How Real Estate Waterfalls Actually Work (and What It Means for You) | Ep 72

James: A lot of investors tend to think that returns get split evenly, but that's not actually the case. There's actually an entire structure behind it called a waterfall that determines who gets paid what and when. And that's what we're gonna talk about on the Furlo Capital Real Estate Podcast, where we dive into the intricacies like this of passive real estate investing.

And our goal, our mission, is to equip investors to invest wisely in both properties and people's fully understanding their returns, so that together we can build wealth while improving housing. I'm James, and this is my wife, Jessi, speaking of water. That was

Jessi: great. We're gonna talk about waterfalls, but

James: Yeah, I'm, I'm not gonna chase them.

We're gonna talk about 'em not chasing

Jessi: them. Yeah. I, I just, I have water on the brain because I'm. Okay. Because you can go to the

James: bathroom.

Jessi: No.

James: Okay.

Jessi: It's because I'm redoing some of the watering systems in our front yard. Okay. And there was just, there was an interesting problem where a pipe kind of broke.

Mm-hmm. Yeah. And we asked an expert. Yeah. Thanks dad. On how to, which by the way,

James: happy birthday. Today's his birthday. Aw. Happy

Jessi: birthday

James: Ben.

Jessi: Yeah, he had a, a brilliant solution that was like, I never would've thought of that, of how to get the pipe out of the other pipe and

James: how to get a pipe that's broken off inside out.

Right. That's broken off in the inside.

Jessi: You know,

James: if you wanna know, leave us a comment. We'll tell you how

Jessi: that is unrelated, but water, you know? Yeah, yeah, yeah. All the little nuances of how pipes sit together and how the water is like you never know. After a season, you turn the water on and it sprays out in random spots and you're like, oh

James: yeah.

And that can often feel like investing, right? Like you invest. Exactly. And then time goes by a lot later and you never know. All of a sudden like money starts coming out and you're going, hold on a second. Is this where I thought the funds were going or not? This is not what I was expecting. And you have questions, so it can be unexpected.

Yeah. And so our goal in this discussion is to help kind of clarify that. All right, so this is, that's interesting. A little bit technical, but I think. If I do it right, you're gonna go, oh my gosh, I totally understand how this works, and I have an amazing analogy. Amazing.

Jessi: Is it a waterfall

James: to start this out?

No, it's not.

Jessi: Oh.

James: So

Jessi: well that the first question

James: that you have to ask is what is the capital stack?

Jessi: Oh, wait, we talked about this.

James: Yeah. Do you remember? Oh, this is like a pop quiz? Yeah,

Jessi: yeah, yeah. Okay. The capital stack. Was

James: stack of capital. A little stack of cash. So capital, another word for capital is money.

Yes. And like, it

Jessi: was like pancakes. We talked about pancakes. I remember that. Yeah. We talked about flipping pancakes and they're,

James: yeah. But essentially it's where is the money coming from to fund a deal? Okay. That's the capital stack.

Jessi: Like you're, like the order of investors. It's not really order it. I guess it's just the chunks of investors where it's coming from.

Yeah, yeah,

James: yeah. Okay. Where's the money coming from? Might be from a loan, might be from a bunch of other places. We're gonna talk about that. Mm mm-hmm. So here's what I want you to imagine. Imagine a high rise, okay? Yes. Highrise building, and each floor represents a layer in that capital stack. Okay?

Jessi: Okay.

James: So on the lower floors you have senior debt, think mortgages.

Okay? Those get out first in the case of an emergency. Okay. What do you mean by get by? Get out? Like if you, like, if you, I don't know if you went bankrupt and you had to get rid of the property. Oh, banks get paid first. They get paid first. The loans get paid first. They get out first. Or like in a building,

Jessi: in an emergency, they're on the bottom floor.

Yeah, yeah, yeah. Something bad happens. Got it. Gotta get the capital out. Yes. They get their money first. Mm-hmm.

James: Whereas those in the penthouse level, often called common equity, they get the best view. In other words, they might get the best return. Oh, but they also take on more risk uhhuh,

Jessi: right. 'cause they gotta go all the way down to the bottom.

Yes. Whereas a mortgage

James: is super boring, right? It's a fixed interest rate. Sure. There's nothing interesting there. Not fancy. So there's, there's essentially, there's four different types of debt. You have, like I said, that senior debt, think bank loans. They're your lowest risk, lowest return, and they get paid first.

