Investing in apartment complexes can be profitable in the long-term, IF you are part of a syndication that knows how to manage and execute on their multifamily business plans.
A property that creates healthy cash flow is highly beneficial to investors, but it is important to know how returns are split. Pay close attention as you read through the investment documents. As mentioned in my previous article not all syndications are the same.
For this, you need to understand a slightly complex mechanism in multifamily investing: the equity waterfall model.
Equity Waterfalls Basics
Investors and syndication sponsors should think of equity as a waterfall that fills up a pool with cash, which then spills over to another set of pools below. In other words, the lower tier pools only get the overflow from the initial pool. Sharing profits is a different story since it involves a disproportionate arrangement. The reason for this is simple: there is a need to compensate sponsors in the form of a “promote,” the amount of which is determined by the income generated by the investment property.
As equity waterfall model seems straightforward, but it includes several key components in the equity distribution process.
- Return Hurdle
This refers to a minimum rate of return that has to be achieved. It also serves as the basis for the distribution of equity down the line.
- Preferred Return
We call a preferred return as the first pool to fill up, with the excess being split as agreed among the limited partners and the sponsor of the syndication. Those entitled to a preferred return are also known as preferred investors.
- Lookback Provision
As agreed, investors are entitled to a pre-determined return. In the event that this amount is not met, investors may look back to their sponsors, who would then pay-off the pre-determined rate using their already apportioned share.
- Catch up Provision
Under this arrangement, investors receive 100% of the equity until the pre-determined rate of return is achieved. Afterward, 100% of the profits in excess will go directly to the sponsor.
These components form the equity distribution structure, which usually follows a three-tier process for splitting cashflow based on how much Internal Rate of Return or IRR is achieved.
For example, a deal could have an initial 80/20 split and a waterfall of 60/40 with an IRR hurdle of 15%. This means that when the IRR reaches 15%, then 20% of the return will go to the sponsor while 80% will go to the investors. Beyond a 15% IRR, the sponsor gets 40% while investors get 60% of the excess cash flow. It is sort of pay for performance for the sponsors.
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