Equity waterfall models in commercial real estate projects are one of the most difficult concepts to understand in all of real estate finance. Cash flow from a development or investment project can be split in a countless number of ways, which is part of the reason why real estate waterfall models can be so confusing. In this article we’ll take a deep dive into real estate waterfall distributions, dispel some common misconceptions, and then we’ll tie it all together with a step-by-step real estate waterfall example.

## What are Investment Waterfall Distributions?

First of all, what exactly is a “waterfall” when it comes to cash flow distributions? An **investment waterfall** is a method of splitting profits among partners in a transaction that allows for profits to follow an uneven distribution. The waterfall structure can be thought of as a series of pools that fill up with cash flow and then once full, spill over all excess cash flow into additional pools.

This type of arrangement is beneficial because it allows equity investors to reward the operating partner with an extra, disproportionate share of returns. This extra share of returns is called the **promote**, which** **is used as a bonus to motivate the operating partner to exceed return expectations. Under a waterfall structure the operating partner will receive a higher share of profits if the project’s return is higher than expected, and a lower share of profits if the project’s return is lower than expected.

## The Importance Of The Owner’s Agreement

With investment waterfalls, cash flows are distributed according to the owner’s agreement. Because there are so many variables when it comes to investment waterfall structures, it’s critically important to always read the owner’s agreement. The agreement will spell out in detail how profits will be split among partners. While there are some commonly used terms and components in investment waterfall structures, waterfall structures can and do vary widely. This means there is unfortunately no one size fits all solution and the only way to understand a specific waterfall structure is to read the agreement.

## Common Real Estate Waterfall Model Components

Although waterfall structures vary widely, there are several commonly used waterfall model components. Before we dive into our step-by-step waterfall model example, let’s first take a look at some basic building blocks.

**The Return Hurdle**

The return hurdle is simply the rate return that must be achieved before moving on to the next hurdle. This is important to clearly define because the return hurdles (or tiers) are what trigger the disproportionate profit splits. Since the term “rate of return” can be defined many different ways, the return hurdle in a waterfall distribution structure can also be defined in many different ways. In practice, the the Internal Rate of Return (IRR) or the Equity Multiple are commonly used as return hurdles. The IRR is the percentage rate earned on each dollar invested for each period it is invested. The Equity Multiple is simply the sum of all equity invested plus all profits divided by the total equity invested, or [(Total Equity + Total Profits) / Total Equity].

Once the return hurdle has been defined the next logical question is, from what perspective will the return be measured? Since a project will have a sponsor and at least one other investor, the return can be calculated from several different perspectives. The return hurdle could be measured from the perspective of the project itself (which could include* both* the sponsor and the investor equity), the third-party investor equity only, or the sponsor equity only.

**The Preferred Return**

Another common component in equity waterfall models is the preferred return. What exactly is the preferred return? The **preferred return**, often just called the “pref”, is defined as a first claim on profits until a target return has been achieved. In other words, preferred investors in a project are first in line and will earn the preferred return before any other investors receive a distribution of profit. Once this “preference” return hurdle has been met, then any excess profits are split as agreed.

A few key questions with the preferred return are:

- Who gets the preferred return? Preferred investors could include all equity investors or only select equity investors.
- Is the preferred return cumulative? This becomes relevant if there isn’t enough cash flow to pay out the preferred return in any given year. In waterfall models this preferred return can either be cumulative or non-cumulative. If the pref is cumulative then it will be added to the investment balance for the next period and accumulate until it’s eventually paid out.
- Is the preferred return compounded? A preferred return can also be compounded or non-compounded. When the pref is cumulative a key question is, is this unpaid cash flow compounded at the preferred rate of return as it accumulates?
- What is the compounding period? If the pref is compounded then it’s also important to know the compounding frequency. The compounding frequency could be annually, quarterly, monthly, daily, or even continuous.

**The Lookback Provision**

The lookback provision provides that the sponsor and investor “look back” at the end of the deal and if the investor doesn’t achieve a pre-determined rate of return, then the sponsor will be required to give up a portion of its already distributed profits in order to provide the investor with the pre-determined return.

