Real Estate Waterfall Model: Overview, Setup, and First Steps (30:34)

In this lesson, you’ll begin setting up the waterfall returns schedule with the formulas for the Tier 1 IRR accruals and cash flow distributions, and you’ll learn why we might need to build in a special case to handle the debt repayment upon construction completion.

Table of Contents:

  • 5:28: Step 1: Calculate Invested Equity and Net Cash Flows After Debt Service Each Month
  • 6:55: Step 2: Tier 1 Beginning and Ending Balances and Investor Injections
  • 8:59: Step 3: Investor Accruals
  • 11:47: Step 4: Tier 1 Accrual Distribution
  • 17:26: Step 5: Investor and Developer Cash Flows
  • 21:46: Step 6: Cash Flow Available for Tier 2 Distribution
  • 26:30: Step 7: Check the Numbers in Different Cases
  • 28:42: Recap and Summary

Transcript: Real Estate Private Equity Case Study 3 – Opportunistic Pre-Sold Apartment Development: Waterfall Returns Schedule, Part 1: Tier 1 IRRs and Cash Flows

Welcome to the next lesson in this Real Estate Private Equity case study. In this lesson we are going to jump into the fun part of the model, or at least the most difficult part of the model, which is the Waterfall Returns Schedule. Now this is something that you are almost always going to have to deal with in real estate, but not necessarily as much in other industries. And the reason you have to deal with it in real estate of course is because of the Waterfall Returns structure that exists for the equity investors in the property.

Remember that in the case study document right here, we were told that the returns are split according to an 80 -20 percentage at the up to 20% IRR level, then they are split 70-30 between 20% and 25%, and they are split 60-40 above 25%. You don’t normally see this with standard leverage buyout scenarios for normal companies, for example, so it is something that is relatively specific to real estate.


And the reason why we have to do it, of course, is because with the metric we just calculated previously, Cash Flow After Draws & Debt Repayment, theoretically at this point we can take this and then the amount of equity we are contributing. And we could use the XIRR function to go through and calculate the overall internal rate of return for the project over this eight year time period. But, of course, because of this return structure, we can’t do that. We have to actually split up the returns here according to the investor class and also according to the tier of IRR that we’re currently in. So that’s why we need to do it.

Now if you are not familiar with how this concept works, take a look at the simplified file that I’ve linked to below this, the simplified Waterfall Distribution Schedule. This is for a normal company, but it shows you in a very simple example how it works.


Where if you have $1000 that are invested upfront, and you split the IRR differently at different levels between the private equity firm and the management team for a “normal company buyout” scenario, how essentially you distribute the amount that corresponds to that 10% IRR according to the 95-5 split. Then you look at the amount that corresponds to an IRR between 15% and 10%, and you split that up.

Then you look at it between the 15 and 20% and you split that up, and then you split up everything beyond 20%, and then you reassemble the pieces here at the bottom. So take a look at this if you don’t understand that concept, and if you go through it, it will all make a lot more sense. We don’t really have time to get into it here, because there is already so much else to cover, but this is one way that may help you to understand it a bit better.

The other thing I would recommend is that if you go back and look at the office development model and the Waterfall Schedule there, in some ways this is very similar.


Our setup looks quite similar, but we’re doing a few things differently, and we are calculating some of the numbers here a bit differently. But if you’ve already been through this in the earlier module, you’ll have a pretty good idea of what we’re going to do this time around as well.

So let’s go back now, and I’m going to lay out what we’re going to do step-by-step in this lesson. First off we need to calculate the Invested Equity and the Net Cash Flows After Debt Service Each Month, because we need to see fundamentally whether we are contributing equity or getting equity back in each period.

Then we need to look at the Beginning and Ending Balances in the schedule, and see what happens when we contribute more equity. Because if you’re targeting a 20% IRR at a certain level and you have contributed $1 million, you need to get back $1.2 million to correspond to that 20% return.


