Distribution waterfalls in commercial real estate investments are an important aspect of the partnership between general partners (GPs) and limited partners (LPs). These waterfalls determine how profits from the investment are distributed between the GPs and LPs and are designed to align the interests of both parties. In this article, we will discuss the three key hurdles that are often included in distribution waterfalls: preferred return, catch-up, and internal rate of return (IRR).
The first hurdle in a distribution waterfall is the preferred return. This is a minimum return that LPs are guaranteed to receive before GPs can begin to receive any profits. The preferred return is typically set at a fixed percentage, such as 8%, and is paid to LPs on a regular basis, such as quarterly. This ensures that LPs receive a minimum return on their investment, regardless of the performance of the property.
The second hurdle in a distribution waterfall is the catch-up. This is a mechanism that allows LPs to receive a larger share of the profits once the preferred return has been met. For example, if the preferred return is 8% and the property generates a 12% return, the LPs would receive the first 8% and then “catch up” to receive a larger share of the remaining 4%. This ensures that LPs are not disadvantaged if the property performs well.
The third hurdle in a distribution waterfall is the internal rate of return (IRR). This is a measure of the profitability of the investment, taking into account the timing and size of cash flows. Once the IRR reaches a certain threshold, such as 12%, the GPs begin to receive a share of the profits. This alignment of interests between GPs and LPs means that the GPs are incentivized to maximize returns for the LPs, as well as for themselves.
In conclusion, distribution waterfalls in commercial real estate investments are an important aspect of the partnership between GPs and LPs. They are designed to align the interests of both parties by ensuring that LPs receive a minimum return on their investment, while also allowing them to participate in the upside potential of the property. The three key hurdles that are often included in distribution waterfalls are preferred return, catch-up, and internal rate of return, which together ensure that the profits from the investment are distributed fairly between the GPs and LPs.
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