How to Invest in Commercial Real Estate

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Episode #014 - Understanding WATERFALL DISTRIBUTIONS In Commercial Real Estate Investing

by Criterion, Braden Cheek, Brian Duck
January 22nd 2021
00:17:32
Description

In today's episode we go over the basics of what a waterfall is, and how it should be used in commercial real estate investing. The waterfall is how the cash flow gets distributed to the investors.... More

You're entitled to a portion of profits for doing the deal and making the investors of the money you gave in the 1st 8%. You've probably been doing that a little bit. Now there's extra proceeds and that's where you as a sponsor can start to make, you know, a percentage of the profits on that deal. Mhm. Hello? Hello? Hello. Welcome back to the head of vested commercial real estate guys. What is up and today is all about the waterfall structure. So, um, waterfall, just fun taxing and share a waterfall structure is what you're doing with the cash flow, nothing above the cash flow line. Just you, you raised money on the deal. You went and bought an investment deal and you have cash flow, you're distributing to your investors and you're distributing that through what's called a waterfall. Okay, so tell us about it, brian, well, the waterfall, waterfall, you, is how you distribute the cash, who you distribute the cash to, uh, it's a legal description, It's going to be an operating agreement typically. Yeah. So generally speaking, when you're getting in these, these bigger deals and you're getting into bigger types of investments, you know, you've already established you invest in commercial real estate.

Yeah, yeah, yada. Um, you, it's less important how much you own of that entity. Right? So when you're putting a financial package together, when you're pitching an investor, you're not going to them and saying, hey, um, I'm soliciting, you know, an investment for $100,000. You know, we're raising a million dollars. Um, you're gonna own 1% of that company. You know, they don't really ask that when you're going to do investor, investors don't ask. I don't know if I've ever been asked, what is my equity percentage going to be? Yeah, they're kind of irrelevant. They're less concerned about that. But this, this is the question you're gonna get is the investor gives you an investment of, let's say $100,000. They're gonna ask, okay, tell me how I'm going to get my money back or how, how am I gonna get returns on that? 100,000. So, if you could describe a waterfall structure is exactly what you just said, How am I going to get paid? What are you going to do with the money once you earn it? So that's what it's about today. We're not focusing on how you're earning the money. The commercial real estate earns money. We've established that we're on episode 1415, something like that. And the commercial real estate property makes money. So it's just how we're distributing now, what are you gonna do with that cash flow?

Yeah. So what's, you know, a common one, what's, uh, just an easy structure that we can start on, on a popular waterfall. So there isn't a standard that applies, uh, but there is a, there is, uh, you know, I would say, uh, maybe there is an industry standard, but its general, and it's flexible, but typically investors want a preferred return. Okay, so we'll define that for you preferred return. Uh, when my, I give my investors have preferred return, it means that I'm gonna pay them a certain percentage on their money before I participate in the cash flow split. Right? So on our deals, we, we do a lot of 8% preferred returns. You, I've seen them six. I've seen them 10. Um, but 8% is probably an average. And so if we have cash flow, I'm gonna, I'm gonna try to pay the investor, uh, 8% of the money pro rated maybe on a quarterly distribution. And only after then do I get to participate in a, in a cash flow split, which is part of the waterfall as a, as a sponsor, as the sponsor? Yes. So the investor, um, That's a, that's an easy marketable thing from a sponsor to an investor.

Hey, I want your investment. I've got this great commercial real estate deal that I think you should put the money in. I'm putting some money in it as well. And the limited partners or investors are getting the 1st 8% a year that that property makes the 1st 8%. And then after that, you may get into what's called an equity split or, you know, a profit share or something like that. Yeah, it's sometimes called to promote for the sponsor. And so how much of the cash flow do they get after the 8%. And it can range, we've done deals at 25, 25%, 75, which means 75% of the cash flow over the 8% goes to the investor. And we've done them as low as 50% of the cash flow after 8% goes to the investor. So why would you do that? Why are you splitting up the profit shares now as a sponsor? Right. I guess you're entitled to a portion of profits for doing the deal and making the investors of the money You gave him the 1st 8%. You've probably been doing that a little bit now, there's extra proceeds and that's where you as a sponsor can start to make, you know, a percentage of the profits on that deal.

And it's, it's market driven, uh, brian you probably can speak to this because you've invested. And I pitched you some of these deals, but investors are more interested in the returns that you can deliver to them, then they are on the structure. Now they're they're going to be sophisticated guys, let's say their private equity money or family office money that can write $10 million dollar checks and they're gonna, they're gonna dictate the terms to you. But when you're just raising funds from friends and family and co workers and things, they're more interested both in you as the sponsor and in the return that you're going to give them. So for us, we we were doing high cap deals, maybe slightly more risk. So the returns were better. And so we say we're going to give you the 8% before we touch it. But if, if the deal is, let's say it's 16% total return cash on cash return, then I can give the first eight goes to the investor. And then we may, we may split what's left 70, 30 or 60 40. And so, uh, let's do the math easy. Let's say it's 50 50 then 16.

