I have been working with a friend of mine who prefers to remain anonymous and happens to be a real estate professional to develop a simple real estate distribution waterfall (I will refer to him as Dimitri for the purpose of this post). Our working relationship consists of me interrupting his day with short emails containing Excel templates and bulleted questions, which he graciously responds to with quick answers pulling from years of experience. It’s a highly iterative process that hopefully consumes little of his time.
Last week we developed a bare bones real estate distribution waterfall that, per his feedback, was as simple as it could be without risking oversimplification: a fine line this website attempts to navigate each time new content is posted.
I thought I would include the commentary he provided that did not make it into the template as I believe it provides insights that would otherwise be lost. The template referenced in the comments that follow can be downloaded HERE.
Funds Invested: The distribution waterfall generally does not take into consideration whether or not the sponsor (GP) invested capital. If the sponsor elects to invest capital it is generally invested on the same terms as the LP capital. For this reason the split between LP capital invested and sponsor capital invested is of little significance to the distribution waterfall.
We decided to keep this feature in the waterfall with the input for percentage of sponsor capital invested set to 0% because the template currently calculates how much the LPs and the sponsor will have to put up in the event of a cash shortfall.
IRR and MOIC Hurdles: This template focuses on multiple IRR hurdles that define how cash flows are split between the LP and GP. In addition to IRR hurdles, a more advanced distribution waterfall would allow for the measurement of a specific IRR or multiple of invested capital (MOIC) at each hurdle.
The purpose of including MOIC is to control for time horizon. IRR calculations are sensitive to time horizon and MOIC calculations are not. By including MOIC the LP is protected in two ways:
- MOIC Provides Short Term Protection: If the sponsor receives an incredible offer months after making the initial acquisition of a property it will result in a high IRR. But it is unlikely that someone would offer a sufficient multiple of invested capital (MOIC) to trigger hurdles more favorable to the GP.
- IRR Provides Long Term Protection: If the sponsor waits a decade to sell the property, they might achieve a multiple of invested capital what would have been appropriate for a 5-year hold period. On a longer time horizon IRR protects against this discrepancy.
Concluding Remarks: After several iterations Dimitri finally came around; “I actually really like this. Nice and simple. But I would want more context surrounding the cash flows.” He elaborated in the email that a novice should spend more time understanding the transaction before taking the time to focus on how the proceeds are split between investors and the sponsor behind the deal.
Fortunately ASM has a template for a multifamily property: LINK.