What are the best practices and pitfalls to avoid when structuring your real estate waterfall?

1 Define the tiers

The first step in structuring your real estate waterfall is to define the tiers or hurdles that determine how the profits are split. Typically, there are at least three tiers: a preferred return, a catch-up, and a promote. The preferred return is the minimum annual return that the investors receive before the sponsor gets any share. The catch-up is the portion of the profits that the sponsor receives until they reach a certain percentage of the total profits, usually equal to their equity contribution. The promote is the additional percentage of the profits that the sponsor receives after the catch-up, as a reward for their expertise and risk. The tiers can be further divided into sub-tiers, based on different internal rate of return (IRR) or equity multiple thresholds, to create more complexity and alignment.

2 Choose the model

The second step in structuring your real estate waterfall is to choose the model that best suits your project and partnership. There are two main models: the American model and the European model. The American model applies the tiers sequentially, meaning that each tier must be satisfied before moving to the next one. The European model applies the tiers pari passu, meaning that each tier is satisfied proportionally at the same time. The American model is more favorable to the investors, as they get their preferred return and capital back first, while the European model is more favorable to the sponsor, as they get their catch-up and promote sooner.

3 Negotiate the terms

The third step in structuring your real estate waterfall is to negotiate the terms with your partners or investors, and document them clearly in the operating agreement or the joint venture agreement. The terms include the percentages, thresholds, and calculations of each tier, as well as the timing, frequency, and method of distributions. You should also consider the impact of fees, expenses, taxes, capital calls, refinancing, sale, and other events on the waterfall. The terms should reflect the market conditions, the risk-return profile, and the expectations of both parties, and be fair and transparent.

4 Track the performance

The fourth step in structuring your real estate waterfall is to track the performance of your project and the waterfall over time, and communicate it regularly to your partners or investors. You should use a reliable software or spreadsheet to calculate the cash flows, returns, and distributions for each tier and partner, and update it as the project progresses. You should also provide periodic reports, statements, and projections that show the actual and projected performance, and explain any deviations or changes. This will help you maintain trust, accountability, and compliance with your partners or investors.

5 Avoid common pitfalls

The fifth step in structuring your real estate waterfall is to avoid some of the common pitfalls that can lead to disputes, errors, or inefficiencies. These include using vague language in agreements, making unrealistic assumptions or inputs into the calculations, having different models or terms for different partners or investors, using outdated or inaccurate data to track performance, and relying on manual processes or tools to manage or execute the waterfall. If these pitfalls are not avoided, they can lead to confusion, distortion of results, complexity, unfairness, lack of credibility and transparency, and an increased risk of mistakes or delays.

6 Optimize the outcomes

The sixth step in structuring your real estate waterfall is to optimize the outcomes for your project and your partners or investors, by adjusting or revising the waterfall as needed. You should monitor the market trends, the project performance, and the partner or investor feedback, and identify any opportunities or challenges that may affect the waterfall. You should also evaluate the feasibility, benefits, and costs of making any changes to the waterfall, such as modifying the tiers, percentages, thresholds, or calculations, or refinancing, reinvesting, or exiting the project. You should then discuss and negotiate any potential changes with your partners or investors, and implement them accordingly.

7 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?