JF2094: Everything You Need To Know About Waterfalls | Syndication School with Theo Hicks

May 27, 2020 | Joe Fairless | 00:22:03

JF2094: Everything You Need To Know About Waterfalls | Syndication School with Theo Hicks

In today’s episode, Theo will be sharing the ins and outs of waterfall structures. Waterfalls are also known as a waterfall model or structure, is a legal term used in an Operating Agreement that describes how money is paid, when it is paid, and to whom it is paid in commercial real estate equity investments.

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To listen to other Syndication School series about the “How To’s” of apartment syndications and to download your FREE document, visit SyndicationSchool.com. Thank you for listening and I will talk to you tomorrow. 


TRANSCRIPTION

Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.

Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.

 

Theo Hicks: Hi, Best Ever listeners. Welcome to another episode of The Syndication School series, a free resource on the how-to’s of apartment syndication. As always, I am your host Theo Hicks. Each week, we air two podcast episodes that focus on a specific aspect of the apartment syndication investment strategy, and for a lot of these episodes, we offer free resources as well. These are PDF how-to guides, PowerPoint presentation templates, Excel calculator templates, some free document to help you along your apartment syndication journey. All these free documents, as well as the past Syndication School series can be found at syndicationschool.com.

Today we are going to be talking about waterfalls. So a waterfall describes how, when and to whom funds are paid in an apartment syndication deal, and then the type of waterfall structure that you as the syndicator chooses will determine the returns that the limited partners and the general partners receive. Ultimately, you get to decide which type of passive investor compensation structure to choose, and if you remember, we’ve already done an episode where we talked about the different types of compensation structures, preferred return, profit splits, different types of thresholds. So I’m not going to go into a lot of detail in this episode on what those are. This is more going to explain what the waterfall structure is for each of those structures; and the waterfall structure, as I’ve already mentioned, describes how, when and to whom funds are paid in a partner syndication deal, but what it means is that money comes in and how is that money allocated. Who gets paid first and who gets paid second, who gets paid third, who gets paid fourth, and then each of those people, how much do they get, and how’s that cash flow going to be allocated. The same thing for any capital transaction like a sale, a supplemental loan or a refinance. So the waterfall structure will let your limited partners or passive investors understand 1) how much money they’re going to make, and 2) who gets paid in what order.

So in this episode, we’re going to go over the written description of the waterfall. So cash flow comes in based off of what structure you’ve created, who gets paid first and in what order. So we’ve got five waterfall structures to go over, and the last one is one that you might not have heard of before; it’s one that I’ve recently heard about. I know it’s a pretty common structure in apartment syndications, but I personally hadn’t heard of it before. So it’s a structure that you might like because it allows you, as a general partner, to get paid cash flow first, without having to wait for the profit split to come into play, or it allows you to have a payment accrue if you don’t receive payment because you can only cover the 8% preferred return, or whatever. So let’s dive into the explanation of the different waterfall structures.

So the first one would be if you have 8% preferred return only. So the waterfall for the cash flow is that the cash flow is distributed to the Class A partner, which is the passive investor, until they receive an annualized return of 8% based on their initial capital contribution. Of course, if you decide to update their preferred return based off of their ongoing capital account, then this would change a little bit. So to start off, being based off of their initial capital contribution, and then after year one, it would change and update based off of their new capital account if they received equity back via profit splits and things like that or with refinances, and then any remaining cash flow is distributed to the Class B general partners. So since this is only preferred return, the Class A partners made their 8%, and then the general partners get the rest of the cash.

Now what about a waterfall for the capital transaction, which is a sale supplemental or a refinance. So first, repay the unreturned capital contributions of the Class A investors, which since this is a preferred return, they’re not receiving an additional profit split, which is considered a return of capital typically. Then they are owed their entire initial equity investment.

Next, make up arrearages in Class A preferred returns, if applicable. So if you were not able to hit an 8% preferred return, then at the capital transaction, that is where that accrued amount is paid back. And then after that, any remaining cash flow is distributed to the Class B general partners; so you’ve got pretty straightforward structure. Preferred return only is what Ashcroft has for the Class A investors, and then this next one, waterfall two, is what they have for their Class B investors, which is a preferred return and a profit split.

So of course, you could see a deal where it’s just a preferred return, which is pretty advantageous to the general partners. So maybe not something that would be common right now, just because there’s not so much money out there, but in the future, who knows, maybe this is something that you can convert to, because this is definitely very beneficial to the general partners, because once they pay the 8%, they get the rest of the money.

So waterfall structure number two is a preferred return plus a profit split. First, you’re going to just– for simple math, we’re gonna go with 8% preferred return, and then a 70-30 profits split. So for the cash flow, first, cash flow is distributed to the Class A, the passive investors until they receive an annualized return of 8% based on their initial capital contribution or on their capital account, depending again on which way you decide to go, and then any remaining cash flow is split 70-30 with 70% pay to Class A passive investors and 30% paid to Class B general partners. So again, very simple.

