What is a Distribution Waterfall and How is it Calculated?
A distribution waterfall is a method of distributing cash flows or profits generated by a real estate development or investment project among the various participants. It is a way of allocating cash flows in a specific order, which is why it is referred to as a "waterfall."
The calculation of a distribution waterfall is typically based on a set of predetermined rules or conditions, which dictate the order in which profits are distributed and the percentage of profits that each party receives. The calculation will depend on the specific terms of the investment and the agreement reached among the parties involved.
Here are just a few examples:
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Preferred return: Investors in the project receive a preferred return on their investment before any profits are distributed to the developers or sponsors. This return is typically a fixed percentage of the invested capital.
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Promote: Developers or sponsors receive a percentage of profits after investors receive their preferred return, this is known as a promote. The percentage that the developers or sponsors receive is known as the promote rate.
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Hurdle rate: A hurdle rate is a benchmark return that must be achieved before the developers or sponsors receive their promote. This ensures that the investors receive a certain level of return before the developers or sponsors begin to share in the profits.
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Catch-up: After the developers or sponsors receive their promote, any additional profits may be distributed to them through a catch-up provision. This allows the developers or sponsors to receive additional profits if the project performs better than expected.
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Equity split: After all the preferred returns and promotes have been distributed, the remaining profits are split among the investors and developers or sponsors according to an agreed upon equity split.
It is important to note that the terms of the waterfall can be complex and dependent on the specific investment. It is always recommended to consult a financial advisor or attorney before making any investment decision.