Are your waterfall terms built to attract the right investors?

Before raising capital, real estate operators must define the waterfall and fee structure. This early planning determines how profits are shared, how risk is allocated, and how investors evaluate the opportunity. Get it right, and you build a solid foundation for the deal. Get it wrong, and you invite confusion and misalignment, making it harder to attract the investors you need to get the project off the ground.

Understanding the Waterfall Structure: How Profits Will Flow

The waterfall outlines how project profits are divided between the general partner (GP) and the limited partners (LPs). While an ordered sequence of distributions is simple in concept, the structure can get complicated fast.

Key elements include:

• Ownership classes: Different types of investors may get paid in different ways, such as preferred equity, common equity, or other special groups.
• Profit tiers: As a project becomes more profitable, the GP’s share typically increases. For example, once returns exceed a certain benchmark, the GP may be entitled to 40% of incremental profits.
• Tiered thresholds: A deal might use one profit split up to $1 million, another from $1 million to $2 million, and a different split above that. Each deal is set up based on its risks, goals, and what investors expect.

Since the waterfall governs how every dollar is shared, operators must establish it before capital is raised and record it in the Private Placement Memorandum (PPM) and operating agreement.

What is a PPM?

A PPM is a legal document used in private securities offerings to explain the investment, its risks, and the terms investors need to understand before committing capital.

Early Planning: Where Many Operators Struggle

Experienced operators often enter new deals with a well-defined, consistent structure. Newer sponsors, however, are usually more flexible as they try to attract investors, which can create additional challenges. Many sponsors work with an attorney to define waterfall terms, but few test these terms with real numbers to see how they hold up under different conditions.

Without scenario modeling, operators may not see how cash flow timing, return tiers, or fee structures will affect GP economics, investor outcomes, and tax results. Running best‑case, average‑case, and worst‑case scenarios during the drafting stage gives sponsors a clearer view of how the deal will play out before the operating agreement is finalized.

For guidance on after-tax cash flow modeling in real estate deals, read our related article.

The Preferred Return: A Core Investor Expectation

Preferred returns give LPs a baseline payout before the GP shares in the profits. A few considerations influence how these terms are set:

• Competitive positioning: Investors compare offerings across the market and within their region.
• Timing of payments: Monthly, quarterly, or annual distributions (some of which may accrue if unpaid) impact project cash flows as well as investor returns.
• Asset type: Value‑add projects with existing tenants generate different cash flow patterns than ground‑up developments.
• Investment timeline: Many real estate investments run on an expected timeline of 1-3 years to develop or improve, followed by 2-3 years to stabilize before exit.

Some operators elect to structure preferred returns as accrued and paid at exit, while others choose periodic payouts to appeal to income‑focused investors.

Fee Structures: Another Driver of GP Economics

Fee structures vary, but most include:

• Management fees: Often around 2% of committed capital during due diligence, transitioning to 1% ongoing.
• Acquisition fees: A percentage of the purchase price, typically paid at closing.
• Disposition fees: A percentage of the sale price at exit.

These fees compensate the GP for sourcing deals, overseeing operations, and managing the investment vehicle.

Evaluating the Right Structure for the Market

Sponsors should ground their decisions in a few core considerations:

• Market competition: How do your terms compare with other operators raising capital today?
• Asset class: Industrial, multifamily, retail, and mixed‑use each come with different investor expectations.
• Geographic location: Terms vary meaningfully across regions of the U.S.
• Sponsor experience: Newer operators may need more investor‑friendly terms to build early momentum, while seasoned sponsors can command stronger economics.

We Can Help

Waterfall design and fee planning are strategic decisions that influence the entire investment lifecycle. Modeling scenarios early shows how each term affects GP and LP results while there’s still time to adjust.

The Elliott Davis Real Estate team helps align structures with market expectations, so sponsors enter capital raising with a stronger grasp of how the deal will perform.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.