The preferred return aligns with the interest of the sponsor and the equity investors. It is the investment-quality structure preferred by private equity investors the world over.
The order in which equity investors get paid — the “distribution waterfall” in industry jargon — is one of the critical concepts in real estate investing. Distribution waterfalls can get confusing. This article aims to clarify preferred returns and the order in which stakeholders in real estate projects receive distributions. The explanation of a project’s waterfall distribution is usually found in the investments operating agreement.
The waterfall (profit distribution) structure can be viewed as a risk-management tool, it allows the downside risk to be shifted away from the equity investor while providing upside potential to the sponsor.
The various stakeholders in the capital stack – Lenders, equity investors, sponsors – have varying positions in the splitting profits. The traditional structure represents an inverse hierarchy of payment priority and risk.
The typical waterfall compensates the sponsor for a successful project, while, minimizing the downside risk for the equity investor.
The concept is simple and effective: if the returns are greater than expected, a disproportionate share goes to the sponsor but if the returns are less than expected, a disproportionate share goes to the equity investors. It allows for the risk and returns to be distributed in a more equitable manner. The lender always gets paid before the sponsor or the equity investor. The following is a simplified version of a waterfall distribution (one I use), some waterfall structures can be quite complex.
Distribution Waterfall Example: A $13,000,000 Mobile home park development project with an 6% preferred investor return to equity investors and a 70/30 split of excess cash flow.
Example: This profit distribution example is based on an investment of
$100,000. A $100,000 investment will grow to $438,000 in 10-years. Assumes a direct investment and sale of the property at end of 10years. See business plan & Operating Agreement for details and assumptions.
Accrued 6% preferred return to Series “A” Equity members, pro-rata plus a 70% percent of the excess free cash flow pro-rata.
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