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One of the hallmark features of a multifamily real estate syndication is the “equity waterfall.” While the concept is simple, the construction of the waterfall itself is often a source of confusion for our students and investors. It doesn’t have to be.
What Is An Equity Waterfall?
When we purchase a property, we use a mixture of debt and equity to finance it. In return for their equity contribution, our investors receive a claim on the income and profits produced by the property. The terms of the “waterfall” dictate how the income and profits are divided between us and our investors.
The waterfall structure can — and does — vary from one transaction to another, so it is important to dig into the details for each transaction to determine if the split is fair and equitable for all parties involved. These details are outlined in a document called the operating agreement, which should be read completely and thoroughly prior to committing funds to a real estate syndication deal.
Here are five things to look for when reviewing the operating agreement.
1. Members And Responsibilities
The “members” in the transaction are those who stand to benefit from the profitable operation of the property. In most cases, there is a general partner (GP) and a series of limited partners (LPs).
The GP is responsible for finding the deal, analyzing it, sourcing capital, closing it and managing the asset once the transaction is complete. Typically, the GP will contribute a small portion of the overall equity needed to finance the purchase — say 20%.
The LPs are strictly passive investors. They place their capital with the GP and expect that they will receive it back, plus a return, from the cash flow generated by the property. The LPs provide the remainder of the equity needed to finance the purchase — say 80%. There may be multiple “classes” of LPs, whose claims on property cash flow have different levels of priority.
2. The Return Hurdles
The return hurdles are the rates of return at which the cash-flow split between the GP and the LP changes. They are structured to incentivize the GP to manage the property as profitably as possible. The higher the return that a property produces, the more money the GP stands to make relative to their initial investment.
Continuing the example above to illustrate this point, a waterfall structure may dictate an initial return hurdle of 8%. Below the hurdle, the GP/LP cash flow split could be pro rata, meaning the GP gets 20% and the LPs get 80% (the same amount they put in). But, above the hurdle, the GP gets 30%, and the LPs get 70%. With this structure, the GP has a strong incentive to beat the return hurdle so they can earn the extra 10% of the cash flow. This bonus is called the promote.
3. Method For Measuring Returns
The return hurdle may be calculated using a variety of different methods, but the two most common are the internal rate of return (IRR) and the equity multiple.
The internal rate of return is the annual discount rate that sets the net present value of future call cash flows, positive and negative, equal to zero. Because the IRR calculation is time dependent, it may be skewed higher for deals with shorter time horizons, so this should be considered carefully.
The equity multiple is calculated as the ratio of capital returned to capital invested and is expressed as a number out to the second decimal position. For example, a $100 investment that returns $150 would result in an equity multiple of 1.50X.
4. Fees
To pay for the administrative cost of underwriting deals, creating marketing materials and sourcing the capital, a GP will often charge the LPs a series of fees. These may be netted from property cash flow and reduce the overall return for the LPs.
5. Capital Accounts
If the cash flow produced by the property fails to meet the required return hurdle in a given time period, the cash flow deficit may or may not be carried over to the next period. If the investor capital accounts are cumulative, the deficit carries over to the next period and will remain until the cash flow is sufficient to clear it. Cumulative capital accounts are favorable for the LPs because it means that the GP will not receive any funds until the deficit is eliminated. If the capital accounts are not cumulative, it is more favorable for the GP.
One helpful analogy is to think of a property’s cash flow as the waterfall itself. As the water crashes to the ground, it spills into a series of pools. As those pools fill up with water, they flow into other pools. The same thing happens with property cash flow, and the rules described above are what dictates how the “water” flows into the lower pools.
To understand these rules, it is imperative to read the operating agreement. This will provide valuable insight into the structure of the transaction and clear direction as to the alignment of incentives in the transaction.