A waterfall and promote structure, also known as a waterfall model, is a method for distributing the profits from a real estate investment in an uneven way. Typically, the project's sponsor (the individual or group putting most of the work in to identify, acquire, and manage the property) receives a disproportionate share of the profits, known as a promote, as long as the project hits certain profitability benchmarks.

In most cases, if a waterfall structure is used in a commercial real estate investment, the exact nature of the structure is laid out in the owner's agreement. The entire structure is usually based on something called a 'return hurdle,' a specific amount of profit that the project needs to generate in order to progress to the next hurdle. This is usually defined by a project's internal rate of return (IRR).

For example, if a sponsor invested 5% equity in a project in a $1 million project ($50,000), and an investor invested 95% ($950,000), the first hurdle could be a 9% IRR. For any returns below 9%, the sponsor gets 5% of the profits, and the investor gets 95%. However, for any returns above 9%, the sponsor gets 10% of the profits, and the investor only takes 90%.

Many waterfall structures have multiple hurdles. For instance, in the example above, there could also be return hurdles at 13% and 16% IRR. Each of these would provide the sponsor a greater proportional return, say, 15% and 20%, on the profits over those amounts.

The main benefit of a promote structure in commercial real estate is that it allows the project's sponsor (the individual or group putting most of the work in to identify, acquire, and manage the property) to receive a disproportionate share of the profits, known as a promote, as long as the project hits certain profitability benchmarks. This incentivizes the sponsor to work hard to ensure the success of the project.

In many equity waterfall structures, there is also something called a preferred return. This allows certain, preferred investors a first claim on the profits until they achieve a specific rate of return. This helps to ensure that investors are rewarded for their risk.

Finally, a lookback provision stipulates that, if, by the end of the deal, the preferred investor has not met their preferred return hurdle, the sponsor has to give back any profits they have received until the investor reaches it. This helps to protect investors from taking on too much risk.

A waterfall structure in commercial real estate financing works by setting a return hurdle, usually defined by a project's internal rate of return (IRR). The return hurdle is a specific amount of profit that the project needs to generate in order to progress to the next hurdle. The entire structure is usually based on this return hurdle.

For example, if a sponsor invested 5% equity in a project in a $1 million project ($50,000), and an investor invested 95% ($950,000), the first hurdle could be a 9% IRR. For any returns below 9%, the sponsor gets 5% of the profits, and the investor gets 95%. However, for any returns above 9%, the sponsor gets 10% of the profits, and the investor only takes 90%.

Many waterfall structures have multiple hurdles. For instance, in the example above, there could also be return hurdles at 13% and 16% IRR. Each of these would provide the sponsor a greater proportional return, say, 15% and 20%, on the profits over those amounts.

For more information, please see Waterfall and Promote Structures in Commercial Real Estate.

The main risk associated with a promote structure in commercial real estate is that the sponsor may receive a disproportionate share of the profits, leaving other investors with less than they expected. This is especially true if the project does not hit certain profitability benchmarks. Additionally, if the preferred return for the investor is set too high, the sponsor may not receive any profits at all, even if the project is successful.

In the case of a lookback provision, the sponsor may have to give back any profits they have received if the preferred investor has not met their preferred return hurdle by the end of the deal.

A waterfall structure in commercial real estate has several advantages. First, it allows the project's sponsor to receive a disproportionate share of the profits, known as a promote, as long as the project hits certain profitability benchmarks. This incentivizes the sponsor to work hard to ensure the project is successful. Second, it allows investors to receive a higher return on their investment if the project is more successful than expected. Finally, it allows for multiple return hurdles, which can be used to further incentivize the sponsor and reward investors for higher returns.

A promote structure can help a commercial real estate investor by allowing them to receive a disproportionate share of the profits from the investment, as long as certain profitability benchmarks are met. This is known as a "promote" and is typically given to the project's sponsor (the individual or group putting most of the work in to identify, acquire, and manage the property). In many equity waterfall structures, there is also something called a preferred return, which allows certain, preferred investors a first claim on the profits until they achieve a specific rate of return.

For more information, please see Waterfall and Promote Structures in Commercial Real Estate.