How do a preferred return and a waterfall work?
A waterfall is the order in which a deal's distributable cash is paid out, and a preferred return is one step in that order: investors are paid first, up to a stated rate, before the sponsor shares.
Key points
- A waterfall lists who receives distributable cash, and in what order.
- A preferred return is a priority in that order, not a promise that the cash to pay it will exist.
- Many deals pay back investors' capital, then the preferred return, then split what is left.
- The details, such as the rate, what it is calculated on and the order of the steps, come from each offering's documents.
- Investors should ask their own advisers how the terms of a specific offering apply to them.
Alejandro Davila, founder of Mownt, Updated
What a waterfall is
A waterfall is the list, in order, of who gets paid when a deal has cash to distribute. Each step is filled before cash moves on to the next, the way water fills one pool before it spills into the one below.
Distributable cash is what is left after the property's operating costs, its loan payments and any reserves the manager holds back. Most offering documents describe two waterfalls: one for regular cash from operations, and one for the larger sums that come from a refinance or a sale.
What a preferred return is
A preferred return, often called the pref, is a step near the top of the waterfall. Until investors have received a stated yearly rate on the capital they still have in the deal, the sponsor does not share in that cash.
It is a priority, not a promise. It is paid only from cash the deal actually has. If the property does not produce enough in a period, the pref is not paid for that period, and what happens to the shortfall depends on how the documents are written.
The pref is also not what an investor ends up with. It sets the order of payment; the total depends on how the property performs, which nobody knows in advance.
A worked example with sample numbers
The figure below follows one sample distribution through a simple three-step waterfall: capital back first, then the pref, then a split of anything left. The numbers are made up and rounded so the steps are easy to follow, and they describe no real deal.
Read it row by row. Investors first receive their capital back. Next comes the pref, worked out at the sample rate on the sample capital for the sample number of years. Whatever remains is divided between investors and the sponsor at the sample split.
A table and a bar show how a sample distribution splits between investors and the sponsor, step by step.
| Tier | Investors | Sponsor |
|---|---|---|
| Return of capital | $200,000 | $0 |
| Preferred return | $60,000 | $0 |
| Split above the preferred return | $98,000 | $42,000 |
| Total | $358,000 | $42,000 |
- Investors: $358,000 (89.5%)
- Sponsor: $42,000 (10.5%)
Capital comes back first, then the preferred return, then the split of what is left.
Actual results vary.
Illustrative example, not a projection or an offering.
Details that change the numbers
Two deals can both say they have a pref and still pay out very differently. Things to look for in the documents: the rate, whether it is worked out on the original capital or only on capital not yet returned, whether unpaid amounts carry forward, and whether capital comes back before or after the pref.
Some structures add a catch-up, a step after the pref that sends a larger share to the sponsor for a while so that its share reaches the portion the documents set. Others change the split once investors pass a higher hurdle. Each of these moves money between investors and the sponsor.
If you cannot explain your own structure in a few minutes to someone new to private investing, simplify it. People who do not understand a waterfall tend to decline quietly rather than ask.
Where the real terms come from
Everything here is general, and the example is sample data. The terms of a real offering, including its pref, its waterfall and its risks, come only from that offering's documents.
Investors should read those documents and talk to their own advisers before they decide. As the sponsor, describe the pref as a priority in how cash is paid, never as a payment anyone can count on.
How Mownt helps with this
- Mownt drafts key terms from your OM and model. You review them and decide what they say.
- Mownt records each investor you accept. You decide when to send subscription docs, from the same screen.
Written by Alejandro Davila, founder of Mownt. Mownt sells the software described here.
The full checklist is inside Mownt. Read "How sponsors are paid" in the Capital Raiser Playbook when you join. Apply for early access
Frequently asked questions
Does a preferred return mean investors are sure to be paid?
No. It sets the order of payment. It is paid only from cash the deal produces, and the documents say what happens when there is not enough.
What is the difference between return of capital and the pref?
Return of capital gives investors back the money they put in. The pref is an amount worked out on that capital at the stated rate. The documents say which is paid first.
What is the split?
After the earlier steps are paid, the remaining cash is divided between investors and the sponsor in the shares the documents set out.
What is a catch-up?
A step after the pref that sends more of the cash to the sponsor for a while, so its share reaches the portion the documents set. Not every deal has one.
Where do the real numbers come from?
From each offering's documents. The figure here is sample data, and investors should ask their own advisers about any specific offering.
Keep reading
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How often should I follow up with investors?
Often enough that each person hears something useful from you, but ask for a decision rarely: keep many value-first touches over time and only a few direct asks.
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How do I raise money for my first real estate deal?
Build relationships and a team before you need the money, open an offering only once a real deal is under contract, and size that deal to what you and your partners can confidently raise.
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