Yeah. You then sometimes have what's called mezzanine debt which is, it's kind of a, an InBetween, it's like a bridge debt sometimes. So who would be giving that to you? Where's a little bit higher interest? So like. Let's say you want to, like a construction loan is oftentimes that kind of debt where you're gonna do a bunch of work and it's kinda more short term, Hey, you can have this for two or three years, maybe the interest rate floats, but we're helping you get by.

Interesting. And you know, helping you do whatever the project is that you're trying to get done.

Jessi: Mm-hmm.

James: And then you have what's called preferred equity. Okay. Okay. So now this is equity, so it's actually investors who own part of the property. Mm-hmm. But. They get a fixed return on their money.

Jessi: Hmm.

James: Okay.

Jessi: Okay.

James: And then the final step, the final group of people to get paid, and this is all going in order mm-hmm. Is what they call common equity. Yeah. Okay. And these are just normal. Your normal investors the sponsor and the passive investors are typically that and they get what's left, but also potentially get the highest upside.

Mm. Because it's like, if you think about. You know, I don't know. We'll make up some numbers. If you have a hundred dollars return, it's like, yep, the bank is gonna get $20. Maybe you have some mezzanine debt. They get $5. The common equity might get $20. And then. Then you had like 65. Mm-hmm. And then the, the equity gets the other 65, but I don't know, maybe instead of getting a hundred dollars back, you're only gonna get $75 back.

Mm. Right. So that's kind of where that risk comes in. Interesting to it. Yeah.

Jessi: Yeah. And so some of those levels are fixed amounts and some of them are percentages, but the waterfall effect, well, they're all

James: percentages, but some of 'em are fixed percentage and some of 'em are percentage based

Jessi: on Oh, okay.

Okay. Okay. Cash. It's all percentage of cash flow of your profit. Mm-hmm. Mm-hmm.

James: Yeah. So does that make sense? Like a capital stack? I think so. And so as a general rule, the higher you are on the stack, the more risk,

Jessi: but

James: the potential for a higher return. Sure. Okay.

Jessi: Is it also like, I mean, really the way that you describe that, the, the.

First three in that capital stack mm-hmm. Were kind of passive investors. They weren't necessarily doing work. All of 'em are. Yeah. But, but at that top level, you were saying it was a sponsor, the

James: sponsor's often included in that. Yeah. Okay. Yeah. But no, they're all, but they're, they're

Jessi: doing more work. You know, if you think about like they're putting the deal together and they're.

James: No, I don't think of it that way. Think of it more of a, that has nothing to do with it, right? No, because like a sponsor, if they're doing the work, they actually get paid a fee to do the work. So, oh. Which

Jessi: is separate from that? Yeah, that's totally separate. This is just the payouts from just the ownership.

James: Yep. Profits. Mm-hmm. Mm-hmm. Mm-hmm.

Jessi: Alright. Yeah,

James: that's helpful. And it's just saying, I'm willing to take my money last. I'll take whatever's left over. Could be risky, but it could also be awesome.

Jessi: That makes sense.

James: Yeah. And like I said, there's pluses and minuses to all of them. So that's the foundation for understanding what a waterfall is.

Mm-hmm. Okay. So a waterfall is the structure that outlines how the cash from operations or a sale, they flow down to the different parties.

Jessi: Okay. Okay.

James: And these are often called tiers. So I'm gonna start with a very simple waterfall structure. The thing that I actually teased at the very beginning. Mm-hmm.

Which is you might have something where the profits are split evenly. Okay. Where it's like, yep. The sponsor gets, I don't know, 30%. All investors get 70%. We split all of it. And maybe that's 'cause you paid cash for the entire building. There's no loan, there's nothing. It's just Hey, we bought this.

Jessi: So in the capital stack you would just have two,

James: there's one. Well, no, it's just, it's just one tier. Just one. Oh, I guess. No, just one. It's just investors putting money in. That's it. Just all common equity and you're saying, yep, we're gonna split it between and this common equity, that piece of it, that tier.

Yeah, that whatever. We're just gonna split it however we do. 30, 70, 80, 20, 50, 50, whatever. So

Jessi: you're like, you're right. This is getting into like the subtleties and the nuances. 'cause I'm kind of like we're get, we're get more complicated. Well, what's the difference between. A loan then and investor money, isn't that just a loan?

