Real Estate Equity Waterfalls Explained

hey guys this is Justin from breaking the CRE and in today's video what we're gonna do is talk about real estate equity waterfalls and what these actually are in a real estate deal now these tend to be one of the most daunting parts of a real estate syndication or fund and when I was first starting out it was really difficult to learn what this was it seemed like every time someone would try to explain it to me or when I would try to read something about it online I would end up feeling more confused than when I first started so what we're gonna do in this video is really break down this concept step-by-step in a simplified way so it's easy to understand rather than over complicating the process we're gonna break down exactly what an equity waterfall is so if you're looking to use an equity waterfall structure in your next real estate deal or you're just trying to figure out how an equity waterfall model actually works in practicality definitely stick around for this video [Music] now if you're new to this channel we talk about real estate investing careers and real estate financial modeling so if you're looking to break into the real estate investment industry for the first time or you're looking to advance your existing real estate investment career definitely subscribe to this channel and hit that notification bell to be notified every time I release a new video now the most important part of this is understanding what an actual equity waterfall is and why it's used in many private equity models so what we're gonna do is break down what a waterfall structure actually is in a real estate deal and we're going to use an example to do it so let's say you're 25 years old you have a little bit of experience in real estate investing and you're ready to start building your multifamily portfolio so you want to buy an apartment project you have $50,000 to invest and you start to hunt for your first deal now after many months of searching you finally find what you believe is the perfect deal and at the asking price you believe you can hit an 18% internal rate of return or IRR over a five-year hold period the problem is that the deal is listed at three million dollars meaning that even if you get about 65 percent of the purchase price as loan proceeds you're still going to have to come up with about a million dollars to close on the deal now even though you only have $50,000 to invest you believe really strongly in the deal and you want to get it done so since you don't have that 1 million dollars to invest on your own you need to go out and start looking for one or more equity partners to help you fund the deal and that's really where the syndication is created you're raising capital from investors to buy a real estate deal so you think about who you know that has some extra money that may want to invest in real estate and may want you as that operating partner so say you think of your uncle mark and your uncle Mark started some social media company a few years ago it starts with an F and you don't really know what it's called but you do know that he's loaded and he can probably help you invest in the deal so you call up Uncle Mark and you say Uncle Mark how would you like an 18% return on your money I found this great real estate deal and Uncle Mark says that sounds great kid but I don't know anything about real estate and I also have my own business to run so I don't have time to do this so you say no problem at all uncle mark I will do all of the work so uncle mark thinks about this for a second and says interesting how much money do you need and you say well I need a million dollars to close on a deal but I have 50,000 to invest so uncle Mark says okay I'll give you nine hundred and fifty thousand dollars I want you to invest the other fifty thousand because I want you to have some skin in the game so let's hit the pause button on this conversation for a second and just recap what just happened so at this point we have a purchase price of three million dollars we have two million dollars of assumed debt and then we have 1 million dollars of equity now at this point Uncle Mark has committed to funding nine hundred and fifty thousand dollars of the required 1 million dollars of equity and you as the general partner or operating partner of the deal need to only contribute fifty thousand dollars on the deal now this is an extremely common structure in real estate private equity usually you'll see somewhere between one and ten percent of the total equity requirement for the deal is going to be funded by that general partner or the sponsor really the person doing the work on the deal and ninety two ninety nine percent of the equity investment is going to be covered by that limited or capital partner that's not going to end up doing the work on the deal so at this point as a 25 year old you're able to control three million dollars of real estate with only fifty thousand dollars of your own capital pretty cool right well it gets better so let's jump back into that conversation so you say back to uncle mark this sounds great to me but one more question for you if you were going to invest your money somewhere else so the stock market or another private equity investment what do you think your return would likely be uncle mark thinks for a second and says probably around 8% per year so now at this point you know how you constructed the deal so you say back to uncle mark that sounds good so how about this in this investment until we hit that eight percent internal rate of return or IRR we're going to split the profits in the exact portion that we initially invested them so I'll get five