Passive Real Estate Investments: The Waterfall
Imagine a list of everybody participating in a deal with debt and equity partners categorized into groups – those with the lowest risk and potentially lowest returns at the top. When cash flow is available, it gets distributed like a waterfall, starting at the top group and if there is enough water, trickles down to those with higher returns and taking a higher risk at the bottom. The structure of how this works is outlined in the Private Placement Memorandum (or PPM) that each investor signs at the beginning of the deal. It explains who, how, and when each class of partner (whether general or limited) gets paid during the life of the deal. Some classes can receive the only cash flow, while others participate in cashflow distributions and capital returns profits when sold or refinanced. As an investor, you need to understand where you are in the pecking order and how it will help you achieve your financial goals. Do you desire monthly cash flow? Or are you targeting capital appreciation and winning big on the exit? Or are you looking for a little of both? Keep in mind that you are likely going to be some category of an equity investor, not a debt investor like the bank holding the mortgage. Mortgages get paid first, almost always. And, cashflow distributions are always paid out after expenses, fees, and debt payments on the property.The Capital Stack
When you invest, do your homework on the property, vet the sponsoring team and make sure you understand who gets paid what, when, and why so there is no confusion. The capping stack in a real estate deal outlines the rank order in which those people who put money in the deal get paid and how. The highest priority, lowest risk partners are at the top, and the lower priority, highest risk partners are at the bottom. Every deal is structured differently, but below are typical categories. At the top, you’ll always have what is called Senior Debt. This includes mortgages and loans to finance the property. Just like you would never miss a house payment, senior debt is the highest priority and gets paid first. Mortgage-type loans have a lower return (3-5% for the past several years) in exchange for being a top priority. Going down the waterfall on the capping stack, preferred equity comes next. They are after debt payments but before common equity. After the mortgage, expenses, and fees are paid, preferred equity has “dibs” on distributable cash. Sometimes, preferred equity or “pref” requires a bigger minimum investment or is capped at some aggregate amount because they have a higher projected cash flow than investors lower in the waterfall. Following preferred equity are common equity that has the highest risk and lowest priority of payment. This group is likely participating in the capital returns and will get some of the cash flow after the preferred investors.Passive Real Estate Investments: The Impact of the Cap Stack
The capital stack impacts investors in two mains ways; cash on cash and IRR (internal rate of return). Cash on Cash returns is the before-tax earnings an investor makes on their invested capital and can also be referred to as cash flow or distributions. If you are a preferred unit investor, you may have better cash on cash returns because you are higher in the capping stack and get paid before common units. IRR means the internal rate of return and measures the deal’s total profitability (cash distributions and capital return profits on sale). It’s a fancy way of calculating your total return while accounting for the time value of money. A dollar today is worth more to you than a dollar you receive 10 years from now, for example. When you have a clear idea of how the waterfall on the capping stack treats cash on cash and IRR for each class of units, you can make better investment decisions to support your personal financial goals and achieve them faster.A typical cap stack and waterfall
Senior debt will be on top carrying the lowest return and the least risk as it ranks top in priority of repayment. Often this mortgage is expressed as a Loan-to-Value or LTV ratio, with 70% being a common benchmark. (for example, a $7M mortgage on a $10M investment) Next is the preferred equity. This group receives projected cash flow at a targeted percent – say 9% preferred return. Often it is cumulative, meaning that if the 9% cash distribution is missed in one year, the amount missed is held on the books and must be paid before the common shareholders are paid. The preferred shares often have a feature that is tied to the IRR. Once the 9% per year payment has been satisfied, then any bigger annual distribution of cash and any capital returns profits on sale are split with the common shareholders. For example, anything cash or capital return above the 9% is split 70/30 with the common equity, with the preferred receiving 70%. Finally, then, the common equity is the highest risk and last in line for payout receiving 30% of profits after the debt and preferred terms are satisfied. Often this common equity is owned by the sponsor and is vested with them as part of their compensation for arranging the deal. Thus, they are willing to be last in the payment stream because they may not have invested cash to receive the shares.Passive Real Estate Investments: Conclusion
The capital stack and waterfall are always outlined in the PPM (private placement memorandum), and you should always read and understand it before investing in any deal. The examples in this piece are simple illustrations, the actual structures of waterfalls can have many more complicated features such as a 70/30 split from an IRR of 9%-14% and then a 50/50 split for an IRR greater than 14%, effectively incentivizing the sponsor to do maximize profits for everyone. Now that you have a basic primer on how investments are made and money repaid, read the next PPM with the confidence knowing you can ensure it fits your investing objectives. For more information, don’t hesitate to contact us today.FAQs – Understanding a Waterfall and Capital Stack in Passive Real Estate Investments
The capital stack describes the order in which different participants in a real estate investment are paid. It ranks debt and equity partners based on priority, risk, and expected returns.
A waterfall refers to the sequence in which cash flow and profits are distributed to investors. Payments start with the highest-priority participants and flow downward to lower-priority investors if sufficient funds remain.
Understanding the capital stack helps investors know where they fall in the priority of payments, how much risk they are taking, and how their returns are expected to be generated.
The waterfall and capital stack are detailed in the Private Placement Memorandum (PPM) that investors review and sign before participating in a deal.
Senior debt holders, such as mortgage lenders, are paid first. Debt payments are made before any cash flow is distributed to equity investors.
Senior debt includes loans or mortgages used to finance the property. It carries the lowest risk and lowest return and has the highest priority for repayment.
Preferred equity sits below senior debt but above common equity. Preferred investors typically receive priority access to cash flow distributions at a targeted return before common equity is paid.
A preferred return is a targeted annual return (such as 9%) paid to preferred equity investors before common equity investors receive distributions.
If a cumulative preferred return is missed in a given period, the unpaid amount accrues and must be paid in the future before distributions are made to common equity investors.
Common equity is the lowest-priority position in the capital stack. These investors take the highest risk and receive distributions only after debt and preferred equity obligations are met.
Common equity is often held by sponsors or general partners and may serve as part of their compensation for sourcing, structuring, and managing the investment.
Investors higher in the capital stack generally receive more consistent cash flow distributions, while those lower in the stack may receive less frequent distributions but participate more heavily in upside potential.
Cash-on-cash return measures the annual cash distributions an investor receives relative to the amount of capital invested, before taxes.
IRR measures the total profitability of an investment over time, accounting for both cash distributions and profits from sale, while considering the time value of money.
The waterfall structure determines how profits are split once certain return thresholds are met, directly affecting each investor class’s IRR.
No. Each deal can have a unique capital stack and waterfall structure, including multiple return tiers, split adjustments, and performance incentives.
No. Examples are illustrative only. Investors should rely on the specific terms outlined in the PPM for each individual investment.
“All investments involve risk, including loss of principal, and returns are not guaranteed.”
