The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
When one talks about a fee waterfall, what they’re talking about is a tiered system where the benefit from an investment shifts from person to person. To see a waterfall in action, one benefits most from looking at an example that involves an investor and a developer going in together on a single project. In this example, the investor will benefit until returns reach a certain percentage, when the benefit suddenly splits to 50/50. After the return grows even higher, the developer may enjoy more of the benefit than the investor. Waterfalls can be completely custom between two investing parties to suit their particular needs, wants, and desired waterfall structures.
How does a fee waterfall work in commercial real estate? So, a waterfall is simply a name for a tiered system of compensation. So, let me give you an example of a waterfall, and then I’ll explain what a waterfall is, because it’s easier to understand what a waterfall is when you actually use a real example. So, let’s say you and I, Richard, invest in a project together and you’re my investor and I’m the developer, okay? Well, we make an agreement about the waterfall here, which is just basically how does the profits get divided between you and between me. Depending on how different thresholds are met for the potential returns on this project. So let’s say we have an agreement that before anything happens, you earn 10% on your money. I don’t make anything except after when you make a 10% return. So the first leg of the water fall is the 10% return to the investor, to Richard. Now, next on the waterfall we may say “Look, from a 10% return to a 13% return, what’s going to happen is that I’m going to get, as the developer, I’m going to get 30% of those profits and Richard you’re going to get 70% of the profits.” Up until a 13% return. So, from 10 to 13% return, there’s this split. Now we may also say that okay between a 13% return and a 15% return, it’s going to be a 50/50 split between me the developer and Richard the investor. And we could say beyond a 15% return, it flips the other way where me as the developer gets 70% of the return and Richard gets 30%.
And so what that does is it aligns the incentives of the investor and the developer. It basically ensures that the investor gets the lion’s share of the profit up to a certain point. But then beyond that point the investor is willing to share disproportionately more money, and the developer demands disproportionately more money of the upside. The thought being that look, if I can deliver a 12-15% return to you, I deserve to share in the bounty also. And so that very fundamentally is how a waterfall works. And you can invent it to make it do anything you want. You could change the percentages, you could do all kinds of fancy things, but fundamentally it’s just a tiered structure where the economic benefit shifts from person to person.