On the other hand, if you’ve contributed $2 million in the same period, over a year, let’s say, you will need to get back $2.4 million to correspond to that 20% IRR. So that’s why that part is important.

Then we’re going to look at the Investor Accruals, which is something that we did go over in the office development model as well. Essentially here, all we’re doing is taking the beginning balance and we’re saying if we are aiming for this 20% IRR, how much do we need to get back in a given month that we’re in right now based on that beginning balance and the IRR in this tier?

Then we’ll look at the Accrual Distribution and see what happens when cash flows are negative, what happens when they’re positive. And then when they are positive what happens when they’re simply less than we’re owed and then what if they are greater than the amount that we’re owed in this IRR tier. Based on this distribution we will then calculate the investor and developer cash flows. The formula for this one is a little bit confusing, so we’re going to break it down step-by-step and go through each component.


Then finally, we’ll take a look at the Cash Flow available for Tier 2 distribution and subtract out anything we’ve distributed in Tier 1 to calculate this.

Then as a last step here, we’ll check the numbers in different cases and see how the Base Case, the Upside Case, and the Downside Case all compare to one another. As you can see there’s a lot to get through here, so I’m going to move relatively quickly and stay focused on the parts that require the most amount of explanation.

So Part 1 here is pretty straightforward. We’re just going to go down and for the Invested Equity we’re setting up this Waterfall Schedule so that it is based on the total amount of Invested Equity from all groups. Sometimes you’ll see variations where it’s just based on the third-party investors, not the developer equity.

But in this case if you look at the case study document, they’re telling us explicitly that we should be looking at the total IRR, not just the IRR to developers or investors. And we should be looking at the total cash flow to equity investors.


So in other words, we’re not just basing this on what the third party investors get, but rather the equity contribution from the developers and the third party investors in this project. To get that, let’s go up and take the draws from right here, the Developer Equity and Investor Equity. Then for the Net Cash Flow After Debt Service, that is just the Cash Flow After Draws & Debt Repayments here, and then we can add these up and get to our total here at the bottom.

Let’s copy this across because we’re going to need it throughout the rest of this model.

So fundamentally all that’s happening here, is it’s saying at a high level, “Are we contributing equity or are we getting equity back because we have positive cash flow?” We’re just getting to a net number here at the bottom that tells us that. We’re going to need this later on in a variety of calculations, so I wanted to set it up here at the very beginning.

Let’s move into Step 2 now, and once again go to my notes here at the top. So now we’re going to take a look at the Tier 1 Beginning and Ending Balances and also the Investor Injections.


You should know the concept of this already, but essentially we track how much investors should receive back in order to get a 20% IRR in this tier in a given month, and those Beginning and Ending Balances represent the amount they’re owed. The Investor Injections represent anything additional they contribute. Those additional contributions are, in turn, going to result in higher Beginning and Ending Balances in the future because when they contribute more they are then owed back more on that amount of contribution. Let’s go down and enter these formulas.

So the Beginning Amount here is just zero, as it always is, and for the Ending Balance we can just add up everything here. And for the Beginning Balance in future periods we can just link to the Ending Balance from the last month before it, and for the Ending Balance we can just copy this formula.


For the Investor Injections, this is why we need the Invested Equity up here. Because we need to flip the sign on this and turn it into a positive so that as we contribute more equity to the project, the amount that we’re owed also keeps going up.

Now of course it’s also going to increase here by the Investor Accruals, so we need to factor that in as well. But as a starting point we do need to account for those Investor Injections. Let’s copy across what we have so far. So let’s take this and then copy all these across, so we have that. We can get to our final owed balance here at the end which you can see which is all based on how much we’ve contributed over time.

Now right now this is completely unadjusted, so we have not yet factored in the fact that we need to be earning a 20% return here. So this right now really just plots how much we’ve contributed over time.


