May 6, 2021

JF2438: What is a Capital Stack and Waterfall in Syndications?


Today Theo and Travis share the difference between the Capital Stack and Waterfall methods. It has a lot to do with risks, due diligence, and just being comfortable in what you’re investing in. But both are very crucial in the active and passive investing perspective.

We also have a Syndication School series about the “How To’s” of apartment syndications and be sure to download your FREE document by visiting Thank you for listening and I will talk to you tomorrow.

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Theo Hicks: Hello, Best Ever listeners, and welcome back to another episode of The Actively Passive Investing Show. As always, I’m Theo Hicks, speaking today with Travis Watts.

Travis, how are you doing today?

Travis Watts: Hey, Theo, I’m doing great. Let’s rock and roll.

Theo Hicks: So today we are going to be talking about capital stacks and waterfall. So a little bit more technical, but it is important to understand what capital stacks and waterfalls are. Because ultimately, as a passive investor, this is going to determine how you get paid and when you get paid. So before we dive into more detail on those two items, Travis is going to let us know why we are talking about this topic today.

Travis Watts: Sure, Theo. To your point, it is a more technical topic; we don’t always dive into technical topics. So I thought this would be good to discuss. This is also a blog on So I just wanted to kind of cover this verbally for folks. It’s important to understand capital stacks and waterfalls, both from a passive investing perspective and also from an active perspective. So I want to highlight a couple of different things, the difference between a capital stack, a waterfall… I’ll have you cover probably some terminology, just to paint the picture a little more broadly… And really, what are we talking about – like always, as an investor, we’re talking about risk. This has a lot to do with risk. This has a lot to do with due diligence, vetting a deal, being comfortable with what you’re investing in. So I’m excited to dive in.  And I guess before I take it away, did you have anything else you wanted to add, Theo?

Theo Hicks: No, let’s get into it.

Travis Watts: Cool, man. I’ll start with discussing the waterfall here from a high level. So the way that the capital stack works, which we’ll talk about in a minute – it’s often referred to the waterfall. So waterfall is how cash flow trickles down and gets distributed to the investors, to the GPs et cetera. It’s important to note is that the waterfall is outlined in the PPM, the Private Placement Memorandum. Every passive investor needs to be reading the PPM; you could obviously leverage an attorney, a lawyer to help you out with that, but it’s very important to understand all the ins and outs; there could be a lot of things and those that are unfavorable, that you may not be comfortable with. So definitely be reading those.

So what the waterfall really covers is who, how and when each partner—we’re talking about a limited partner or a general partner—gets paid from the performance on this particular real estate syndication that we’re talking about. I don’t care if we’re talking about multifamily, or self-storage or mobile home parks; this is about syndications, real estate private placements.

Some share classes, as an example, may only receive cash flow; others may receive cash flow plus equity upside. So we’re going to talk about that. So the question is, upfront – I always talk about knowing your criteria, knowing yourself, knowing your goals – are you more cash flow-focused? Are you more equity-focused? Maybe are you a combination of the two? Do you kind of like that 50/50 mix or whatnot?

So it’s also important to note that common equity and preferred equity, which we’ll define here in a minute, they’re not debt. So cash flow gets paid out after expenses and debt on the property are paid. Okay, so more on that in a bit. But, Theo, I want to turn it over to you real quick, just to cover a few definitions and paint the picture a little more broadly. I’ll jump into the capital stack in more detail here in a minute.

Theo Hicks: Yes, so just a follow-up on what you said. So for the waterfall, when you’re in the PPM, it’s kind of written out in paragraph form. So it says, “First, this happens. Then assuming that there was cash leftover, then this happens. Then assuming there’s cash leftover, then this happens.” In the PPM, you’ll see it. They may call it different things, like ongoing cash flow, and then how the cash flow and sale is distributed, right?

Travis Watts: Yep.

