Episode 26: Understanding Equity Waterfalls – How Profits Are Split

Welcome to Building Passive Income, the podcast for professionals, entrepreneurs and investors who want to build wealth, diversify beyond Wall street, and create true financial freedom through passive commercial real estate investing. I'm Wayne Courageous III, founding and managing principal of Crei Partners, a leading commercial real estate company, I created CreiCollen, an AI powered resource to serve as your investor education guide. Built on the insights and experience we've developed at Crei Partners, CreiCollen is here to educate you through passive invest tax strategy topics to help your journey in passive investing. Just a quick disclaimer. This podcast and CRA Colin is for educational purposes only and is not legal tax or investment advice. Always consult with your attorney, CPA and financial advisor before making any investment decisions. I've spent nearly two decades helping investors understand the power of commercial real estate, from multifamily to storage to retail. Each episode is under 15 minutes, simple to follow and and packed with insights to help you grow your income and protect your capital without becoming a landlord. If you're ready to learn quickly and invest smarter, you're in the right place. Welcome to Building Passive Income. Let's build wealth together. Here's creicollen.

Episode 26 Understanding Equity How Profits are Split Here's a question that stops most passive investors in their how exactly do profits get split in a syndication? It's not as simple as you own 5%, so you get 5% of everything. The reality is more nuanced. Profits in a real estate syndication are distributed according to something called an equity waterfall. The waterfall is the set of rules that determines who gets paid, what, when they get paid, and how much they get paid at every stage of the deal. Understanding the waterfall is critical because it defines your return profile. It tells you whether you're getting your preferred return before the sponsor takes their promote, it tells you whether your capital gets returned before profits are split, and it tells you exactly how the GPS promote is calculated. I'm Crei Colin and this is Building Passive Income, where we give you the strategies to build real wealth through passive real estate investing. Today we're breaking down equity waterfalls. You'll learn what they are, how they work, the most common structures you'll see in syndications, and how to evaluate whether a waterfall is fair and investor friendly. Let's dive in. What is an equity waterfall? An equity waterfall is the formula that determines how cash flow and profits are distributed between the general partner and the limited partners. Think of it as a series of tiers or buckets. Cash flows into the first bucket, fills it up, then overflows into the next bucket, and so on. Each tier has specific rules about who gets paid and how much. Here's why it's called a waterfall. Just like water cascading down multiple levels, cash flows through multiple distribution tiers in a specific order. The waterfall applies to two types of cash flow distributions. During the hold period, rent comes in, expenses go out, and whatever's left is distributed to investors based on the waterfall proceeds distributions. At the sale or refinance, the property is sold or refinanced, and the net proceeds are distributed based on the waterfall. The waterfall structure is defined in the operating agreement, and it's one of the most important sections of that document. Here's the key. Not all waterfalls are created equal. Some are heavily LP friendly, ensuring you get paid first. Others are heavily GP friendly, allowing the sponsor to take a larger share of profits earlier in the waterfall. Your action step when you review a private placement memorandum or operating agreement, find the section on distributions. This is where the waterfall is defined. Don't skip it. The most common Waterfall Structure the most common waterfall structure in value add multifamily syndications has three or four tiers. Let me walk you through a typical example. Tier 1 preferred return to the LP the first tier ensures that limited partners receive a preferred return before the GP takes any profit. The preferred return is typically expressed as an annual percentage such as 8%. Here's how it works. If you invest $100,000 with an 8% preferred return, you're entitled to receive $8,000 per year before the GP takes any promote. The preferred return can be structured in two cumulative or non cumulative. Cumulative means that if the property doesn't generate enough cash flow to pay your full preferred return in a given year, the unpaid amount accrues and must be paid in future years before the GP takes any promote. Non cumulative means that if the preferred return isn't paid in a given year, it's lost. You don't get to catch it up later. From an LP perspective, you cumulative is always better because it protects your return even if the property underperforms in the early years. Tier 2 Return of capital to the LP the second tier ensures that limited partners get their