When modeling the equity structure in a real estate deal, flexibility is important, as there are countless nuances to consider. Here, I will expand upon two common but different ways to structure the profit splits between general partners (GPs) and limited partners (LPs): IRR Hurdle Waterfall and CoC Hurdle + Promote.

First, let’s define some key terms:

Limited Partner (LP): passive investor with limited control rights

General Partner (GP): active partnership with control rights who organize and offer the investment.

Promote: Share of profits allocated to the GP, usually after a preferred return is paid to LPs

Preferred Return: the return that LPs are entitled to before GPs can earn their promote

Cash on Cash Return: Return metric that measure return on capital (Cash Flow / Capital Invested)

IRR: Internal rate of return, a sophisticated return metric that provides the time value of money-adjusted return of an entire project (capital outlay, cash flow, and liquidity events) – must include return of capital.

Waterfall: type of profit-sharing model that includes tiers or hurdles in order to incentivize GP performance.

Hurdle: the return threshold that LP cash flows must achieve to advance to the next tier in an equity waterfall structure.

You can see that both structures feature a preferred return, but it is important to understand that they can have completely different implications on LP returns due to the hurdle type. Let’s start with the more simple structure: cash on cash hurdle + Promote. In this example, LPs are entitled to an 8% cash-on-cash (CoC) return before any profit splits take place. In other words, GPs do not get compensated (by earning their promote) until LPs earn 8% on their capital. After this hurdle is met, GPs are entitled to their promote, which is 30% in this example.

In the IRR Hurdle Waterfall structure, LPs are entitled to a certain IRR before GPs can earn their promote. In this example, the IRR hurdle implies that LPs are entitled to a 7% IRR. Note: the IRR hurdle entitles LPs to not only a time value of money-adjusted 7% return ON their capital but a full return OF capital before any profit splits take place. Further, in this example, there is a waterfall aspect present. Here are the implications of the waterfall terms pictured in the above screenshot in simple terms:

Tier 1: LPs are entitled to a 7% IRR preferred return.

Tier 2: Thereafter, profits are split 80% to the LP and 20% to the GP until LPs earn a 15% IRR.

Tier 3: Thereafter, profits are split 60% to the LP and 40% to the GP.

I hope this helped demystify the profit-sharing models most common in commercial real estate syndication.

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