How Waterfall Structure Works and How to Avoid Hidden Fees

Important Note: Streitwise does not charge waterfall fees to investors.

Unless you’re ready to purchase and manage a property completely on your own, exposure to real estate will come through passive investments in REITs, funds, or individual syndications. For investors, this creates the ability to earn truly passive income and exposure to real estate as an asset class.

However, not all investment opportunities are equal. In addition to choosing the investment firm, and the property, it’s also crucial to understand how distributions and profit share are allocated between different classes of investors. For instance, while some ventures distribute profits pro rata, based simply on a percentage basis of the capital invested, more common in real estate is a disproportionately weighted profit share structure typically referred to as the waterfall.

Understanding what the waterfall fee structure is and what it means for investors ensures that you’re making an investment choice that is best for your strategy and personal financial goals.

What are waterfall structures? How do they work?

The term waterfall structure refers to the method in which property cash flows are distributed to investors, and generally has multiple tiers of distribution hurdles.

Essentially, waterfall structures work similarly to a waterfall in nature. Imagine a typical waterfall where flows reach the first level pool below, and then into a subsequent pool below that, and so forth, repeating the process until the bottom is reached. In the same vein, real estate investments with waterfall distributions allow the profits generated to cascade down, starting at the top until the first pool of investors receive the profits they’re entitled to, with an adjusted allocation in the second tier, and potentially further allocation adjustments beyond that.

Let’s take the two interested investor parties in the waterfall structure: limited partners and general partners. These two groups are generally referred to by the initials LP and GP. LPs are the investors whose funds make it possible for the GPs to purchase a property.

In virtually every case, the LPs and GPs are repaid their initial capital commitments and a certain “preferred return” first, together in the same percentages as their initial commitment. This is called “pari passu” or directly side by side sharing of the cash flows. After that tier, profit is typically shared disproportionately in favor of the GP (away from the LP).

All investments are different, and the exact numbers associated with any investment that you’re considering will vary based on that particular GP’s structure. However, for the sake of gaining a better understanding, let’s look at a hypothetical waterfall structure.

Example of waterfall structure

In order to keep the numbers even, we will assume that the subject investment property costs $1 million. In order to raise that $1 million, the GP puts in $100,000 while the LP puts in $900,000. Obviously, in exchange for putting up only 10% of the funds necessary to purchase the property, the GP takes on the responsibilities associated with managing the property. This can include collecting rent, managing the property, advertising the property, handling the taxes associated with the property, and everything else.

In this hypothetical waterfall structure, the first tier is when the money is distributed to the investors pro rata (“pari passu”) until they have recovered their initial investment and the preferred return of 6%. In the second tier, the LP receives 80% of the profits while the GP receives 20% until a 15% IRR hurdle is crossed. Finally, all cash flow above that 15% IRR is disbursed 60% to the LP and 40% to the GP.

Beware of hidden fees

It’s also not uncommon for these waterfall structures to include fees (“hidden” and otherwise). In many cases, the GP will charge the investors asset management fees, transaction fees, and other charges, which come directly out of the profits generated by the investment.

Overall, the waterfall structure, while viable, redistributes cash away from the LP in favor of the GP.

At Streitwise, we’re committed to implementing investment structures that don’t come with any hidden fees, tiered returns, or any other factors that can muddy the investment waters. We do not have a waterfall fee structure. Our approach to investing is simple: make sure that our investors earn a great return and are treated fairly in the process.

Adam Luehrs

Adam Luehrs is a writer during the day and a voracious reader at night. He focuses mostly on finance writing and has a passion for real estate, credit card deals, and investing.

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