When investing in real estate, the suitable waterfall model for cash distribution helps passive investors earn higher returns. The reason why real estate syndications prefer using these waterfall models is to structure and also compensate both principals and investors.
Also, the waterfall real estate model can be seldomly altered once a developer creates an appropriate structure. However, there are several ways in which these models are designed. This article sheds light on models, their components, and the breakdown of the waterfall model.
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What is meant by the waterfall model in real estate?
Using the waterfall model, a project’s cash flow returns can be distributed unevenly among the project’s stakeholders, providing more significant profit margins. Once all the pools are complete, the extra cash flow is split into other pools, creating the structure.
Investors benefit from entering into such an arrangement since it allows them to provide the operational partner with a larger and more equitable share of the profit margins. In addition, by promoting a partner’s profit share, you’re encouraging them to do better than expected.
A waterfall real estate model works so that a higher share of profits is given to the operating partner when the project’s return is higher than the expected return and vice-versa.
Components of the real estate waterfall model
There are many different models but a few essential elements. The real estate waterfall model includes several components, some of which are listed below:
The Return Hurdle
The rate of return that must be attained before the cash flow continues to the next hurdle is what it means by a “return hurdle.” In order to avoid an unequal distribution of earnings, it’s critical to define these impediments clearly. The waterfall model may include numerous hurdle rates, frequently assessed using IRR or Equity Multiple. It is necessary to establish from whose perspective the return hurdles will be calculated when evaluating projects: from the project’s perspective, the investor, or the sponsor.
The Preferred Return
Until the target return is achieved, the preferred return is known as the first claim on profits. Simply put, the project’s preferred investors will receive a higher rate of return than any other investors. Excess earnings will be dispersed as previously agreed upon once this “preferred” return hurdle has been cleared.
The Catchup Provision
The Catchup Provision, as the component of the real estate waterfall model, states that the investors will receive 100% of the property’s preferred return until a predetermined rate of return has been achieved.
The Lookback Provision
The Lookback Provision as the component of the real estate waterfall model provides that both the sponsor and the investor will look back at the end of the deal. In case a predetermined rate of return is not achieved by an investor. The sponsor will be liable to give the investor a predetermined return by giving up on the already distributed share.
Breakdown of a real estate waterfall model
A real estate waterfall model constitutes of four levels or hurdle rates:
Level 1: All of the project’s partners receive 100% of the project’s distributed cash flow.
Level 2: Preferable return hurdle rate with cash flow distributed among partners until the preferred rate of return reaches.
Level 3: Cash flow is distributed among the project’s partners until a set returns archives with the help of a “catchup” provision.
Level 4: When the return on investment exceeds expectations, the partners receive an unequal share of the payouts.
Conclusion
Even seasoned real estate investors may have difficulty developing and comprehending the real estate waterfall model. These models aid in determining how to pay back investors by distributing a portion of the company’s cash flow to them. If used correctly, these waterfall models can build relationships with existing investors and attract new ones.