Now what about a capital transaction? So first, unreturned capital contributions is paid to Class A, and so this is going to be either the initial equity investment; if the 8% preferred return or less was hit, or the reduced equity investment amount based on capital return from that profit split. And if it’s a second capital transaction – let’s say if we’re going to refinance, that would be the reduced equity amount based on the return on capital from the profit split and the finance or the supplemental loan. So equity gets returned first, second arrearages in Class A preferred returns, if applicable, again. So if 8% preferred return isn’t hit, then the accrued amount is paid back after the equity is returned, and then any remaining cash flow is split 70-30, with, as I mentioned, 70% going to the Class A and 70% going to Class B.

So if you remember, we have a simplified cash flow calculator available on the syndication school website, so syndicationschool.com. Or if you find the syndication school episodes about underwriting, just go to joefairless.com, search “underwriting” at the top, you’ll see that come up. We have a link to download the free simplified cash flow calculator, and on that cash flow calculator, this preferred return plus profit split is what is currently set up on that cash flow calculator. So once you input the preferred return and the profit split number, then it’ll automatically calculate returns to your Class A investors based off of this waterfall I just described. So you don’t need to do anything to that cash flow calculator if this is the type of waterfall structure you are doing. Obviously, if you’re doing any of the other ones, then you’re going to need to make some updates to that model, with the easiest update being the waterfall number one, which is just a preferred return. So the other ones are a little more complicated, like the next one, which is waterfall number three, which is a preferred return plus a profit splits with a return hurdle. So the waterfall for the cash flow is going to be the exact same as the waterfall for the previous waterfall we discussed, which is the preferred return plus profit split, because the hurdle’s typically not going to come into play until a capital transaction, most likely the sale being that capital transaction. So just as a reminder, for cash flow, first, cash flow is distributed to the Class A passive investors until they receive an annualized return of 8% based on their initial capital contribution or their capital account, and then any remaining cash flow is split 70-30, with 70% going to Class A and 30% going to Class B general partners.

The capital transaction is where it’s a little bit different. So obviously, unreturned equity is paid back to the Class A investors first. Next, any arrearages in the preferred return to Class A, and then cash flow is split 70-30 with a 70% paid to Class A and 30% paid to Class B up to a certain return hurdle. So a very common return hurdle is the IRR, the internal rate of return hurdle, and the internal rate of return isn’t going to be a positive number until they receive all their money back anyways, which typically, is not going to happen until sale. So that’s why you’re typically not going to hit your hurdle from ongoing cash flow unless you’ve had a really large refinance where they received 90% of their money back, and then maybe at year four, they received enough cash flow so that they’ve received all of their capital back, and then maybe ongoing cash flows change. But typically, it’s not going to happen until sale.

So it’s a split of 70-30 up to, say, 13% internal rate of return, and then once that 13% internal rate of return is hit, the remaining cash is split 50-50 between the Class A and Class B. Of course, there can be more than one hurdle. It could be 70-30 up to 13%, and then 60-40 up to 15% IRR, and then 50-50 thereafter. It could be really any combination of these things, whatever you decide to do. As I mentioned, this is something that is not on the simplified cash flow calculator. If you’re going to want to set up a hurdle, you’re going to need to download a hurdle Excel calculator; I’m sure you can find one for free online; or you can do more of an iterative process where you keep changing the sales proceeds to the limited partners such that the IRR equals 13%, and then after that, you can change that remaining number to 50-50. That’s probably the fastest and the easiest way to do it, but if you do want to update the simplified cash flow calculator to do it for you automatically, it is possible; it’s just some pretty complicated formulas.

Okay, waterfall number four, which is having two passive investor tiers. So this would be if you have, let’s say, Class A receives a preferred return only and then Class B receives a preferred return plus a profit split. So the waterfall for the cash flow would be cash flow is first distributed to Class A until they receive their annualized preferred return based on their initial capital contribution. So let’s go with 10%. So the money is first paid to the Class A until they achieve an annualized return of 10%, and then next, the cash flow goes to the Class B until they receive an annualized return of, let’s say, 7% based on their initial capital contribution, and these 10% for Class A and 7% for Class B is what Ashcroft currently does. That’s why I’m using those as an example. And then any remaining cash flow after that is split 70-30 or whatever, 50-50, 60-40, whatever you decide, with the 70% going to Class B. So Class B are the ones that get the profit split, not Class A; and then 30% going to Class C which, in this case, would be the general partners.

Now. the waterfall for the capital transaction would be repaying the unreturned capital contribution to Class A first. So Class A gets paid before Class B. And since Class A isn’t receiving a profit split, then their capital account isn’t reduced, unless there’s been some refinance or supplemental loan, next you repay the unreturned capital contributions to Class B investors, and this is going to be, again, like I said before, their initial capital contribution or their capital account based off of profit splits received, or refinances, things like that.

