Breakdown of Real Estate Equity Waterfalls
Real estate equity waterfalls is one of the most widely used concepts and anyone looking to scale their real estate portfolio must have a grip on it.
For some reason, it's also typically one of the most difficult aspects of real estate to comprehend so I’ll try to distill it as much as possible.
Let’s use an example right off the bat.
Imagine you're 28 years old, have some experience investing in real estate, and are ready to increase your multifamily portfolio. So you've chosen to invest $100,000 into an apartment building and are on the hunt for your first deal.
You've finally found what you consider to be the optimum pricing after months of searching, and you believe that at the asking price, you can earn at least a 16 percent internal rate of return (IRR) during a five-year holding period
The transaction is worth $3 million, which is a huge sum. That means that even if you obtain 65 percent of the purchase price in loan funds, you'll still need about a million dollars to complete the transaction.
You are confident in the deal and want to see it through, even though you only have $100,000 to invest.
You'll need to find one or more capital partners to help you fund the deal because you don't have $1 million to invest on your own. And it is here that the concept of syndication emerges. You're seeking for investors to assist you in purchasing a piece of property.
So you start thinking about who you know who might have some spare cash and be interested in partnering with you to invest in real estate.
Let's say you're thinking about your friend Zuck, and you know he founded a little firm(starts with F) a few years ago and you know he is wealthy.
"How would you like an 18 percent return on your money?" you say to Zuck over the phone. You say you've found a fantastic real estate deal.
Zuck says he has no time and has no idea about real estate. But you convince him you will take care of everything and he agrees to invest $900,000 in the deal but wants you to put the rest of $100k to have some skin in the game.
At this point, I have a $3 million purchase price and a $2 million assumed debt. Then there's the equity of $1 million.
Zuck has now agreed to contribute $900,000 of the $1 million in stock required. And all you have to do as the deal's general partner or operational partner is put up $100,000.
This is a relatively common structure these days. In real estate private equity the general partner or sponsor or the operator, who is effectively the person doing the work on the deal, will often provide between one and ten percent of the total equity to have skin in the game.
And that limited or capital partner or multiple partners will cover 90% to 99% of the equity investment.
In this example, you may now manage $3 million in real estate as a 28-year-old with only $100,000 in your pocket.
"I think this is fantastic," you say, "but I have one more question for you. What do you believe your return would be if you invested your money somewhere else, such as the stock market or another private equity investment?" Zuck says after a brief pause, "I can probably get around 8% every year.”
This info of what he expects is super crucial. It’s like Zuck is giving you an alley hoop and you just need to dunk.
You say to him: until we reach that 8% internal rate of return, or IRR, we'll divide the profits in the same proportion as we initially invested them, so I'll get 10% of all cash flows up to that 8% internal rate of return, and you can get 90% of all cash flows.
Up until this point, you are only taking into account capital contributions from you and Zuck but you are also doing the work so you need to account for that as well.
So you tell Zuck that since I'm doing all the work on the deal, you should encourage me to do an even better job and deliver outstanding financial returns for you.
If our investment generates a higher annualized rate of return than 8%, I'll take 30% of the profits for every dollar generated beyond that rate of return.
"That actually sounds amazing," Zuck says, adding, "I was only planning on obtaining an 8% return anyhow, so anything above that is icing on the cake.”
Let's take a moment to reflect on what just happened. This is when the waterfall portion of the equation starts to merit attention.
So you're asking for a 30% portion in Zuck’s earnings over the current IRR of 8%.
This is crucial to understand: You are not asking for 30% of the total additional earnings but 30% of Zuck’s additional earnings.
If your internal rate of return (IRR) is 16, 18, or 20%, you're effectively taking 30% of any profits your limited partners make in order to split your overall cash flow as a general partner.
From a numerical standpoint, this means that for every dollar of profit over that 8% internal rate of return, you'll take 30% of Zuck’s 90 percent, or 27 percent of the total profits, plus your initial 10% of the profits from the equity that you invested, for a total of 37 percent of the profits for every dollar of profit over that 8% IRR.
Let's fast forward five years. After all, instead of an 8 percent internal rate of return, you've obtained a 16 percent internal rate of return.
Even yet, it's a terrific return; everyone is thrilled with how smoothly the job went, and you end up with a sizable profit.
In fact, this deal has netted you nearly a million dollars in profit. So, where does all of that cash end up? What are the divisions?
In this example, let's say we made $400,000 in profit up to that 8% internal rate of return, and $600,000 in profit over that 8% internal rate of return.
Zuck would get 360,000 of the $400,000 profit since his contribution was 90% and you would get the remaining 40,000.
Zuck, on the other hand, will get 63 percent of the $600,000 profit, or $378,000. You will receive the remaining 37 percent, or $222,000.
So Zuck has gotten 360,000 + 378,000 in profit. Which is ~16% IRR over the period of 5 years.
Zuck would be happy since he got a much better return than he would have gotten from the stock market or another investment vehicle.
Meanwhile, thanks to the promotional interest you received for exceeding the 8% internal rate of return, you earned roughly a ~50 - 52% internal rate of return on your initial investment of 100k as the syndicator.
All of this is how real estate syndication works, and the equity waterfall model is an important part of it. You can get creative with deal structures but this is the most common waterfall structure I've observed in the US.
Real estate is filled with concepts that are misconstrued as complex theories but in reality, all you need to do is see a simple breakdown.
My goal with these emails is to continue surfacing easy frameworks and examples so you can decrease the time to implementation and accelerate your RE investing journey.
I hope this has given you a better understanding of equity waterfall models.