Yeah, we have 16. So the 1st 8% goes to the investor and then the 2nd 8% get split up 50 50. So 4% to the investor and 4% to me as the sponsor. And so that the investors getting a 12% cash on cash return. And if there's enough cash flow, I'm getting 4% uh, of that cash for a quarter of that cash flow. Yeah, I think you're right. I think the first thing that catches their eyes, if they see that they're going to get, I want 12% cash on cash, then that's what gets them interested. And then of course they look at our our maybe. But, and, but then I think most people will, uh, see, well, how is that? They'll dig in and they'll see how that that structure, how that waterfall is working. Yeah, investors always ask, you know, whoever they're giving money to is what's in it for this guy. You know, how is this guy making money? How is he making money off of this investment? What's in it for him? And as a sponsor, you've got to be able to look your investors in the face and write it in legal documents right in your private placement memorandum and operating agreement where the money is going and you've got to be able to tell these guys, yeah. You know, after the first, After I paid you 8% in that year and then it, The property is going to make another 8%.

You're going to get 12% that year. It's not a bad thing that I'm only getting for, you know what I mean? And giving them that 1st 8% there's, there's a lot of, and, and it can be whatever, right. Like if you're just getting started, you may give your investors the 1st 10 or 12% because it's, you know, you're looking at a higher yield deals maybe, and you need to give your investors somebody, once again, it's market driven. So if your investors have a better investment that they think is safer, they can earn them more, then you're gonna, you're gonna have to give them more of the deal or a higher pref in order to get them interested in your deal. So that's just how it goes. Uh, so, so I've got a question for you. So as waterfall, just on the cash flow is the waterfall part of the, what about when the property sells the asset cells? And there's a capital distribution. Is that part of the, the waterfall also, is that even called a Waterfall or is that something completely different? Yeah, it's definitely called the waterfall. Um, you've typically got two different sections. You've got a waterfall for distributions during operations. You know, you're gonna go in and buy this asset maybe hold it for 10 years before you want to sell.

So during that 10 years you'll operate under the operational waterfall. Right? You'll also have a, a recapitalization waterfall, which means if there's a capital events such as a sale or a refinance, then you follow that waterfall. And what's more common in those is you pay back all of the equity and then you go to a different profit split. Okay. So I thought that it might even be required that all the equity gets paid back first and then to split. Here's the beautiful thing about it. The operating agreement, the private placement memorandum and the waterfall. You get to write, you write, you write it however, your attorney, right. However you write it. That's how it is. It's the rule book. It's the bible of the investment, whatever you wanna call it, whatever you want to refer to it. As we write it, we make up the rules. It's, it's Market driven, like Joel saying it's 100% dictated by your investors in the market, but it's probably not too common to take a split before the investor's equity is paid back. Is it at the end of the capital event? I would say on a capital event, it's typically not, you wouldn't, you, I wouldn't take a split before they get all of their capital back.

Um, Now some sponsors, the, if they're, you know, maybe they got strong armed by a private equity group or whatever they, they'll, they'll do an eight pref and then anything over the eight pref goes to pay back the capital. So let's use that same example the properties making 16 their pain and a pref. Anything over that. Okay. So then anything over that eight prep, let's say it's another 8% that goes to pay down their capital. Okay. So now they only have 92% of their initial capital in which also means the press is going Down and then the prep is going down because then the next year I'll only pay an eight pref on the 92% And then I'll give them the other 8%, which it goes down to now 84 and you work that capital balance down and only after that, the capital's paid 100% paid back. Do, does the sponsor in that scenario, you know, share in the waterfall. Right? And there's some important terms and I don't want to get too in the weeds here. But you know, it's important when you get into waterfalls, your distinguishing return of and return on Investment.

Right? So preferred return that 1st 8% that you're giving them is probably a return on investment. You invested something and this is the return that investment made a return of investment is giving you your original money back. So you have to be able to distinguish that. And it's important that if you're doing it, like we just describe where you're paying an 8% promote or whatever and then anything above that that the property produces, you're paying down the investor capital that they need to be aware of that. And that needs to be written in the business plan from day one. Right? Because it's, that would be a different structure than somebody saying, hey, I'm going to hold all of your money for the entire 10 years as opposed to, You know, because of that preferred returns going down and you're seven, you're probably going to have 50% of the investment left in the deal and you're only getting 8% of half of your investment. So you need to know what you're going into and you need to know what, you know, the market is driving and what your investors want. And so I'll give an example of how, how we do it. Just, just so people know precision equity is, We typically do an eight pref and, and then we do some split of the cash flow over that.

Uh, let's call it 60 40 60% to the investor. So we, we give the 1st 8% goes to the investor, then 60% goes the investor. And then precision takes, takes 40 anything over the 8% is split 60 40. And, and then, and that's, that's how we address the yearly cash flow. And then if there's a capital event, like a refinance or a sale, Uh, then as long as we've paid at least a pref through the whole holding period, then we, we pay 100% of the capital back. And then we split 60% to the investor and 40% of precision equity of the prophet. That that's left over. Okay. But, but the uh, the split could be different right? For the, for the cash on cash, over and above the over, above the pref. The split could be different for the, for the cash on cash and for the capital distribution writer. Is that usually the same? I think it's usually the same. Um, There is a situation where it gets a little complicated on the on calculation, we try to keep it simple, but let's say it's an eight pref, and then it's a 70 30 split until I until I get the investor to 12%.