James: No. It, well, it depends. Mm. Right. So sometimes investors can give you a loan mm-hmm. And they can act more like that senior debt where they have a fixed interest rate and they do get paid first. Mm-hmm. So that, that is definitely a thing. So it

Jessi: depends on the terms that you agree upon. Mm-hmm. When, when people give you money.

Mm-hmm.

James: Yeah. Yeah. But common equity is like, it's not a loan. They have ownership Right. Of the property. Okay. Okay. We're gonna look at a more complicated example again. Oh boy. Here we go. So again, like this is waterfall. So from a waterfall perspective. Banks and the senior debt always gets paid first, right?

Yeah. Then the common equity happens. So maybe you have one where it's like you have a, a tier one, this is your first tier where it could be what you do is you first say, we're gonna do a return of capital. So everyone who put their money in, they get their original investment back first.

Jessi: Okay.

James: So whatever, whatever cash flow, whatever sale happens, like mm-hmm.

We give you your money back first proportional to how much you put in. Okay? Okay. Or you could have, what would they call a preferred? Return based on, say like an IRR. So some percentage, right? You might say, we're going to pay back our investors 8% first. Mm-hmm. And we're gonna, they'll get almost all, they'll get a hundred percent of the profits until they hit that 8%.

Mm-hmm. Preferred return.

Jessi: Okay.

James: Okay. Yeah. Which is very similar to preferred equity in that regards, but that's just a piece of it.

Jessi: Sure.

James: And then what you potentially have. And also like in, in this like a tier one and a half, I guess, I don't know, is you could have this optional catch up provision where once all the investors hit maybe that 8%, the sponsor then gets to catch up to also hit an 8%.

So you're not. Waiting necessarily till the very, very end, right? Right. So you might be like, we're getting all the waters flowing to the investors until they hit 30%, and then the water's gonna flow until the sponsor hits their 8% uhhuh. And then you might hit a tier two where instead of it being a hundred percent, you go, well, the profits, the profits are gonna be split like, let's say 70, 30, 70% to the investors, 30% to the sponsor.

And we're gonna do that until we hit 15%. Irr. Mm-hmm. Okay. So now they've hit a 15% return. They feel good about it, and then, and, and they're gonna get there faster because they're doing a 70% and the sponsors, whatever it is. Once you hit that, you maybe have a tier three where maybe it's a 50 50. Because they've already hit their 15%.

Okay. And now half of it goes, and now the sponsor's overperformed essentially. Sure. Because usually that tier, the end of that tier two, is defined at whatever they put in the underwriting. Hey, we think you'll get 14%. We think you'll get 15%. Okay, whatever. And so we hit those metrics. Yay. Now means the sponsor for Overperforming.

I, I get a bigger proportion of it. It could be 50 50, and in theory you can have, you can have a ton of tears if you really wanted to get crazy. Like you could have, you could have a dozen, you could have 20 of them. Mm-hmm. Potentially where it's like, hey, for each percentage we switch the, you know, for each IRR hurdle.

Jessi: Mm-hmm.

James: We switch a little bit how, you know, gradually shifts over to the sponsor potentially. And

Jessi: you, you agree on all of that. Ahead of time,

James: Uhhuh.

Jessi: So when someone's giving you their money, they know how the payout's gonna happen, right?

James: Yes. And that's part of the point is you need to ask about it. You need to understand Oh yeah.

How that works. Okay. And it's often written out in a little legalese, right? They might, they might have like a one or two liner bullet point. I actually put graphics in my stuff so people understand that's, that's, as I was

Jessi: just about to say, was like. Can't you do like a graphic that shows you like the, the order and the percentages?

I feel like that would be really helpful.

James: But the trick is too, you gotta make sure that what's written into your PPM, which is like the legal document, putting together the partnership mm-hmm. That, that what is verbally described matches whatever they showed, because at the end of the day is the verbal, legal description is the thing that matters.

Jessi: That's, that's what they're gonna enact. Yeah. Yeah,

James: yeah. So one of the goals of doing a more complicated version is. It gets the sponsors their money mm-hmm. Sooner, but then it tries to balance that out with, if the sponsor does really well or gets the investors their money sooner. And if the sponsor invests well, they get more of that upset again there last one to get the money so they potentially Yeah.

Get, they

Jessi: should get a, a slightly higher return

James: potentially. Yes.