**The Catch Up Provision**

The catch up provision provides that the investor gets 100% of all profit distributions until a pre-determined rate of return has been achieved. Then, after the investor achieves the required return, 100% of profits will go to the sponsor until the sponsor is “caught up.”

The catch up provision is essentially a variation on the lookback provision and seeks to achieve the same goal. The key difference is that with the lookback provision the investor has to go back to the sponsor at the end of the deal and ask the sponsor to write a check. With the catch up provision, the investor gets 100% of all profits until the required return is achieved and only then will the sponsor receive a distribution. Typically the sponsor prefers the lookback provision (since they get to utilize money even if they have to eventually give it back), while the investor prefers the catch up provision (since they get paid first and won’t have to ask the sponsor to make them whole at the end of the deal).

Again, the important thing to remember about waterfall structures is that there is no one sized fits all solution and these terms and conditions will all be spelled out in the owners agreement. With these basic building blocks in our toolkit, let’s next move on to a detailed, step-by-step example of a real estate waterfall model.

## Multi-Tier Real Estate Investment Waterfall Calculation Example

Suppose we have a general partner and an outside investor who contribute a combined total of $1,000,000 into a project. The general partner invests 10%, or $100,000, and the outside investor contributes the remaining 90%, or $900,000. All equity investors (which includes both the general partner and the third party investor) receive a 10% annual preferred return on their invested capital. If distributions in any year fall below the preference level of 10%, then the deficiency will be carried over to the following years and compounded annually at the preferred rate of return. In other words, the pref is both cumulative and compounded.

After the 10% preferred return hurdle has been achieved, then all additional profits up to a 15% IRR will be allocated at a rate of 20% to the general partner and 80% to the equity investors. After a 15% IRR hurdle has been achieved, then all additional profits will be allocated at a rate of 40% to the general partner and 60% to the equity investors. All IRR hurdle calculations will be at the project level.

So, based on the above assumptions, we have a 3 tier waterfall model with all IRR hurdles measured at the project level. The first tier or hurdle is a 10% IRR, the second tier is a 15% IRR, and the 3rd tier is anything above a 15% IRR.

Now, let’s looks how how we actually calculate these waterfall distributions. First let’s take a look at our project level cash flow before tax and equity contributions over the holding period:

The first line is simply our before tax cash flow calculation from a standard real estate proforma. As you can see, the calculated IRR for the entire project is 21.24%. Intuitively this tells us we will reach the third IRR hurdle since 21.24% is greater than our third waterfall hurdle of 15%. The next few lines show how much equity is contributed to the project by the sponsor and investor and when it is contributed. Since all of the equity for this project is required at the beginning, it is all shown at time period 0.

Here is a summary including percentage allocations of the total equity contributions to the project:

As you can see, the sponsor provides 10% of the equity, or $100,000, and the third-party investor contributes 90% of the equity, or $900,000. Next, let’s take a look at a summary of our promote structure discussed above:

There are 3 tiers (or hurdles) in this promote structure. Profits are split pari passu up to a 10% IRR. After the 10% IRR is achieved, then profits will be split disproportionately. Profits above a 10% IRR up to a 15% IRR will be split 80% to the third-party investor and 20% to the sponsor. In other words, the sponsor gets an additional 10% of profits in addition to his 10% pro-rata share of profits. This additional 10% is the “promote”. Finally, all profits above a 15% IRR will be split 60% to the third-party investor and 40% to the sponsor. This means the sponsor is getting a 30% promote after the final 15% IRR hurdle is achieved.

So far all of our assumptions are pretty straight forward and easy to understand. We have a 90%/10% equity split between the third-party investor and the sponsor, and then we have a 3 tier promote structure. Now we need a way to actually calculate the profit splits at each tier.

**Real Estate Waterfall Model Tier 1**

To calculate the profit splits at tier 1 we have to first determine the cash flows required to achieve a 10% IRR. Then, we’ll allocate these cash flows to the sponsor and the investor based on the agreed upon profit splits at this tier. Finally, we’ll calculate how much remaining cash is available from the project that can flow into the next waterfall tier.