Next, make up arrearages in Class A preferred return, and then make up arrearages in Class B preferred returns, if applicable for both of those. Generally speaking, at least for Ashcroft’s deals, the Class A is going to get their 10% because they make up 25% of the actual investors, and so the deal itself doesn’t need to cash flow 10%. If they only make up 25% it needs to cash flow around 2.5%. to hit that 10% number on a deal level. But sometimes, the Class B investors might not make their entire 7% preferred return. So if that’s the case, then at the capital transaction that accrued amount will get paid. Then any remaining cash flow from a capital transaction is split 70-30, with 70% paid to Class B and 30% paid to Class C. Of course, for this same structure, we could add a hurdle as well, so that 70-30 split might be up to a certain IRR to class B, and then that profit split changes to a 50-50 or 60-40.

The last waterfall structure– so this is what I was talking about in the beginning, which is more beneficial to the general partners, because long term, I’d probably say, waterfall structure number one is the best, just because once they hit that 8% preferred return to their investors, they get the rest of the money.

Waterfall number five is a general partner catch up. So this is a waterfall structure where you are able to start receiving distributions starting from day one or start accruing distributions starting from day one.

So for the cash flow first, cash flow is distributed to Class A until they receive their annualized preferred return amount based on their initial capital contribution – so let’s go with 8% – and then cash flow is next, distributed to Class B general partners until they receive an annualized return of 3.43%, and this is gonna be based off of the Class A initial contribution. Now this 3.43% is based off of the profit split. So the profit split is 70-30 overall, and the Class A investors are getting an 8%. So that 8% to 70% is the same as 3.43% is to 30%. So it’s like an algebra equation where it’s 70 over 30 equals 8 over x, and when you solve for x equals 3.43%. So it’s just keeping the ratio of profit splits the same and applying that to the preferred return.

So the preferred return to Class A is 8%, to Class B general partners is 3.43%, and then any money remaining is split 70-30, with 70% going to Class A and 30% going to Class B. Then the capital transaction, again, is gonna be very similar to the previous one, which is the two tiers. It’s similar in all of these. So first is unreturned capital contributions to Class A, so equity is returned first, and then arrearages in Class A preferred returns is paid, arrearages in Class B preferred returns. So that’s it for the general partner. So the 3.43% preferred return accrues as well. This is why this is a beneficial structure for the general partners. And then any remaining cash flow is split 70-30, with 70% going to Class A and 30% going to Class B.

Now the entire point of this episode was to give you an explanation of what is happening on a simplified cash flow calculator, or really any cash flow calculator that you’re looking at, any underwriting model you’re looking at. When you plug in all these numbers and it spits out a five year ROI to your limited partners, and it spits out cash flow that goes to the general partners. And it’s great to see that and share that to your investors, but it’s also good to understand exactly how that is being calculated, and how that’s being calculated is the cash flow calculator is saying, “Okay, we’ve got $100,000 in cash flow. The first 8% goes to the limited partners, so $80,000, and then $20,000 is split 50-50 to Class A and Class B. So for that first year, Class A receives $80,000 in preferred return plus $10,000, in profit split, and then the general partners receive that last $10,000.

So that’s where that $90,000 and $10,000 is coming from. So it’s much better to understand that, and if you look into the formulas, you’ll be able to see that, but here’s just a written explanation of what those formulas are actually doing. So this gives you a better understanding of what’s going on on those cash flow models, so that if an investor asks you about it, you can answer and let them know exactly what the waterfall is.

So that’s really everything you need to know about the waterfall structure. As I mentioned on the simplified cash flow calculator, that waterfall structure number two, which is the 8% preferred return, and the 70-30 profit split is what’s currently set up on that model. If you want to do one or the other waterfall structures, you’re gonna have to do some manual manipulation. Really, all of them are pretty easy to do except for the hurdle, which takes a little bit of a more high-level grasp of Excel, which is why I prefer the iterative process, which is again, just changing the sales proceeds to the limited partners until they’ve hit that IRR hurdle. So let’s say $100,000 at sale, you send $30,000 to the LPs and see what the cash flow calculator calculates as the IRR. Oh, it’s at 10% IRR. Okay, let’s try $40,000, so now it’s up 15%. So you can keep going higher, lower, higher, lower, higher, lower, higher, lower until you hit that sweet spot of $35,275.16 that is exactly a 30% IRR, and then you know that the remaining cash flow above that will be split 50-50.

So okay, that concludes this episode. Thank you all for listening. If you want to listen to other syndication school episodes and check out some of the free documents we have available, that is all available at syndicationschool.com. Thank you all for listening and I will talk to you tomorrow.

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