Jessi: Or that's one way it could be structured. Yeah. Yeah, yeah,

James: exactly. So I got some questions as a passive investor. You can ask a sponsor. Yeah. I got five of them. First one just simply like, so where am I in this capital stack? Right.

Jessi: Yeah.

James: And especially like, 'cause when we do flips, they're a lot lower on that capital stack because they are getting a fixed return back. Okay. Right. So they're not sharing in the upside, they're

Jessi: acting more like a bank.

James: Yes. Correct. And it's just good to know that Sure. They don't get any of the upside, but they get a guaranteed percentage return.

Sure. So, you know,

Jessi: which some investors that might be their priority. Oh yeah. Hundred percent. Yeah.

James: They might ask what's the preferred return and is it cumulative? The cumulative is really important.

Jessi: Like, okay, gimme an example of it is or it isn't.

James: So so that preferred return, right? Mm-hmm. It's that, like that 9% or 8% IRR maybe in year one, you don't actually make enough money to be able to pay out a full 8%.

Jessi: Oh, maybe you get like a 5%, a fraction of it, and then. Over time, you make up the difference, but they're only gonna get 8% total over time. Is that how that works?

James: Well, so IRR takes into account time, right? Mm-hmm. And so if you, it's it's, it's worse. Or how do I, I'm trying to figure out a succinct way to say this.

It's not just like, Hey, whatever, you know, if you put in a hundred dollars mm-hmm. You gotta make your $8 back. That's, you know, and you just say every year, like, I owe you $8, $8, $8, $8, because your base is that a hundred. Yeah, well the IRR is a little bit different because in order for you to, in year one, yes, I just have to give you $8, but in year 10, it's like $12 to hit an 8% IRR because there's a time value of money component to it.

So, so it's not based

Jessi: on what you put in, it's based on what the property makes. Well. Why would that number be different? What do you

James: Well, it's all about, so the IRR isn't just a straight return on investment, right? It's the longer you wait, the lower the IRR goes.

Jessi: Oh.

James: So if you're gonna keep the IRR the same.

You have to give them more money. Mm-hmm. It's not just a straight Okay. Percentage. And so the cumulative piece is saying, well over the entire hold period, it's gotta be 8%. So if I don't hit it at the beginning mm-hmm. Then that means I have to make up for even more of it. Yeah. You have to catch up because it's cumulative or you just go, ah, it's just 8%.

Which they wouldn't actually say IRR at that point, they would just say 8% return on investment. Yeah. And say 8% every year. And it's not cumulative. If they say it's an 8% IRR, it's. Cumulative is implied like mathematically. It has to be. That's how that works. Okay. And, and it gets really bad if, say, potentially you could set it up where if I don't pay the full amount, let's say that let's go of the $8, maybe I can only do $4.

Mm-hmm. In theory that $4 now gets put into the, into the a hundred dollars bucket. And so now it's like the next year is now $104. Oh, I think it's

Jessi: reinvested. Well,

James: kind of. Kind of. It's just saying, I owe you, I owe it to you.

Jessi: Mm-hmm. And

James: I owe you interest on what I owe you.

Jessi: Mm-hmm.

James: That's how it could potentially, like if they don't hit their numbers, whoa.

Skyrocket really quick. Yeah.

Jessi: Huh. Yeah. So let's just say I'm an investor. Yeah. I'm not great at math.

James: Okay. Fair enough. And

Jessi: that's really complicated. Yeah. Do sponsors like. If I'm like, is it, is it standard practice for me to say I wanna invest this much? How much will I get back? Just, just tell me the numbers.

Don't tell me the math. Mm-hmm. Don't tell me the payout structure. Don't tell me the capital stack. Yeah. Just if I invest it here and you pay me here, how much am I gonna get?

James: Yeah. I actually, in my spreadsheets, I built a little thing out so I can do that exact math. Okay. And usually I'll give an example.

Hey, if you invest $50,000, you'll get X. Yeah. If you invest a hundred thousand dollars, you'll get this. And I'll even show it. Every single year, here's the estimate that you'll get back.

Jessi: Okay.

James: I feel like plus the total,

Jessi: for most people, that's how their brain works, is just what am I putting in? What am I getting out?

James: Yes. But you do wanna know what the structure is that's driving those numbers.

Jessi: Some people might wanna know, might wanna know. That's fair. You, yes. You probably should know how that's working. Okay.