This is where waterfall distribution models get complicated, so let’s take it step by step.

The table above has a lot of information, so as we work through it below remember that all we are doing is calculating what a 10% IRR (Tier 1) looks like. Then, once we figure out what cash flows are needed for a 10% IRR, we simply allocate those cash flows (or available cash flows) between the Sponsor and Investor based on our Tier 1 promote structure. Finally, after netting out our Tier 1 cash flows from our before tax cash flows for the project, we figure out how much cash flow is remaining for Tier 2. With this big picture in mind, let’s walk through each line item in the table above.

Year 0 is the beginning of the project and as you can see our beginning balance is $0. On the next line below, you can see our equity contributions at the beginning of the project total $1,000,000. Next is the Tier 1 Accrual line item. This is simply the amount that is owed to the equity investors based on the 10% IRR. In this case the calculation is just 10% times the beginning balance, which for Year 0 is $0 since there is no beginning balance.

The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.

The Ending Balance line item takes the sum of the beginning balance, equity contributions, Tier 1 accrual, and Tier 1 distributions. This is simply taking what we start with (beginning balance), then adding in any new equity contributions, then accounting for the difference between what’s owed to us at this tier (the accrual) and what’s been payed out (the distribution).

In Year 1 we use the ending balance from the prior year (Year 0) as our Year 1 Beginning Balance. Then we simply repeat the process discussed above by calculating our Accrual based on the beginning balance for this period, then we calculate our actual distributions for this period, and finally our Ending Balance for this period. We continue this process for all years in the holding period and once completed we can then move on to splitting up cash flows between the Investor and the Sponsor in this tier.

The cash flow splits are shown on the three line items below the Ending Balance: Investor Cash Flow, Sponsor Equity Cash Flow, and Sponsor Promote Cash Flow. Investor cash flow is the percentage of Tier 1 distributions that flow to the investor and sponsor cash flow is divided into two components. First, the sponsor equity cash flow is the portion of Tier 1 distributions attributed to the sponsor’s pro-rata (10%) equity investment. Second, is the sponsor promote cash flow, which is the bonus cash flow that flows to the sponsor for achieving the IRR hurdle. In Tier 1 there is no promote, which means 90% of the Tier 1 distributions flows to the investor and 10% flows to the sponsor.

**Real Estate **Waterfall Model Tier 2

Now let’s take a look at the second IRR hurdle and repeat the same process we followed for Tier 1:

This table is exactly like the table used above for the first hurdle. The key difference is that this time we are calculating the cash flows required for a 15% IRR and then we are splitting them up between the investor and the sponsor at different rates. When calculating the cash flow splits we are also taking into account any distributions made in Tier 1. Let’s take a look at how this works.

In Year 0 we start off with $0, contribute $1,000,000 in equity, and since our beginning balance is $0 there aren’t any accruals nor any distributions. In Year 1 we start off with the $1,000,000 ending balance from Year 0, and our Year 1 accrual is 15%, which is $150,000. However, the project cash flow before tax is only $90,000, so there is a deficiency of $150,000 minus $90,000, or $60,000. This $60,000 deficiency gets added to our ending balance and carried over to the next year, where this process continues.

Once we’ve followed this process for all years in the holding period, we can then move on to calculate the cash flow splits between the investor and the sponsor. This is the same process we followed for Tier 1, except now the sponsor has a 10% promote. This is an additional 10% allocated to the sponsor above and beyond the sponsor’s 10% pro-rata share. Since we are allocating an additional 10% to the sponsor, this 10% is taken away from the investor’s original 90% allocation, which leaves the investor with 80% of the cash flow in Tier 2.

Besides including the promote in this Tier, the other difference here is that we are also netting out the cash flow taken in Tier 1. Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).

