There are multiple terms in the commercial real estate market that might sound confusing. For example, many would not know about the real estate waterfall. This waterfall model discusses how cash flow distribution works among the partners and owners of a real estate deal.
Private equity firms use it to distribute returns among the investors. However, all equity waterfalls are diverse, and the agreement will specify the structure. For more details, you will have to read and understand the concept.
What is Meant by the Waterfall Model?
The model aims to split the profit among the partners and prevent uneven distribution. One can also take it as a pool. Once it is full of cash flow, the excess is spilled into other pools. The model is beneficial because it rewards the operating partners with added returns. This, in turn, helps in motivating the partners.
All waterfalls are diverse and have their hurdles and provisions. However, the concept remains more or less the same. The general partners will likely receive higher cash flow once they reach higher hurdles. The outline of each deal specifies the investment structure and guides the cash flow.
Standard Components of the Model
Return hurdle refers to the rate of return attained before landing upon the next hurdle. It is the return hurdles that trigger the excessive profit splits. Similar to the rate of return, the hurdles in the waterfall structure can be defined in multiple ways. Generally, the internal rate of return and equity multiple are frequently used as return hurdles.
After defining the return hurdle, the next thing to do is look at the return measurement. Having a sponsor and the investor makes the return calculated through different measures. The hurdle calculation can be done from the project, sponsor equity, third-party equity, etc.
The ‘pref return’ or the preferred return signifies the first claim on the profits. Investors earn it until a particular target has been achieved. It has often been compared to the way banks pay interests. One significant difference is that banks mostly pay on current. But here, payment is made on both current and accrued.
Another difference is the absence of a guarantee. The distribution will only take place if there is anything to be distributed. First, the preferred return hurdle is reached. Then, the additional profit gets split among parties as per the outline of the deal. Therefore, the returns will vary from deal to deal.
The lookback provision comes to play when the equity waterfall pays the cash flow distribution before asset disposition. It works on the principle that if the investor fails to receive his agreed rate of return, the sponsor will have to share his already received revenues.
Therefore, the sponsor ensures investors with their predetermined returns. It is another provision to motivate the sponsors to bring in some action.
The catch-up provision states that 100% of the profits will go to the sponsors once the investors have their predetermined share. It is a variation of the lookback provision with a slight difference. Many sponsors prefer these provisions because they can use the money in the short term. You can reach out to a real estate investment group for more details.
The structure aims to nurture the existing relationships with investors and simultaneously attract new ones. The waterfall model seeks to check cash flow across all tiers and examine the entire return metrics.