Theo Hicks: And so at the end of all this, the money that you’re getting from the waterfall is going to be calculated as a certain return to you. And the two common return factors that are used in multifamily syndications, and really any syndication that I’ve looked at, is the cash-on-cash return and then the IRR. And so as the waterfall plays itself out, all that cash flow that you received, the cash-on-cash return is going to be based off of that and how much you invested. So super simple numbers – if you invested $100,000 and then you received $10,000 in cash flow from the waterfall, then the cash-on-cash return is going to be 10%.

The other return factor is IRR. And so it’s a little bit different than cash-on-cash return, because IRR is going to take into account the timing of those distributions. The cash-on-cash returns just kind of absolute once the waterfall has played itself out, all the cash value that you’ve gotten divided by your total investment is the cash-on-cash return. IRR is a little bit more of a complicated, a pretty long formula, but basically, it takes the time value of money into account. So if you receive that $10,000 in one year or two years or five years, the actual value of that as a little bit different, because the value of money in five years is different than the value of money today.

So unless you’re investing in a deal that’s held for like a year, the IRR is going to be a little bit lower than the cash-on-cash return. The way I like to think of IRR is a really good comparison tool to compare multiple investments, to see how they’re absolutely performing. Because cash-on-cash return might not be a good indicator, because of the fact that maybe you get no money upfront, and then a bunch of money at the very end, which would look the same as getting that same money spread out day one, and then nothing at the end. So I think IRR is a better metric to look at.

And then another important, not really a metric, but just something to think about, that we’ve talked about on the show before, is the velocity of your money. And this is another reason why IRR is so important, because the sooner you get that money back, not only is it worth more, but it’s also able to work for you more. So you can reinvest that back into another deal, and make a faster return, as opposed to get that money later, waiting a year or multiple years before reinvesting that.

So that’s basically the output of these waterfalls. So you really want to dive in to see when you’re getting your money back; not necessarily [00:06:52].00] but when you’re getting it. So for example, if there’s some sort of preferred return or a coupon offer and it’s not hit year one, when does that accrued money get paid out? Because if the timing of when it gets paid out will definitely impact that IRR. There’s something to keep in mind ultimately, that you want to understand – when you get paid, how much that’s going to be, because you can better plan for when you’re going to get that money back and be able to reuse it to invest in other opportunities.

Break: [00:07:18] to [00:09:20]

Travis Watts: So let’s get a little more technical then. I want to talk about the capital stack, I want to define a few things with different tier classes, IRR hurdles, splits… So this is the technical portion. For those that know me, I’m not the most analytical person, but I think this is important for the episode.

So the capital stack in a real estate syndication is basically where the debt and the equity partners are ranked in order, based on the relationship between risk and priority; so let’s define that. So the highest priority in the capital stack usually holds the lowest amount of risk. So the classic example here is your senior debt. This could be Fannie Mae, Freddie Mac, this can be a private loan. This is the debt on the property, the mortgage; you could think about a single-family home, your mortgage.

Usually those returns, as far as thinking about the lender or the bank, are quite low. They could be 2% to 4%, let’s say, for example purposes. That’s a pretty low return, but they’re in first dibs, first position, first lien, this kind of stuff, so they have the top priority. Then depending on the structure, not every syndication obviously is going to have preferred equity, but I want to talk about that a little bit. So preferred equity has first dibs on distributable cash flow after the debt service has been paid. So this could be outlined different ways. What I’ve seen commonly is that preferred equity may have just a nice solid cash flow return, call it a 10% or a 13%, or 12% cash flow, maybe no equity upside, but again, they’re first in line after debt and expenses are paid on the property. And back to the definition, real quick… Cash flow is distributed after expenses and debt get paid. So they would be just under your senior debt there—all debt always has top priority.

This is the same to, again – we draw parallels all the time into the stock market. Same concept – when a company goes bankrupt, a publicly-traded company, let’s say the debt gets paid first. And then it’s the equity holders and the shareholders, if there’s money left over, then they get paid. So that’s just how it works in business.