James: Another question you want to ask is, is there that catch up provision or not? I tend to not put it in personally.

You just are gonna do the, I'll just do a preferred equity return and then, and then we, until we hit that, whatever that is, a hundred percent to them. Right. To whoever's, whoever's a hundred percent to all equity owners. Mm-hmm. Which some, oftentimes the sponsor has money in themselves. Right. And so they're.

Jessi: They're grouped into that as well. Getting money as well as,

James: yeah. And then and then after you hit that, it goes to a split until you hit 15% and then it splits to 50 50. Hmm. For the most part, unless it's designed to be a super long-term hold and like we're primarily going off of cash flow.

Jessi: Okay.

James: Then I will do actually the really simple version go. Nope, we're just splitting it. 70, 30, 80 20, whatever that is. Hmm. Just because otherwise you never hit the preferred return metric. And it's just like, well, great. It means a sponsor. I'm not getting anything. Right. That's which. So you ought, you try to, try to find that balance.

Hmm. Okay. Another question. At what point does the sponsor start earning profits? And that's kind of related to that question. 'cause if, especially if you're doing the more complicated tier structure. They might be like, whoa, don't actually earn anything for like six years until we sell the building.

Mm-hmm. Right. Like and, and you as an investor might be like, awesome, but you might also be like, whoa, like that's weird, like mm-hmm. Will the sponsor then do something to try to accelerate that timeline? Will they make some short-term decisions to get something paid back?

Jessi: Interesting. Yeah. Quicker.

James: Again, it's all about trying to find that balance.

Mm-hmm. Right. And then lastly. You like this number, this question? Can I see an example of waterfall with real numbers? Yeah. And like I said, I built it into my spreadsheet so I can show it. And I often have it on my, when I'm sharing a property of like, Hey, $50,000 invested gets you Yeah. This is what, this is what, that's just, it's super helpful

Jessi: to have concrete examples.

Yep. You know, so people can put themselves into it. Yeah, yeah, exactly. You

James: know? All right, so I wanna recap this. So a capital stack is who gets paid and in what order. Mm-hmm. A waterfall is how the profits will get split for that last group. Okay? Mm-hmm. So that's just the next time you see an investment opportunity.

You want to ask to see that capital stack and waterfall structure before committing.

Jessi: All right. There you go. That's, that was highly detailed, but helpful.

James: Yeah. Yeah. I think it's yeah, I think it's just one of those, it's such a simple word and

Jessi: I kept, I kept in my head. Trying to envision a, a waterfall and the payout, and it's almost like the, like a waterfall isn't a correct flow of water in my brain.

It's almost like it's a fountain. And so it like. Okay. Bubbles up the top and fills up the little cup, and then once that cup's filled up, then it fills up the other little cup. But it's a a, it's like a upside down fountain. Yeah. I guess, I don't know. I just, I overthought it visual, I overthought it and I really had to focus to, yeah.

Yeah. Stop thinking about the water.

James: No, think of it more like one of those where it's got like a bunch of different cups. The waters just slowly start going here, and then it fills into, and then it goes into, into another one. It fills into this one. Yeah. Yeah. You know? And is it a small spigot or a big spigot?

Mm-hmm. That kind of determines the speed at which things move. Yes.

Jessi: Okay. That's a, that's.

James: Yeah. Yeah, yeah. So there you go. Those are waterfalls. Mm-hmm. And in some ways you probably should chase them. That's like the one line I know from the song, so I'm just gonna repeat that over and, and over. Do go chasing

Jessi: waterfalls?

James: Yeah, yeah, yeah. Do chase after them. Find good ones that are well balanced. Right. That's the key. Well balanced. Don't try to find one where if a sponsor is really skewing it to be in your favor. Like you might have to ask, like, that usually means the deal's not great and they're tweaking some dials to make it seem great.

And then on the other end, you know, if it's like, wow, it really seems like this isn't, like I'm still making good returns, but the waterfall's not in my favor at all. Mm-hmm. And go, okay, that's another weird, like, you gotta check off with that. So hopefully down in the middle. All right. There you go. Alright, that was a short and sweet think, I don't know, I didn't actually time this talking about waterfalls.

So if you enjoyed that, thank you. Would love to hear about that. Leave a comment wherever it is that you listen to podcasts. And if you would like to learn more about us and how we treat waterfalls and our investing thesis, you can check us out online at furlo.com thanks for listening and have a great day.