And then it may switch to 50 50. And so you're, you're basically, You always want your sponsor's interest to be aligned with yours. That's why the press makes so much sense, is that, Hey, they don't get to participate in any profit until they at least get me 8% on my money. Because why Should they if you're promising them a 12% cash on cash return, I don't want my sponsor really making anything until I'm getting pretty close to that. What you pitched me right? Yeah. And another really good point I think is that these can be as complicated and as simple as you want them to be. Like you said, you can say, Hey, they get 100% of the cash flow up to 8% and then it's 70% of the cash flow up to 10% and that's 50% of the cash flow up to 15. I mean you can do this forever and ever and ever and ever. At the end of the day, you're gonna have to write it in the docks and explain it to people. And people have I mean sophisticated guys and even us. You can go through these and it can get complex really fast because there's so many entities. There's so many splits. You know, it's a lot to keep track of if you're just now starting. So I would highly suggest to get something that your investors can understand and digest.

Like don't do an I. R. R. Hurdle on your first deal. That's so complicated for your first deal and your investors aren't going to understand it. And what people don't understand, they don't invest in guys. You know, our first couple of syndications, we did a straight 75 25 split with no pref now I still got some people to invest that. Uh Now they want to prep they're used to oppress, but back then that was as simple as it was if the property made money, Um then we just gave 75% of that, that profits the investors and we kept 25 as the as the promote. So it can be really simple. Um I agree with you. If people look at that and they just don't quite understand it, they're not gonna don't wanna put their money towards something they'd understand. It's kind of like when I go gambling, I don't understand craps. Uh if I do crap, so I'm just gonna be throwing my money away because I don't understand it. Yeah. So yeah, you're right. They're not going to invest if you make it too complicated. Yeah. Another big things ask questions. You know, I know we did a whole episode on asking questions and, you know, asking bigger questions or whatever, but you need to be going out to people who are raising money or doing deals or investors and just ask them, hey, would you be interested in something like this?

If I could find you a great commercial real estate deal and pay you the 1st 8% a year, would you be okay with me taking 30% of the profits above and beyond that and I should still be able to get you 12 what you should be able to have that conversation with some people. And if you can't, you're not going to be able to raise the money. Yeah. So you've got to start understanding it. You've got to start getting comfortable with it. You've got to start talking to people about it and then it will, it will, it will become, yeah. But you shouldn't be shy about about it because the fund manager needs to make something. So, I mean, he's got a lot on the line. So, um, shouldn't be shy about about saying that. Well, I'm gonna take some of the split. The fund manager is going to take some of the split over and above the prep. That's a really good point. Uh, don't, don't be afraid of getting paid for being a sponsor. You know, this, we want to encourage people to get in this game. You know, for me, we, we've made a lot of investors a lot of money. We've paid distributions, uh, Above market, I would say for the last 10 years straight.

Uh, and yeah, we've, we've sometimes taken a little bit more of, of the back end profit over the eight than, than maybe some family offices would let us or some private equity would let us, but the idea is that I'm delivering good investments for the investors and investors should want the sponsor to be motivated just like, right now, we haven't pitched a deal in the last year because they're hard to find. Uh, and so you want your, your sponsor to be motivated to bring the deals to you as long as they're, they're making good returns because otherwise your money is sitting, uh, or, or in the stock market waiting. So we had a really good conversation yesterday, um, with Andy over the Woodmont group. And it was just this discussion because we, we funded this kiddie academy and that kiddie academy was, um, It was an eight pref in a 6040 split, which maybe, you know, 40%, uh, sponsor split on the back and some people could back about. But at the end of the day when you're doing a deal that can justify it can get me all the return I want as a limited investor within a pref in a 60-40 split all the return I want and he can still take 40%.

I'm like. good job. Dude, I don't, I don't need to be chasing deals that have like no split left to work with and the sponsors, you know, not making any money because the deal is barely getting the investor what they need. You know, if, if the deal is great, then the sponsor maybe should take a little bit more on the back end. And, and that's okay. And I would, I would like that deal. Yeah. That just means that the sponsor did his homework and his or her homework and found a good deal and it may just be a really good deal. Exactly. Well, good. I think it's a it was a broad coverage of how to structure the deals and the waterfalls. Um There's an unlimited way to do these. Uh but you just got to ask questions and and kind of find out what others are doing. Absolutely. Well we'll be back in a few days um with the next episode, but thanks for watching and listening and make sure to check us out on the web how to invest in sierra dot com. Thanks guys. Thanks, mm. Yeah.

Episode #014 - Understanding WATERFALL DISTRIBUTIONS In Commercial Real Estate Investing
Episode #014 - Understanding WATERFALL DISTRIBUTIONS In Commercial Real Estate Investing
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