All About Equity Waterfalls, Part 1

By Jay Maddox, Principal, Avison Young

Many real estate projects are financed with infusions of joint venture equity capital provided by third-party investors seeking extraordinary returns. Developers and sponsors increasingly rely on such investors to fund as much as 90 percent of the required project equity. Assuming the developer can successfully navigate the capital markets and attract a willing equity partner, there is still a mountain to climb, or, more appropriately, a waterfall to go over—hopefully without injury. The challenge is how to structure a mutually acceptable joint venture.

What is the “waterfall”?

The equity “waterfall” in commercial real estate joint ventures is one of the most challenging financial concepts in all of commercial real estate. Unlike loans, which are generally simple in their structure, there are countless ways equity investments are structured. Before embarking on a project, an agreement between the equity investor and the developer needs to be reached, as to how to divide the cash flows from the project based upon the projected financial results, which is deemed fair and equitable among the partners.

How is an equity waterfall typically structured?

The waterfall structure is intended to align sponsor and investors interests, and to reward the sponsor for exceeding expectations. If the deal is properly structured, everyone emerges from the venture satisfied, provided the projected economic results have been achieved or exceeded. However, it is critical for sponsors to understand the basics and the inherent trade-offs in order to avoid misunderstandings and potential pitfalls.

When considering a joint venture, it is critical for the sponsor and the equity investor to have their investment objectives aligned. The typical joint venture structure involves the investor contributing a disproportionate share of the initial equity as a limited partner or LLC member, while ceding day-to-day control to the developer sponsor, who contributes the balance of the equity as the general partner or managing member of the LLC. For example, the equity investor may contribute 80 percent or more of the required equity. The developer sponsor typically provides any financial or performance guaranties required by the senior lender.

Preferred returns

Joint venture returns are generally structured to provide a minimum threshold return to the investor that must be achieved before moving on to the next hurdle. For example, the investor may earn a minimum preferred return of 8 percent to 10 percent before profit splits. Generally, the sponsor also receives the same preferred return on its equity contribution, subordinated to the investor. If there is not sufficient cash flow, the preferred return is typically deferred and accrued/“cumulative” until cash flow is sufficient to pay it.

Return of capital and profit splits

The next step in the waterfall is to repay investor and sponsor initial equity contributions, in that order. The remaining cash flows are then distributed in myriad ways, and that’s where the complexity really begins. Generally, the distribution percentages are disproportionate to the parties’ initial equity investment. For example, although the developer only contributed 10 percent of the equity, it may be entitled to 30 percent of the residual cash flow, and that percentage typically goes much higher once the investor has earned a minimum threshold rate of return (IRR) or multiple of capital (MOC) invested.

There may be as many different ways to structure the equity waterfall as there are investors. For that reason, it is wise for developers, especially the uninitiated, to consult with expert professionals when entering into a joint venture investment.

This is the first part of a two-part series on equity waterfalls. Stay tuned for part 2.