Then below preferred equity, if that’s even part of the equation, then you have common equity. And this is what most limited partners are investing in, is the common equity. So you might participate just in cash flow or you might be participating in cash flow and equity, upside in a deal. So I want to talk about that a little more in detail, because you can have different common equity share classes; you could have A class and B class and C class and so on, of common equity.

And I’ll give you the example that a lot of folks are using nowadays, that I see in the multifamily space. They’ll have an A class and a B class; we’ve talked about this before on the show. So if the investor is more looking for cash flow, maybe a higher yield, maybe a higher preferred return, that’s commonly your A class shares. So you might receive, for example purposes right now 10% coupon or a 10% preferred return, but you’re not participating in equity upside, meaning if the property was purchased at $50 million and it later sells at $60 million, you’re not partaking in that upside, that $10 million gain; there’s no part of that, you’re just getting a flat 10% return, assuming that the property can produce that.

And then the B class would be participating in cash flow as well, but sitting lower in the capital stack. So you have your senior debt, you have your preferred equity if that’s part of the coin, and then you have common equity, which is your A class, and then common equity B class. So they might be receiving a little bit lower cash flow, let’s call it a 7% coupon or preferred return, for example purposes; but then they are participating in any potential equity upside in the deal.

And that same example, where the property was purchased at $50 million, sells at $60 million – so then there would be usually a split.

I want to talk about splits for a minute. So a split means a split of the equity and/or the cash flow between the limited partners and the general partners. So let’s say the split is 70/30, just to use a pretty common metric that a lot of firms use. So it could be that after the preferred return — let’s talk about cash flow first. So after these B Class common equity limited partners receive their 7%, and assuming the A Class and preferred equity and everybody else has made their money, there’ll be a 70/30 split. So every percentage point over seven is split 70% goes to the limited partners and 30% to the general partnership.

Same thing with equity in that example of $50 million purchase price, $60 million sale price – there’s $10 million there in equity. So a 70/30 split would suggest that 70% of that $10 million, or $7 million, gets sent to the limited partners pro rata, based on everybody’s percentage of ownership in this particular dealer fund, 30% or $3 million goes to the general partnership. So that’s what a split means. The numbers will vary; you might see a 50/50 split, a 70/30, a 60/40 an 80/20, and that’s just what they’re talking about when you’re talking about splits.

So that’s important to recognize, obviously, for obvious reasons; you want to know how favorable that is. And to take it one step further – this is all part of the fee structure by the way and vetting out the deal and deciding how comfortable you are – is to consider that there could be an IRR hurdle as well to further complicate this.

So there might be a clause in your PPM or in your waterfall that suggests that after these B Class limited partners, common equity, get, let’s call it a 15% IRR, Internal Rate of Return, then the split changes. It was a 70/30. Once you achieve a 15 IRR, now it goes to a 50/50 or a 60/40. There’s different ways to structure all this. As Theo pointed out earlier, it’s just important to review, and it’s usually laid out in paragraph format; like, he said, “If this happens, then that happens. Once that happens, then this would happen.” So you’re just kind of reading through this in story format to kind of read between the lines, and then see what would ultimately happen in all these different scenarios.

So it can get quite complex. That’s why it’s always good to leverage a legal team if you can, if you have the resources to do so. If not just really study up on the PPM. Just really understand what it is you’re investing in. General partners can structure all different kinds of ways. I’ve seen everything, from the most simple 70/30 split across the board, there’s no hurdles, there’s no prefs, it’s just 70/30; every dollar that gets made is 70/30. And then I’ve seen very, very, very, very complex structures that are really tough, even for some legal attorneys and lawyers to figure out. So just be comfortable with it is my bottom line, and hopefully, that was informative.

