What is a waterfall model?

What is a Waterfall Model?

In real estate, the waterfall model is a tiered system for distributing investment returns, starting with the return of initial capital to investors. After returning the capital, profits are allocated to provide a preferred return to investors, followed by a potential "catch-up" phase for the general partner. Remaining profits are then split between the general and limited partners according to a predetermined ratio, incentivizing the general partner to exceed performance thresholds.

The "waterfall" name comes from the way the returns flow down to different types of investors at varying stages:

1. Return of Capital: Initially, all cash flow or profits are used to return the original capital to the investors. This ensures that investors get back their initial investment before any profits are divided.
2. Preferred Return: After the return of the initial investment, the next step is typically to allocate a preferred return to investors. This is a predetermined rate of return that investors are promised before any additional profits are shared.
3. Catch-Up Phase: This phase occurs if there are still profits remaining after the preferred return. The general partner (GP), typically the deal sponsor or manager, may receive a larger share of these profits until they "catch up" to a certain percentage of the overall profit split.
4. Profit Split: Once the catch-up phase is complete, any remaining profits are split between the general partners and the limited partners (LPs, or investors) based on a predetermined ratio. This split often favors the general partner to incentivize them to exceed the preferred return threshold.

This structured approach helps investors receive a fair return on their investment based on the risk they have undertaken, and motivates the general partner to perform well because their higher share of profits is only realized after fulfilling their commitments to the investors.