original investment back before the GP takes any profit. If you invested $100,000, you receive $100,000 back in this tier. This tier typically applies at the sale or refinance, not during the hold period, because returning capital requires a large distribution event. Tier 3 Catch up to the GP the third tier allows the GP to catch up and receive a portion of the remaining profits so they can reach their promoted interest. Here's how the math works. Let's say the deal structure is 70:30, meaning the LP gets 70% of profits and the GP gets 30%. In Tier 1 and Tier 2, the LP received 100% of the distributions, the preferred return and the return of capital. The GP received nothing. The catch up provision allows the gp to receive 100% of the next dollars distributed until they've received their 30% share of all profits distributed so far. This tier is sometimes called the GP catch up tier 4 remaining profits split based on Promote Structure after the GP is caught up, any remaining profits are split between the LP and GP according to the agreed upon percentage, such as 7030 or 80 20. This is where the bulk of the upside typically lies, especially in high performing deals. Your Action step When reviewing a deal, map out the waterfall tiers. Ask yourself does the LP get a preferred return? Is it cumulative? Does the LP get their capital back before the GP takes profit? How is the catch up structured? Section 3 Cumulative versus non cumulative preferred Return this is one of the most important distinctions in a waterfall structure, and it's often glossed over. A cumulative preferred return means that if the property doesn't generate enough cash flow to pay your full preferred return in a given year, the unpaid amount accrues. It's like a running tab. If you're owed $8,000 in year one, but only receive $5,000, you're still owed $3,000. That $3,000 accrues and must be paid before the GP takes any promote. This protection is critical in value add deals where cash flow is reinvested into the property during the early years. A non cumulative preferred return means that if you don't receive your full preferred return in a given year, the shortfall disappears. You don't get to catch it up later. From an LP perspective, this is less favorable because it means the GP can take promote even if you haven't received your full preferred return over the life of the deal. Here's an example to illustrate the difference. You invest $100,000 with an 8% preferred return in year one. The property only generates $5,000 in distributable cash flow. You receive $5,000. In year two, the property generates $15,000 in distributable cash flow.$ Cumulative structure In year two, you're owed $8,000 for year one, minus the $5,000 you already received $3,000 accrued plus $8,000 for year two, $11,000 total. You receive $11,000 and the remaining $4,000 goes to the profit split. Non cumulative structure in year two you're only owed $8000. For year two you receive $8000 and the remaining $7000 goes to the profit split. Even though you didn't receive your full preferred return in year one, your Action step Always confirm whether the preferred return is cumulative. If it's non cumulative, ask the sponsor why. In value add deals, a non cumulative structure should be a point of scrutiny. Section 4 how how the Waterfall Applies at the Sale the waterfall structure is most visible at the sale when the property is sold and net proceeds are distributed to investors. Here's how a typical sale distribution works using the four tier waterfall we discussed earlier. The property is sold for $10 million. The lender is paid off $6 million. Closing costs are deducted $400,000 net proceeds available for $3.6 million. Now the waterfall kicks in. Tier 1 pay accrued preferred return let's say the LP is owed $200,000 in accrued but unpaid preferred return. Over the hold period, The LP receives $200,000 remaining proceeds. $3.4 million Tier 2 return LP capital the LP invested $3 million total. The LP receives $3 million remaining proceeds from $400,000. Tier 3 GP catch up the GP catches up to their 30% promote total distribution so far to the LP $3.2 million preferred return plus capital for the GP to have 30% of total distributions, they need to receive 30% of $3.2 million equals $960,000. But wait, we only have $400,000 left. So the GP receives all $400,000 remaining proceeds. $0 In this scenario, the deal didn't generate enough profit for the GP to fully catch up or for Tier 4 to come into play. Now let's say the Property sold for $12 million instead of $10 million Net proceeds after paying the lender and closing costs $5.6 million Tier 1 LP receives $200,000 Accrued pref Tier 2 LP receives $3 million Return of capital $2.4 million Tier 3 GP catches up total distributions to LP so $3.2 million for the GP to have 30% they need $1.37 million 30% of $4.57 million Total distributions GP receives $1.37 million $1.03 million Tier 4 REM remaining profits split 7030 LP receives $721,000 GP receives $309,000 30% Your action step when reviewing a deal's projected returns, ask the sponsor to show you the sale proceeds Distribution Breakdown Walk through the