Now for the Investor Accruals, the next part, and the Cash Flows here, we need to bring in a few numbers. So for the Investor Accruals, and this now takes us into Step 3 of the process. I’m just going to link to the 20% threshold right here, the IRR between, so we need that. Then for the split at this level, we want to link to the investor split up here, 80%. And then right below it, the developer split of 20%. So we have those numbers from our assumptions.

Now for the investor accruals themselves, let’s go up once again to my notes and see what we’re doing here. The idea, as I said, is that we want to take the beginning balance and then increase it by the monthly amount that corresponds to the 20% IRR. So you can see the formula right here. I think it might be a little bit easier if I just copy it in and then explain what it’s doing.


But essentially E150 here, it’s 20.2%, so we’re taking 1.2 and we’re raising it to the power of 1/12 and then we’re subtracting 1 from that. Why are we doing that? If you think about the way the math here works, let’s take 1.2, and let’s raise it to the power of 1/12, which gives us 1.0153.

But in this calculation we don’t want to just take the beginning balance and make it bigger. We want to take the beginning balance and take some small percentage of it that corresponds to this accrual amount. So if we subtract 1 here, then we figure out that it should increase by about 1.5% of its beginning number, and that is what the Investor Accruals here should be. So let’s take this formula, and then let’s go down and paste it in here.


So I think it’s a little bit easier to understand once we start copying it across. You can see what happens here now, that we have this beginning balance and we say we should be earning a 20% annualized return on it. But we need to come up with monthly numbers here, so we’re going to raise it to the power of 1/12, and then subtract 1. Then on a monthly basis essentially we’re converting this annualized return to a monthly number instead.

You can see that as we go across, we get to a significantly higher number here by the end. So overall it looks like we’re owed back around R$ 40 million for this deal over time. Of course we haven’t yet factored in the Accrual Distribution or the amounts that we’re actually distributing in terms of cash flow to these equity investors. So that is the next part of the process.

The Tier 1 Accrual Distribution formula gets a little bit involved, so I’m going to go up to my notes once again. The basic idea here is that we need to see if we should distribute anything to equity investors in this month, in this IRR tier.


So if you think about what’s going on here, there are really three cases. First off, our cash flows could be negative, and so to show you an example of that, let’s go down and take a look at this. So if the Cash Flows to Equity Investors are negative here, as they are in the first month, and then in various other months throughout the rest of this model, then by definition we cannot possibly distribute anything because we don’t have anything to distribute.

These correspond to negative IRRs, so they’re certainly not going to correspond to a 20% IRR. So that’s one case you have to think about. But then the other case is what happens when the Cash Flow to Equity Investors is actually positive.

With this, one of two things could happen. Number one, this is positive and so we can distribute something, but it’s less than whatever balance we’ve built up over time.


And if this is the case, we can’t possibly distribute this entire balance. But we can distribute what we have so far. Because remember, this is not a minimum IRR tier. This is a tier where we go up to a certain amount.

So the minimum here is really zero, and as long as we have a positive number for the cash flow, we can distribute that. So that’s another case.

But then there’s a third case to consider. You can’t really see a good example of this for right now, so I’m going to skip over it at the moment. The third case to consider is what if we have a case where we finish up the construction period, and then the amount of cash flows here actually exceeds whatever balance we’ve built up over time. In this case you don’t want to distribute the entire amount of cash flows. You only want to distribute the amount that corresponds to this balance we’ve built up.

So those are the three cases we have to watch out for. And I have some notes written over here on the side about it, and we’re going to use a MIN/MAX function to do all this once again.


I have the logic right now here in words, but essentially this maximum part in the middle is just summing up whatever we have so far before these distributions. So that corresponds to the case where the cash flows are positive, and so all we’re saying here is that if this balance in the middle is greater than the cash flow amount, then we want to distribute the cash flows that we have.

We’re using negative signs to flip this and so all we’re saying here in the middle is that if our cash flows, the F145, is greater, then we want to distribute this balance instead. On the other hand, if this balance is greater, then we want to distribute those cash flows instead. We have a MIN(0 on the outside to ensure that if any of these parts are negative, meaning the cash flow is negative, we distribute nothing. So let’s copy this formula down and then see it in action, and see how it actually works here.