Break: [00:16:26] to [00:17:07]

Theo Hicks: One thing I would say is, it can get very, very complex, especially hearing it. And so if you go to, we have an accredited investors’ category. There is a lot of things that Travis just talked about, understanding the different types of splits and cash-on-cash return versus IRR, these hurdles he talked about, what’s the difference between preferred return and cash-on-cash return… We’ve got long posts that go into a lot of these things. But yes, that’s the whole point here is usually when you’re presented with an email from a syndicator, you just see what the projected or forecasted return is. So this is the behind the scenes of how that number was calculated. To make things even more complicated, there’s also something called a GP catch-up.

Travis Watts: Yes.

Theo Hicks: Because let’s say for example — let’s say there’s just a straight-up pref offer to one group of 10%, let’s say, and the deal only cash flows 10% the entire time. And the GPs technically haven’t gotten any of their half a split yet. So as a sale, they catch up to make things even based off of whatever the equity split is, so 70/30, and then the rest is split 70/30.

And then as I mentioned for the hurdle, IRR is going to be zero until you’ve gotten your money back. So this hurdle usually just comes into play at sale. Unless there was some massive refinance, the profit split shouldn’t change during the actual hold period. So it’ll be more like the $10 million profit at sale, the first $5 million is split 70/30, and then that happens in bring you to that 50% IRR, and then the next $5 million is split 50/50.

But ultimately, it is important to understand the behind the scenes, because it helps you understand where the return factor is coming from… But at the end of the day, what really matters to you is are you comfortable with that return that they’re offering? Are you comfortable with that structure? Are you comfortable with when you are paid compared to when everyone else involved in the deal is paid? You used a really good example that we talked before the show about something that seemed that it was very favorable to the GPs, but it was actually, you got a return that you were comfortable with, so it was fine.

Travis Watts: Yes, I’ll share that story really quick. I was a limited partner in a deal, in a syndication type offering, and the general partners in this particular offering were taking 66% of all profits and leaving approximately 33% to the limited partners, which is what I was. But when all was said and done, when we exited that deal, I had around a 15% IRR return as a limited partner, even though they took that much in profits. So I was okay with that. As a limited partner, if I could get a 15% return all the time, I’m good. So I was comfortable with it myself. And this was a little bit different business model. This wasn’t your typical multifamily syndication kind of deal. But it just made sense to me.

But not everyone would be comfortable with that. Some people would look at that fee structure and say, “Absolutely not, there’s no way I would do that.” And that’s fine. We’re all different. But to me, that met my criteria.

We always talk about vetting the team and the market and the deal… This whole conversation we’ve had today is about vetting the deal, and it’s some of the more technical analysis that we go into that. And as Theo pointed out, we have tons of resources. This, to me anyway, me personally, if I was listening to this episode today, I would need a visual. I would need something to actually look at and to study and to read over paragraphs, and I would have to go pull out a PPM and I would have to read through what you’re talking about. But hopefully, it added some value for those that can just envision what we’re talking about and just some things to jot down to be on the lookout for. So it’s all I got.

Theo Hicks: Yes, a good visual, would be why it’s called a waterfall. Just think of it like a waterfall that starts at the top, that’s the cash flow, and it hits that first ridge. And then once that ridge fills up and it gets what it gets, then the rest of the remaining falls in the next ridge and then the next ridge, and then the next ridge, and at the end, what’s leftover goes to the last person. So just think of it that way. I think that’s where the terminology came from, like, a multi-tiered waterfall with all the cash flow getting split between different levels. So definitely check out our accredited investors category on our Best Ever blog. That’d be very helpful if you’re more of a visual learner.

So Travis, anything else you want to mention before we sign off?

Travis Watts: I don’t think so. Just do your due diligence, as we always point out. That’s it.

Theo Hicks: Perfect. Well, thanks again, Travis, for joining us today. As always, Best Ever listeners, thank you for listening, have a best ever day and we’ll talk to you tomorrow.

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