. Factors like the expected duration of the project, the risk profile, and the economic conditions present determine this return. Typically, when there is a higher risk associated with the project, the preferred return will also be higher. This helps to bring in investors to more complicated and higher-risk projects.
Preferred returns typically attract more conservative investors. These are investors who are looking for less risk and more predictable returns from their investment. Because the preferred return provides a fixed rate that ensures the minimum level of return prior to profits being shared from this point, investors have less risk overall.
The next component is the return hurdle, which is what helps to create the tiered system of profit payouts. For each of these hurdles, or tiers, there is a higher rate of return. Profit sharing only happens when the previous hurdle is achieved. As a result, this method incentivizes each of the performance benchmarks.
The catch-up provision helps to provide some balance for the interests of the general partners within the organization and limited partners. Once limited partners receive their preferred return, general partners are then able to receive a larger component of the profits after that point. This encourages general partners to strive for more profits beyond the preferred return level.
Types of Real Estate Waterfall Structures for Investors
Two key types of waterfall structures are typically used in these commercial real estate investments.
- The first is focused on returning all capital to the capital investors plus an expected return rate. This is called the hurdle rate.
- The second method is to use the preferred rate of return on a periodic basis.
Factors Affecting Waterfall Structure
Numerous other terms and components can help create more of a fine-tuned investment structure within the waterfall method. Consider a few key other terms.
High water mark
The high water mark is a term used to measure the success of the investment against prior performance levels, noting the previous “highs” the project achieved. In this situation, it is possible to compare outcomes in situations where profits tend to be significantly different over various periods. This allows investors to be protected from various types of profit distributions in that they receive their return up to the high water mark. This happens prior to any profits moving down to lower tiers.
Another important factor sometimes used is cumulative pref, which focuses on unpaid preferred returns before the prior periods that are moving forward. These are typically then added to preferred returns in later terms. This method is often necessary in situations where the investment has varied cash flows.
Waterfall Model Common Mistakes
There are numerous mistakes that can complicate this process, including the following:
- Lack of transparency: The waterfall method only works when there is clear transparency on tiers and the hurdles that must be met. Without clear communication, investors are less likely to be trusting.
- Exceedingly high hurdle rate: If the rate is too high, this can backfire easily, encouraging investors to look elsewhere since the goals seem out of reach.
- Limited explanation: It is also critical that all investors involved in this strategy clearly understand it, which may mean some level of education.
The commercial real estate waterfall method is highly effective in creating a structured way of paying out profits when projects reach specific hurdles or benchmarks. With ample transparency and communication, it can be one of the most effective ways of allowing profit payouts to occur in a way that better aligns with risk and reward.