So I just entered it and I think visually you can see this a lot more easily. You can see how we’re essentially just adding up everything here for the inner part of the function. We’re using a negative sign because we want to turn this into a negative, since we are comparing it to the Cash Flow to Equity Investors. And what ends up happening here, if you really think about it, is if the Cash Flow to Equity Investors is positive, this will become a negative number, but it will still exceed the negative number that we have for this part in the middle. So that’s why we’re doing this. And if you copy this across, you can see how this works.

So in Month 2 for example, we have a big balance here of around R$ 9.5 or R$ 9.6, R$ 9.7 million, that’s this part, that’s negative R$ 9.7 million.


But then we have a negative R$ 1.5 million up here for the cash flow, and negative R$ 1.5 million is greater than negative R$ 9.7 million. So we just use the negative R$ 1.5 million and that’s one of the cases.

Now in a lot of these other cases, we just have zero here because our cash flow is negative, so we cannot possibly distribute anything in that case. When both of these parts, when the MAX function here just returns some positive number, the minimum between zero and some positive number is always going to be zero, so that’s how we handle that case. And if you go across you can see more of how this works.

In particular, look at what happens here in March of 2017. We have R$ 13 million of Cash Flow, we have an R$ 45 million balance built up so far. We can’t possibly distribute the whole thing, but we can distribute the R$ 13 million or R$ 13.3 million that we have at this point.


Then as you keep going across and looking at what happens here. Look at what happens in June of 2018. Now we have R$ 46 million of cash flow. We have an R$ 40 million balance built up, and so in this case the formula correctly handles it and says, “You know what? We have the R$ 46 million of cash flow, but we don’t need to distribute the whole thing. We just need to distribute the amount of R$ 40 million because that corresponds to a 20% IRR at this point in time.” So we distribute, actually, R$ 41 million here which is less than this R$ 46 million that we have. So that’s how the formula works. Let’s move into the next step now because it’s very closely related.

Step number five here is about the Investor and Developer Cash Flows. Just like we had this Accrual Distribution that handled these three different cases, we have basically the same three cases here. It’s just that it is set up a little bit differently.

So in case number one, we actually have Investor Injections, the Cash Flow to Equity Investors is going to be negative, and so we just split up that negative cash flow according to the 80/20 split that we have.


In Cases 2 and 3, we don’t have injections, so we have positive cash flow. But the key difference is the Accrual Distribution number next to the Beginning Balance plus Accruals.

So if the Accrual Distribution number is less than that figure, then we can distribute some of the Cash Flow but we don’t have enough to meet the total amount that corresponds to this IRR. On the other hand if it’s greater than the Beginning Balance and Accruals, then we just distribute the Beginning Balance and the Accruals. Now if you think about it, because of the way we set up the function before, the Accrual Distribution, for the Accrual Distribution, we can never really get Case 3 here so it’s really just Cases 1 and 2. But just to be careful we have set up a check for this anyway, in case someone comes along and changes around the model later on.

So here is the formula for it. I think it’s easiest to just paste this down. I have an explanation of the logic for this right here, but I think it’s easiest just to paste this one in and show you how it works.


So for the Investor Cash Flow I’m going to paste that in and then for the Developer Cash Flow, we can just take our Investor Cash Flow divide by the 80%, anchor that and then multiply by the 20% right there. So for these numbers, let’s just copy them across and then I’ll show you a few examples of how this formula is actually working.

If you think about what’s happening here, row 149 and row 151 could never both have numbers in them. In other words, if we’re injecting equity we can never possibly have a distribution. So it’s only going to be one or the other of these. So if we have an Investor Injection here, we flip the sign, we get negative R$ 9.6 million.


And then we compare that to the Beginning Balance plus the Investor Accruals, which in this case is just zero. So of course negative R$ 9.6 million is less than zero, and this just comes out to negative R$ 9.6 million and we multiply it by 80%.