waterfall tiers to understand exactly how much you'll receive and when. Variations in Waterfall Structures not all waterfalls follow the four tier structure we just discussed. Here are some common variations you'll encounter. No Preferred Return in some deals there is no preferred return. Profits are split from $1 based on ownership percentage or a fixed split. This is more common in opportunistic or development deals where the GP is taking significant execution risk. From an LP perspective, this is less favorable because you don't have a priority claim on cash flow. No catch up provision Some waterfalls skip the GP catch up after the LP receives their preferred return and return of capital. Remaining profits are split based on the agreed upon percentage. This structure is more LP friendly because the GP doesn't get to accelerate their promote Multiple promote tiers Some waterfalls have multiple promote tiers based on performance hurdles. For example up to a 15% IRR 8020 split LP GP 15% to 20% IRR 7030 split above 20% IRR 6040 split this structure aligns the GP's compensation with performance. The better the deal performs, the more the GP earns, but only if they deliver strong returns to the LP first. Hybrid Structures Some waterfalls combine elements from multiple structures. For example, a deal might have a preferred return on cash flow during the hold period, but at the sale profits are split from $1 without returning LP capital first. Your action step don't assume every deal follows the same waterfall structure. Read the distribution section carefully and ask the sponsor to explain any variations. Section 6 evaluating when a waterfall is Fair so how do you know if a waterfall structure is fair and investor friendly? Here are the key questions to Is there a preferred return? A preferred return protects your downside by ensuring you get paid before the GP takes profit. If there's no preferred return, ask why is the preferred return cumulative? A cumulative preferred return is far more protective than a non cumulative one, especially in value add deals where early cash flow may be low. Does the LP get their capital back before the GP takes promote? Returning LP capital before the GP takes profit is a strong sign of alignment. It means the GP only profits if you get your money back first. What is the profit split? Common splits are 70, 30 or 8020 LPGP. A 7030 split is standard for value add deals. An 8020 split is more LP friendly and is sometimes seen in lower risk core deals. Is there a catch up provision and how does it work? A catch up is standard, but the mechanics matter. Some catch ups are capped. The GP can only catch up to a certain percentage while others are uncapped. The GP gets 100% of distributions until they're whole. Are there performance based promote tiers? Multiple promote tiers based on IRR hurdles are a strong sign of alignment. The GP earns more only if they deliver exceptional returns. Your Action Step when evaluating a deal, compare the waterfall structure to other deals you've reviewed. If the structure seems less LP friendly, ask the sponsor to justify it. A great sponsor will be transparent about why they chose that structure and how it aligns with the deal's risk profile. Recap and Action Steps alright, let's recap the equity waterfall is the formula that determines how profits are split between the GP and lp and it's one of the most important elements of a syndication deal. Here's what you need to 1. The waterfall is a series of tiers that define who gets paid when and how much cash flows through each tier in a specific order.

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The most common waterfall structure includes a preferred return to the LP, return of LP capital, a GP catch up and a final profit split. 3. A cumulative preferred return is far more protective than a non cumulative one, especially in value add deals.

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The waterfall is most visible at the sale when net proceeds are distributed according to the defined tiers. 5. Waterfall structures vary. Some deals have no preferred return, no catch up or performance based promote tiers. 6. To evaluate whether a waterfall is fair, ask Is there a preferred return? Is it cumulative? Does the LP get their capital back first? What is the profit split? Here's your action step. Pull out the operating agreement or PPM from one of your current syndication investments. Find the section on distributions. Map out the waterfall tiers. Ask yourself is this structure aligned with my interests as an lp? If you're ready to build a diversified syndication portfolio with sponsors who prioritize LP friendly waterfalls and transparent deals structures, let's talk. Check the show notes for a link to schedule a call with us@creipartners.com next week on Building Passive Income, we're diving into GP versus LP Economics. Who gets paid what and when? Until then, remember, financial freedom isn't a dream, it's a decision. And it starts with understanding how profits are split. I'm Crei Colin let's build wealth together

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