**Real Estate **Waterfall Model Tier 3

Finally, let’s take a look at the last hurdle, which is an IRR above 15%:

This is the easiest to calculate since we don’t have to figure out the required cash flow for a particular IRR. Instead we simply take all remaining cash flow and allocate it according to the percentage splits at this tier. In this case the sponsor gets a 30% promote in addition to his original 10% share, which leaves the investor with 60% of the cash flow. Just like in Tier 2, all of the cash flow in years 1 through 4 is distributed in the prior tiers, which is why all the cash flows in Tier 3 are from the sale in Year 5.

**Waterfall Model Returns Summary**

The last component in our real estate waterfall model is to look at the total cash flows across all tiers for the investor and the sponsor and then finally we’ll calculate some overall return metrics.

In this table we are simply adding up the cash flows from each tier for both the investor and the sponsor. Then we calculate the overall IRR and equity multiple for both the investor and the sponsor. Recall from our project’s cash flow before tax that our project level IRR was 21.24%. However, based on our promote structure the sponsor earns a disproportionate share of these cash flows resulting in a 36.34% IRR for the sponsor and an 18.91% IRR for the investor. This disproportionate cash flow split is also reflected in the equity multiple, which is 1.98x for the investor and 3.85x for the sponsor.

## Conclusion

In this article we tackled the real estate equity waterfall model, which is perhaps the most complicated topic in real estate financial modelling. The reason why real estate waterfall models are so complex is because there are so many variables that can be changed. We discussed some common components in equity waterfall models and emphasized the importance of reading the owner’s agreement in order to truly understand a waterfall structure. Finally, we walked through a detailed 3 Tier waterfall model example step-by-step.

How do you calculate the year 5 cash flow necessary to achieve the hurdle rate? E.g. how did you calculate the cash flow of $546,161 in year 5 on the first hurdle to achieve the 10% IRR? Thank you.

FYI I was able to utilize the Goal Seek function in excel to arrive at this (estimated) value assuming the target IRR

It’s calculated the same way as all the other years. In year 5 in the first hurdle you simply take the beginning of period balance of $496,510 and multiply by 10%, which is $49,651. Then add this to the beginning of period balance to get $546,161. Since this “accrual” amount is less than the project’s cash flow before tax in year 5 ($1,300,000), this accrual amount is the distribution.

Why are you distributing more than 10% in tier 1? For example, 10% of an accrued $1.1mm equity balance in year 2 is $110k, however, you distribute 180k to the equity group.

Because the amount owed in year 2 is actually the beginning balance of $1,010,000.

https://www.dropbox.com/s/psyihab0voxtetk/Property%20Metrics%20Promote%20Waterfall%20Example.xlsx?dl=0

^I’m not sure if this link works but I am coming up with slightly different figures for hurdles 2 and beyond in this model. I’m not sure where I’m going wrong here.

Where did you get your model?

I found this model on the internet

As mentioned in this article, waterfall models vary widely. It appears your model calculates the hurdle from the perspective of the third party investor, not all equity investors. This is a big difference and there could also be other differences as well. There is no one size fits all waterfall model unfortunately.

Hi Robert,

Thanks for the article. Still trying to wrap my head around this whole calculation! How do you calculate the “Remaining Cash to Distribute in Tier 2”

It’s just the project’s cash flow before tax minus the amount distributed in tier 1.

First off, very information article, so thank you. In your explanation of the formula for Accrual Distribution (lesser of: (i) beg. balance + contribution + accrual, or (ii) distributable cash), I found it difficult to put it into Excel using the MIN function when the numbers are expressed as negatives, as in your example. To me, it’s easier to conceptualize when the numbers are positive and the DISTRIBUTION is expressed at a negative. Plus, the formulas in Excel become easier. Does that make sense or am I missing something?

This may be simple, but I’m missing how you calculate to get the tier accrual distributions.

IE: like in tier 1 the line item

0k 90k 180k 180k 300k 300k

Take a look at the explanation for Tier 1 again:

“The Accrual Distribution line item is next and this is what actually gets distributed in this tier. This may or may not equal the prior Accrual line item. This accrual distribution calculation takes the lesser of 1) the Beginning Balance, plus Equity Contributions, plus the Tier 1 Accrual line item, or 2) the project’s cash flow before tax. The reason why this is the lesser of these two items is because we are limited by the cash flow available from the project and can’t pay out more than this amount. Conversely, if there is more than enough cash flow from the project to pay out what’s owed to us, then we don’t want to pay out any more than this.”

the math does’t add up. if you add 1) as stated, you will have -1,000,000, which is less than 0.