But then if you look at it in the next period here, take a look at what happens. So G149 + G151 here is just the negative R$ 1.5 million. We flip the sign, and this becomes positive. So it’s positive R$ 1.5 million and then we compare it to G148 plus G150, but this is a much bigger number. This is closer to R$ 10 million, so of course our Cash Flow is less than the total amount that we’re owed. So we can’t distribute this total amount, because we don’t have it, but we can distribute whatever we have, which is the R$ 1.5 million and that’s what we split up here. So that is how that works.

Now to show you another example of this, another case, let’s go all the way to June of 2018. So here is an interesting case because this is when we have excess cash flow, R$ 46 million. But we only distribute R$ 41 million.


Well in this case you can see exactly what happens, which is that we take our Tier 1 Accrual Distribution of negative R$ 41 million, and flip the sign so this becomes positive R$ 41 million. And then we compare it to the Beginning Balance and the Accruals, and this actually comes out to be the same number in this case. So it doesn’t even end up mattering. It’s the same number, and we just distribute that R$ 41 million and we split it up and we multiply by 80%.

So because of the way we set it up, we can never really get into this case where it goes to this number at the end instead. But just as an error check or in case something changes we have this right here. So that is how that formula works. Let’s go into the next step now. And if you’re confused about any of this, I have an explanation of this all written out in words right here under Step 5. So take a look at this in the Excel file and you’ll see more about how this works.


For Step 6 we need to distribute the Cash Flow for Tier 2 or at least make available the Cash Flow for distribution in Tier 2.

This is pretty easy because if the Cash Flow is negative nothing is going to be available. Otherwise if its not negative, then we take the Net Cash Flow After Debt Service, we subtract Investor and Developer Cash Flows, and then we actually have something available for Tier 2, Tier 3, and beyond.

So let’s take a look at how this formula works. Let’s look at our Investor Cash Flow here, because we want to factor in all these distributions and everything like that, we don’t want to look at it before this. We’d rather look at it after it (i.e., these distributions). So if this is less than zero, then we’re going to have zero. Otherwise, we’re going to take our Net Cash Flow After Debt Service and then subtract Investor Cash Flow and Developer Cash Flow.


Now you might be looking at this and wondering, “Okay, wait a minute, why are we taking Net Cash Flow After Debt Service and not the Total Cash Flow to Equity Investors?”

Truthfully, we could actually do that and it wouldn’t really make a difference here. But I’m not setting it up that way because we want to sort of ignore the Invested Equity. All we’re really looking at here is how much is available, and then comparing it to how much we’ve distributed. And if we get a case where there’s actually something for Invested Equity, then F154 is going to be the less than zero anyway, so we handle that case. But basically here I’m doing it because I want to ignore the Invested Equity and simply look at it in terms of Cash Flow Available versus Cash Flow Distributed in this tier.

So let’s take this across, and then let’s just take a quick glance at these numbers before we do more checking right after this.


The real question here is, do we ever have Cash Flow available for Tier 2 distribution? The answer is yes, but we have to go out quite a ways to get to it.

So in June of 2018 we finally get to this, and you can see exactly why because our Cash Flow After Debt Service exceeds this R$ 40 or R$ 41 million balance that we’ve built up that corresponds to the 20% IRR that we’re owed, and that’s why we get something after this. So we get to R$ 5 million right here and that’s what’s going to be available for Tier 2.

Now if you keep going, you’ll see that in the Base Case we never get anything else. We actually have a negative right here, because this is when construction ends. We don’t have enough cash to repay all the debt. So we actually have to contribute more equity in that case, so we get to a negative there.

We might actually have to end up going back and fixing this later on but we’ll see what the final model looks like first and evaluate it at the end. And the way we’ve set it up may already handle this condition, but we’ll have to check and see.


It’s a bit of an odd case because of how this is set up, but that is something else that we want to consider here. So we’ll just save this for now and make a mental note that we should check this at the end, and make sure that the returns still are calculated the right way.

