Exploring the Benefits and Drawbacks of Waterfall Structures in Multifamily Real Estate Investments

My personal preference is an 80/20 straight split, but if the deal is right, a waterfall structure could make sense.

What is a waterfall structure?

In multifamily syndication, it's a way to distribute returns between limited partners and general partners. There are different tiers of returns based on the deals performance.

Here's an example of a waterfall structure from a property analyzer that I use.

What this is showing is how profits will be distributed on a sale. In this case the percentage is the IRR metric.

For example:

Let's say the deal itself provides a 17% annual IRR for the entire hold period.

Now it has to go through the waterfall structure.

The first 7% of the profit goes to the limited partners. The general partners get none of this money.

Between 7% and 15%, the profits are split 70/30. The limited partners get 70% of the spread of 8%. The general partners get 30% of 8%.

Anything above 15%, limited partners and general partners split 50/50.

What the limited partner gets on a 17% IRR:

Tier 1, they get 7%

Tier 2, they get 5.6%

Tier 3, they get 1%

Total: 13.6% IRR out of 17% IRR

What the general partners make on 17% IRR:

Tier 1, they get 0%

Tier 2, they get 2.4%

Tier 3, they get 1%

Total: 3.4% IRR out of 17% IRR

Don't feel too bad for the general partners though because they're getting this return on the entire equity pool. Often times, a general partner team will put around 10% of the equity raise up personally.

Comparing to 80/20% split as a Limited Partner

13.6% IRR / 17% IRR = 80%

3.4% IRR / 17% IRR = 20%

If the deal gets a 17% IRR, the returns between this waterfall structure and an 80/20 straight split are exactly the same (not including different fees, if there's a preferred return, etc.). In this example, if the deal does worse than 17% IRR, the advantage is for the waterfall structure. If the deal exceeds 17% IRR, then the advantage is to the 80/20 straight split.

Pros:

A waterfall structure like this combined with a 7% or higher preferred return can actually give the limited partner better returns than a straight 80/20 split if the deal meets the pro forma numbers or does worse than the business plan pro forma.

Cons:

Can be complicated for investors to understand compared to a straight profit split.

If the deal hits a home run, you'll make significantly less than a straight split because above a 15% IRR, profits are split 50/50.

If the deal does poorly, say around 7% IRR per year, then the general partners make no money except for things like acquisition fee or asset management fee. If the person operating the deal is making close to no money, their incentives to put maximum effort into the deal could be compromised making the deal perform even worse.