It takes the absolute value since we are calculating money owed to us.

Hi Robert — For Tier 2, how do you get the splits 80/10/10% what base are you multiplying these % splits to, to get at $233,823 / $29,228 / $29,228 ? TIA!

Check the spreadsheet that is now available for download.

Awesome article, thanks for putting this together. Just as a note, it would be very helpful if the excel download included the formulas and not just the values. It would be a lot easier for us to reverse-engineer the logic of the entire model.

Thanks!

The formulas are included in the spreadsheet.

Hi, I made it work with the following formula in Excel:

=IF(“Remaining Cash to Distribute in Tier2”>0,0.8*((“Remaining Cash to Distribute in Tier2”-“Remaining Cash to Distribute in Tier3”)),0).

In Tier2 you can only distribute between 10-15%IRR.

Thanks,

Kris Van Lancker

Optimus Global Investors

http://www.optimusinvestors.com

Why do you make distributions in Years 1 through 4 of Tier 2 if the remaining cash to distribute in Tier 2 is $0 for Years 0 through 4, per the tier 1 model?

The “Accrual Distribution” line item is only for calculating the distributions required at this tier. The cash flow line items show the actual cash distributed to investors, taking into account prior tier cash flows. Check the spreadsheet now available for download. Also, here is the explanation from the article:

“Since Tier 1 was calculated based on a 10% IRR, the Tier 2 15% IRR already includes the first 10%. In other words, the cash flow distributed in Tier 2 is only the incremental cash flow above 10% and up to 15%. To account for this we must subtract out any cash flow taken in prior tiers when calculating the cash flow for the current tier. This is why the cash flow is $0 for the first four years in the holding period (all of the cash flow was already distributed in Tier 1).”

In your tier 2 distribution, won’t you need to add the distribution you made in tier 1; so the tier 2 distribution formula should add back the distribution you made in tier 2. You currently leave that out?

Take a look at the cash flow lines…you’ll notice that that tier 1 distributions are netted out do they aren’t double counted.

Does Pref Equity always assumes that the property will be sold after the Term? What if the Sponsor wants to keep the building and at the refi event pays out the pref equity partner assuming he can match the expected return.

The above example is a Joint Venture, so the relationship will continue until the asset is sold or one partner buys the other partner out (at a mutually agreed price). The same would be true for Pref Equity (assuming it is participating Pref Equity) — one would need to buy out the other. There are sometimes non-participating Pref Equity structures where a buyout would not be necessary assuming the refinance is sufficient to payoff the non-participating Pref Equity. These are essentially just Mezzanine loans but documented differently.

How do you model it if you hit the promote before the final year and you are in promote territory from say year 2 onwards?

For example if the cash flow is as such

Year 0: -1,000,000

Year 1: 90,000

Year 2: 1,200,000

Year 3: 300,000

Year 4: 300,000

Year 5: 1,300,000

You would expect this scenario could arise if you have a multi-asset portfolio and you sell some assets prior to project end date

The model only works as it assumes you only hit >10% IRR in year 5

Try plugging in your example cash flows into the spreadsheet. Is this what you are looking for?

Why would you use Before Tax Cash Flow to determine the Cash Available for Distribution? Shouldn’t we use After Tax Cash Flow since there will be a tax bill?

Depends how the entity is taxed. Many commercial real estate projects are held in pass-thru entities (LLC for example), which means the individual LLC members are taxed on their portion of taxable cash flow at the personal level (not corporate). Alternatively, some entities like Pension funds are tax exempt altogether.

rob

What if you are unable to distribute during a quarter how would this affect your pref calc?

It depends. Take a look at the cumulative and compounded options under the pref section in the article.

How are you calculating the exact amount of distributions necessary to achieve each IRR hurdle? When I model waterfalls I “back into” the IRR but I can’t follow how you did it here.