Understanding Waterfalls

What happens when a general partner boosts the value of a facility by 200%? At Spartan Investment Group, we’ve written about the power of a value-add strategy before. But how do operational and facility improvements impact a limited partner’s return on investment?

Today, we’re exploring how operators structure deals — and what that means for individual investors.

We’ll dive into the core elements of distribution waterfalls and detail what accredited investors should look for when considering a deal. We’ll also illustrate how waterfalls function with a case study from Spartan’s portfolio.

The Makeup of a Deal

Real estate syndication can be a powerful tool for those looking to begin investing in self storage. Syndications allow individuals to pool resources to invest in larger commercial properties. However, navigating the world of real estate syndication can be complex, and it is essential to grasp how a deal works. Waterfalls are one of the most important concepts to unpack.

In a real estate syndication, the waterfall outlines the order in which profits are dispersed and how much of the profits each partner is entitled to. There are many ways to structure a waterfall, and the terms will depend on the specific syndication. Generally, waterfalls rely on three common components.

• The preferred return is a percentage of the profits paid to the limited partners before the general partner receives any profits. While preferred return income is not guaranteed, if there is profit, limited partners will receive their preferred return before any splits with the general partner.
• The hurdle rate is a minimum rate of return that a deal must meet before the general partner begins to receive any profits. The hurdle rate ensures that limited partners receive compensation before the general partner.
• The promote is a percentage of the profits dispersed to the general partner after the deal meets the hurdle rate. The promote can take a variety of forms. These can include a fixed percentage of the profits or a tiered structure that increases as the investment performs better.

By carefully reviewing the terms of the waterfall for any given deal, limited partners can ensure they are comfortable with the level of risk they’re taking on and the potential returns they stand to receive.

A Spartan Success

In the example referenced at the beginning of this article, Spartan purchased a self-storage facility that the previous owner had neglected for many years. We offered investors an 8% preferred return and a 65/35 split.

After closing on the property, Spartan implemented our value-add strategy. We increased operational efficiency, enhanced infrastructure and ramped up marketing efforts. As a result, the facility quickly started driving a profit.

At this point, we initiated monthly distributions, and investors’ preferred return balances began accumulating. Distributions started at a rate of 2-5% per annum. As the facility reached full occupancy, these rose to 7-9% per annum.

As net income climbed, so did the facility’s value. When Spartan hit a 200% value increase, our team decided to pursue a cash-out refinance. Thanks to our strategic improvements to the property, the bank offered enough cash to return 100% of the investors’ initial principal, make up the preferred return balance and provide additional profit.

Operational Cash Flow Versus Liquidity Events

In the scenario above, we structured the waterfall to provide investors with a preferred return before any splits. We made distributions from operational cash flow in the following order:

1. First, to limited partners in proportion to their respective preferred return balances until each such member’s preferred return balance reached zero.
2. Then, to limited partners in proportion to their respective percentage interest.

However, liquidity events — like the sale, refinance or partial sale of a property — often produce excess cash. These events generally trigger a liquidity waterfall, separate from that for operational distributions. In this case, we distributed cash from refinancing in the following order:

1. First, to limited partners in proportion to their total capital contribution balance until each such member’s total capital contribution balance reached zero.
2. Second, to limited partners in proportion to their preferred return balance until each such member’s preferred return balance reached zero.
3. Third, to the sponsor, in proportion to their total capital contribution balance, until each such member’s total capital contribution balance reached zero.
4. Fourth, to all members (limited partners and sponsors) in proportion to their respective percentage interest.

The first step of the liquidity waterfall made certain that all passive investors received the principal of their investment back. Then, we paid down investors’ preferred return balances, offsetting the early years of lower cash flow.

Any funds Spartan had invested were then repaid. Finally, we split the remaining funds between the limited partners and Spartan, the general partner.

The waterfall structure and the facility’s advantageous positioning meant that our investors not only received all of their investment plus a return but also retained 100% of their ownership and continued to enjoy monthly income.

Why Waterfalls Work

Syndications can be a lucrative investment vehicle for individuals looking to earn higher returns and diversify their portfolios. That said, as with any transaction, it’s critical to grasp the fundamentals before taking the leap.

Distribution waterfalls offer many benefits. They are transparent and predictable, providing investors with a clear model to anticipate their distributions. And, through their hierarchical structure, waterfalls typically dictate that limited partners receive a percentage of the profits before the general partner. Therefore, limited partners can feel confident that their investment is protected and that their interests come first.

One of the best ways to succeed in passive investing is to learn as much as possible about the key terms and concepts used in the field. By understanding the roles and responsibilities of the various players in real estate syndications — such as the general partner and the operator — limited partners can make informed decisions about their participation.

At Spartan, everything we do focuses on mitigating risk, reducing complexity and prioritizing transparency. Want to know more about how Spartan structures our deals? Schedule a call with a member of our Investor Relations (IR) team.

If you enjoyed this content, look out for our upcoming eBook, “Passive Investing 101,” which will focus on the structure and benefits of syndications.