In most commercial real estate deals, the developer (General Partner or GP) puts in the work, and the investor (Limited Partner or LP) puts in the money. The "Waterfall" is the mechanism that dictates how cash flow and profits are split.
The Preferred Return ("Pref")
This is the first hurdle. The LP typically gets 100% of the cash flow until they have received a certain annual return (e.g., 8%) on their invested capital. The GP gets nothing (other than fees) until this hurdle is met.
Return of Capital
After the Pref is paid, the next priority is usually the return of the original investment. In a sale or refinance event, the LP gets their money back before any profits are split.
The Promote
This is where the GP makes their money. Once the LP has received their Pref and their Capital back, the split shifts in favor of the GP. This is called the "Promote."
Example Structure:
- Tier 1 (8% IRR): 90% to LP / 10% to GP (pari passu with contribution).
- Tier 2 (15% IRR): 70% to LP / 30% to GP.
- Tier 3 (20%+ IRR): 50% to LP / 50% to GP.
Fees
Don't forget the fees. The GP needs to keep the lights on during development. Common fees include:
- Acquisition Fee: 1-2% of purchase price.
- Development Fee: 3-5% of hard costs.
- Asset Management Fee: 1-2% of gross revenue.
Conclusion
A well-structured waterfall aligns interests: the GP is motivated to exceed return hurdles to unlock the promote, and the LP is protected by the preferred return.