percent of all the cash flows up to that eight percent internal rate of return and you can get ninety five percent of all of those cash flows sound good uncle mark says yeah sure that makes sense but then you say since you're doing all the work you're going to add some sort of promoted interest into the deal so you say to your uncle mark but since I'm doing all the work on the deal to incentivize me even more to do a great job and achieve really strong investment returns for you when everything is said and done if our investment hits over an eight percent annualized rate of return for every dollar of profit over that eight percent annualized rate of return I'm going to take thirty percent of what your profit would otherwise be now Uncle Mark thinks about this for a second and says that actually sounds good I was only planning on getting an eight percent return otherwise so anything above that is icing on the cake so let's stop this and talk about what just happened here and this is really where the waterfall part of the equation comes into play so what you're asking here is for 30% of uncle Mark's profits over that eight percent IRR so notice this doesn't mean that a 30 percent promoted interest means that you take 30% of all of the profits if you hit a 16 or 18 or 20 percent IRR you're really taking the 30 percent of whatever your limited partners profits are to get your total cash flow split as a General Partner so what this means from a math perspective is that for every dollar of profit over that 8 percent internal rate of return you're going to take 30 percent of your uncle Mark's 95 percent or twenty eight point five percent of the total profits plus your initial 5 percent of the profits from that equity that you invested for a total of thirty three point five percent of the profits for every dollar of profit over that eight percent IRR so let's say we fast forward five years and when it's all said and done you've hit a 16 percent internal rate of return rather than an 18 percent internal rate of return still a great return everybody's happy the project performed well and you have a lot of profit at the end of the day in fact you have over a million dollars of profit that you've earned on their steel so where does that profit go and how is it split well in this case let's say we have four hundred thousand dollars of profit up to that eight percent internal rate of return and six hundred thousand dollars of profit over that eight percent internal rate of return so for the four hundred thousand dollars of profit up to that eight percent internal rate of return uncle mark would take home three hundred and eighty thousand of that and you would take home the remaining twenty thousand but for the six hundred thousand dollars of profit over that eight percent internal rate of return uncle mark is only going to take sixty six point five percent of that or three hundred and ninety nine thousand dollars and you're going to take the remaining thirty three point five percent of that or two hundred and one thousand dollars now even with that let's say uncle mark gets a fourteen percent internal rate of return on his investment even though the project hit a sixteen percent internal ready to return uncle mark is still really happy and achieved a much better return than he would have gotten in the stock market or another investment vehicle but meanwhile you as the syndicator you earned over a forty percent internal rate of return on your investment based on that promoted interest that you earned from achieving over that eight percent internal rate of return and that's where the waterfall structure comes into play and all of that put together is really how a real estate syndication works and how the equity waterfall model plays into that real estate syndication now this is the most common waterfall structure that I've seen in the u.s. obviously there are many different waterfall structures and many different ways to structure a real estate partnership but this is really the way that I wish someone would have explained real estate equity waterfalls to me when I was first getting started in the business now if you want to learn more about how to actually build these waterfalls in Excel how to actually build an equity waterfall for your next real estate deal I definitely recommend checking out my course the real estate equity waterfall modeling master class it's the same concept when I was first learning how to build this I couldn't find a resource that could teach me how to build a real estate equity waterfall in a way that actually made sense and so this course is my way of breaking this process down in an easy step-by-step format so you can actually understand how to build an equity waterfall model so I'll link that course in the description below so definitely check that out if you want to learn more about equity waterfall modeling in Excel so I hope that helped you understand equity waterfall models and a little bit more of a clearer way thanks so much for watching if you liked this video make sure to let me know by hitting that like button subscribing to the channel and sharing it with anyone else who might find this helpful thanks so much for watching and I hope to see you in the next video

Channel: Break Into CRE

Views: 122,727

Keywords: Equity waterfall real estate, equity waterfall, real estate equity waterfall, real estate equity waterfall excel, equity waterfall model, real estate syndication, real estate syndication structures, equity waterfalls, equity waterfalls explained, real estate equity waterfalls, real estate promoted interest

Id: Um4Bx3zkKrM

Length: 10min 34sec (634 seconds)

Published: Thu Aug 08 2019