Common Deal Structures In Multifamily Syndications

The last structure that we will cover is the most complicated and adds additional hurdles to the waterfall. A “waterfall” (this term is covered in the glossary section of our website) can be thought of as a series of pools in which cash flows to one entity or individual to fill a single pool before spilling over to the next one. In other words, a waterfall is used to describe how limited partners and general partners are repaid through a share of distributions. The preferred return structure is one example of a waterfall structure because the pref ‘pool’ so to speak must be filled prior to any straight split taking place. The waterfall structure is usually based on a type of return hurdle that must be met in order to progress to the next level of the waterfall. There are a variety of waterfalls that can take place and this type of structure is most commonly used when a sponsorship team partners with a sophisticated private equity firm. As more and more layers are added to a waterfall, the structure becomes more complex. An example of a complex multilayered waterfall based on multiple return hurdles is shown below.

1. 6% preferred return
2. 80/20 split of profits until passive investors (limited partners) receive a 10% internal rate of return (IRR)
3.  Then, a 70/30 split until investors have reached a 12% IRR
4. 50/50 split between limited partners and sponsors

Let’s keep things a bit more simple and say that there is an IRR hurdle of 10% with a 50/50 split thereafter. This means that once the investor achieves a 10% IRR on capital invested in the deal in the form of cash distributions, refinance proceeds, and sale proceeds from the project, anything after is a 50/50 split. This would be an example of where investors achieve a solid target of 10% IRR, and the project’s general partners (the sponsorship team) receive a bonus for hitting those return hurdles (i.e. the promote). A nuance to this is that sometimes the preferred return is compounding. What this means is that any shortfall in distributions in one year is then multiplied by the pref percentage and owed in the next year. The compounding preferred return can be complicated to understand and I won’t dive into it but is nonetheless an important aspect to note.

For those of you that want to dive deeper into the weeds, I want to make you aware of a complicated private equity (PE) structure that could take place. This “complicated” PE structure involves a catch-up provision which means that the limited partners receive 100% of distributions until they achieve some preferred return requirement (whether an IRR hurdle or simple pref calculated as a percentage of equity committed to a deal). With a catch-up provision, once the limited partner receives their pref, the general partner receives 100% of excess cash flow until some equitable balance is reached (that balance is usually a percentage of all cash flows received up until that point). For example, imagine a limited partner contributes 100% of the required capital to a real estate deal for a 12% preferred return and 50% of all excess cash flows above that threshold. The catch-up provision states that the limited partner will receive 100% of all cash distributions until they have earned a 12% IRR, at which point the general partner receives 100% of cash distributions until both partners have received 50% of profit distributions. Once the general partners have caught up with the limited partners, both partners receive any remaining cash flow 50/50. This structure with a catch-up provision is unlikely to be seen unless there is a private equity firm investing in the deal at hand.