This month we’ll discuss one of the ways we align with our investors and put them first via our preferred return and waterfall structure.
What is a Preferred Return and Waterfall?
“It is literally true that you can succeed best and quickest by helping others to succeed.” – Napolean Hill
When we purchase apartments and bring on investors, it is structured to put investors first and incentivizes us to provide strong returns to investors. The more we outperform and exceed our targets, it becomes a win-win scenario for both us (General Partners, or GP) and our investors (Limited Parters, or LP).
We do this by having a favorable and simple investment structure, which is composed of two parts. The preferred return and waterfall.
So what is a preferred return and waterfall?
A preferred return is the percentage of profits that are paid to investors first. For example, let say someone invests $100k with an 8% preferred return. 100% of the profits from the investment go to the investor until the investor earns 8% per year.
A waterfall is a method of splitting profits from an investment among partners. After the preferred return is exceeded, the profits are split according to the waterfall structure.
How do we structure our investments?
We believe in keeping things simple and straightforward. We have seen investments with complicated structures, consisting of multiple preferred returns and waterfalls. Our investments are structured with a 10% preferred return and a 70/30 waterfall. Anything in excess of 10% annual returns is split 70/30, with 70% going to investors (LPs) and 30% going to the management team (GPs).
We also have a cumulative preferred return, which means the remaining preferred returns are carried over into the next year. Our deals are value-add deals and cash flow is low in the first few years. If we have a 3% profit in Year 1, the remaining 7% is carried over to Year 2 in addition to another 10%. So the preferred return for Year 2 is now 17%. In this case, the GPs do not benefit from the waterfall until we exceed 17% in profits in Y2.
This aligns us with our investors and incentivizes us to hit our targets. The first 10% of cumulative profits go to the investors. If we underperform, the GPs do not get to share the profits from the waterfall. The more we overperform, the more the GPs earn from the waterfall’s 70/30 split. It limits your downside risk and gives you a majority share of the upside.
Typically we aim for 15% annual returns to investors, net of fees and the waterfall structure. To date, our investors have earned 25%-50% annually from the properties we sold. The more you earn, the more we earn too. It’s a true win-win scenario for everyone.