Now looking at this in intuitively, you know from the case study document that we are targeting a 25% IRR and a 2x multiple of Invested Capital. If you look at this so far, your conclusion would be that we’re probably not even going to hit a 20% IRR. Why is that the case? Because if you look at the Cash Flow available for Tier 2 distribution right here, this actually comes out to be a negative number, which means that not only do we not really have enough to hit Tier 2 – if this is negative, we probably don’t even have enough to hit Tier 1, the 20% IRR right here. So without even finishing the rest of the model, you can pretty much tell in the Base Case that we’re not going to achieve a 20% IRR.


If you don’t believe me, you could just take a look at it this way, you could look at the Cash Flow to Equity Investors, use the XIRR function, and then enter the values, and the dates, and we get to around a 17% IRR, so that just proves what I was saying. So without even doing anything more complicated, you can already tell that this is probably going to be a tough deal to make an investment recommendation in favor of. Though we will continue going through the model and looking at everything else.

One other thing I want to do here before moving on, is to compare and contrast this in different cases. So first let’s change this to the Downside Case and see just how bad it looks. So in a Downside Case, let’s just use XIRR once again, this comes out to basically a 0% IRR and if you add up the Cash Flows to Equity Investors, you can see why. These are negative, so this comes down to a very, very low number.


Of course, we never get any Cash Flow available for Tier 2 distribution in this case. We do get to this very negative number at the end, but that’s about it. So things look very, very dire in this case, as they should. And if you change it to the Upside Case, let’s do some quick IRR math again. And now we can see that we get to a very positive IRR, 72%.

So there is a huge difference between these cases. We’re not talking about a difference of 15% versus 12%, versus 9%. We’re talking about a difference of 72% versus 17%, versus some very negative number. Again, this is because we are looking at an opportunistic investment, and there is a very high degree of variability in a scenario like this depending on how it goes.


Also in this Upside Case, if we go across and just take a look at the Cash Flow available for Tier 2 distribution, in a lot of months this is zero, but in certain months it becomes very, very positive. And then if you keep going it’s also positive in further months down the road.

So in this case we are very, very positive on the Cash Flow and the amount of cash flow that’s available for further distribution in Tiers 2 and 3, and beyond. We can just see intuitively that we get to a very high IRR in this case as well. So that’s a bit of a check of the numbers here.

Let’s go up and do a recap and summary now. I’m going to leave this set to the Upside Case because it’s easier to check our math as we go through it, because we can actually distribute something across all the tiers in the Upside Case.


We need to do this because of the Waterfall Return Structure; we split the returns depending on the overall project IRR, and so it’s critical to do this. We can see on my notes up there, but we started this by calculating the Invested Equity and the Net Cash Flow After Debt Service to get to our total Cash Flow to Equity Investors. Then we set up the Beginning Balance, the Investor Injections, and the ending balances here. We figured out what amount this will have to increase by each month to correspond to a 20% IRR in that month.

Then we looked at the Tier 1 Accrual Distributions and said how if cash flow is negative, then you have nothing here. If it’s positive, you either have that amount that you distribute, or if that amount is greater than the balance that you’ve built up to this point, then you distribute that balance you’ve built up.

We calculated the Investor Cash Flow and Developer Cash Flow here at the bottom, through much the same logic, where if cash flow is negative, we just distribute that negative.


If it is positive, though, then once again we are taking the Tier 1 Accrual Distributions, or if somehow there’s a distribution greater than the balance we’ve built up so far, we’re just going to take that balance so far. And then we multiply it by the 80% and 20%, and then to figure out how much goes into Tier 2, we just do a check of our Net Cash Flow After Debt Service.

So that’s it for this lesson. Coming up next, we’re going to look at Tiers 2 and 3 and then we’ll put everything together at the end, and see what this looks like. And we’ll also see if we have to make any adjustments for that case I showed you, where all the debt is due and where we have to put in additional equity to fund it.