Imagine you're at a high-end restaurant with a group of friends. You all agree to split the bill based on who ordered what. First, you settle the cost of the essentials—the main courses, drinks, and appetizers everyone enjoyed. Then, if there's anything left over, you divvy up the remaining balance according to a prearranged agreement.
This is similar to how waterfall structures work in passive real estate investing. The preferred return ensures investors (the limited partners, or LPs) get their fair share first—just like covering the cost of the meal essentials. Only after that do sponsors (the general partners, or GPs) get their portion of the profits through the promote (carried interest)—similar to splitting any extra costs or adding a tip for great service.
Waterfalls dictate how investment profits "flow" from top to bottom, ensuring a fair distribution between investors and sponsors. Let’s examine how preferred returns and promote structures work, compare them and explain why they matter in investment decisions.
What Is a Waterfall Structure in Real Estate Investing?
A waterfall structure is a tiered system for distributing profits between LPs and GPs. Like an actual waterfall, cash flows through different "levels," with each tier determining how much is allocated before moving to the next stage.
A well-structured waterfall ensures:
- Investors get paid first before the sponsor earns additional profits.
- GPs have an incentive to drive strong returns beyond the preferred return hurdles.
- The risk-reward balance is fair, protecting investors while motivating sponsors.
Ultimately, the waterfall structure helps establish transparency in how profits are distributed. By understanding how cash flows through each tier, passive investors can better assess whether a deal aligns with their risk tolerance and return expectations.
Preferred Returns: The First Step in The Waterfall
A preferred return is a predefined percentage of profits that LPs receive before GPs earn a share of the remaining profits. It acts as a priority payout, ensuring passive investors get a set return on their investment before the sponsor receives additional compensation.
The preferred return (or "pref") is like the “house cut” in a poker game—investors get their share before any winnings are divided. It guarantees that LPs receive a set percentage of returns before the sponsor earns a performance-based share.
Breakdown of How Preferred Returns Work:
- First in Line: similar to a paycheck that covers essential living expenses before discretionary spending, the preferred return guarantees that LPs receive payment before sponsors do.
- Typical Range: prefs usually fall between 6%–10% annually, depending on the investment type.
- Cumulative vs. Non-Cumulative: some preferred returns roll over if unpaid (cumulative), while others do not (non-cumulative).
- Simple vs. Compounded Interest: returns can be based on either a fixed amount or compounded growth over time.
Example of Preferred Returns
Imagine you invest $100,000 in a real estate syndication with an 8% preferred return. This means you are entitled to receive $8,000 annually before the sponsor takes any share of the profits. If the investment generates a return of 10%, you get your full 8% preferred return first, leaving 2% in excess profits to be divided according to the deal’s waterfall structure.
If, however, the investment only produces a 6% return, you would receive that full 6%, but the missing 2% might accrue for future payments (if the pref is cumulative). In this scenario, the sponsor would not receive any promote because the preferred return threshold hasn’t been fully met.
Promote (Carried Interest): The Sponsor's Incentive
Promote, commonly known as carried interest, refers to a portion of the profits that General Partners (GPs) earn as compensation for effectively managing and increasing the value of the investment. It is performance-based, meaning sponsors receive this share only after achieving the preferred return and generating additional profits.
Think of it like a chef’s bonus at a restaurant. A chef receives a base salary (similar to a preferred return), but their true incentive comes from performance bonuses linked to the restaurant’s success. The better the food and service, the more customers return, leading to increased revenue—and, ultimately, a larger bonus for the chef.
Similarly, GPs only earn their promote after exceeding the pref, ensuring they’re motivated to maximize investment returns instead of just managing the asset passively.
Breakdown of How Carried Interest Works:
- Earned After the Pref: the sponsor gets nothing until the LPs receive their preferred return.
- Typical Split: the remaining profits are often split 70% to LPs / 30% to GPs, but it can vary.
- Performance-Based: the higher the returns, the more the GP earns.
Example of Promote (Carried Interest)
Let’s say a real estate investment generates a total annual return of 16%, and the preferred return is 8%.
First, LPs receive their full 8% preferred return. The remaining 8% in profits is then split based on a 70/30 promote structure, meaning 70% goes to LPs and 30% goes to the GP as their performance-based share.
For a $100,000 investment, you would receive $8,000 from the preferred return, plus $5,600 (70% of the remaining profits), while the GP earns $2,400 (30%) as a promote.
If the total returns were only 7%, you would still receive that full amount, but the GP would earn no promote since the pref wasn’t met. This ensures that sponsors only benefit when investors do.
Comparing Preferred Returns to Promote: What It Means For Investors
Let’s break it down side by side:
Key Takeaways For Investors:
- Preferred returns offer stability, ensuring you get paid first.
- Promote rewards performance, keeping the sponsor motivated.
- A well-balanced structure aligns LP and GP interests.
Why This Matters For Investors
For passive investors, the waterfall structure directly impacts how and when you receive returns. A well-structured pref ensures you get paid first, providing a reliable income stream before profits are split further. This makes preferred returns particularly appealing for those seeking steady cash flow with lower risk exposure.
At the same time, a fair promote structure keeps sponsors motivated to maximize property value and overall returns. Since they only earn their share after surpassing the pref, their success is directly tied to the deal’s performance—aligning their interests with yours.
Before investing, take a close look at the waterfall terms. A balanced pref and promote signals a well-structured deal where both investors and sponsors benefit. Understanding these mechanics will help you make smarter, more strategic investment decisions.
Building a Strong Foundation For Passive Investing
Waterfall structures might initially seem complex, but they are simply a framework for fair profit distribution in real estate investments. A strong preferred return protects investors, while a well-structured promote incentivizes sponsors to maximize performance—creating a win-win scenario for both parties.
As a new investor, educating yourself on key investment structures will help you make more informed decisions and avoid common pitfalls. The more you understand waterfalls, risk mitigation, and deal structures, the more confidently you evaluate opportunities.
To continue expanding your knowledge, visit the RockStep Capital Learning Center, where you'll find articles and resources on commercial real estate investing. You can also check out the Shopping Center Investment Academy YouTube channel for in-depth video breakdowns of investment strategies, market insights, and expert interviews. You’ll be well on your way to building a successful real estate portfolio by consistently learning and refining your approach.
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