Phase 2 - Real Estate 101 (How to or one big idea)

Podcast - Waterfall Structures and Pro Formas Explained

Tyler Stewart
December 14, 2022
Podcast - Waterfall Structures and Pro Formas Explained


Apple Podcasts


Featured On This Episode

Charles Tu

Daniel Mulvhill Endowed Chair, Chair, Real Estate Department

University of San Diego's Knauss School of Business


Learn More About Burnham-Moores Center for Real Estate

Learn More About Charles Tu

About ULI

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Final - Waterfall Structures and Pro Formas Explained

[00:00:00] Adam Hooper: Hello and welcome. I'm Real Crowd CEO Adam Hooper, and this is The Real Estate Investing for Your Future Podcast. Here we explore the latest in commercial real estate trends, insights, and investment strategies that passive investors can use to build real estate portfolios that last 

[00:00:20] RealCrowd: all opinions expressed by Adam Tyler and podcast guests are solely their own opinion.

And do not reflect the opinion of real crowd. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. To gain a better understanding of the risks associated with commercial real estate investing, please consult your advisors. 

[00:00:41] Adam Hooper: Welcome to a special bonus episode of this series we recorded with our friends from the Urban Land Institute at the fall meeting in Dallas.

In today's conversation, we're joined by Charles two, the Daniel Millville endowed Chair of the Real Estate Department at the University of San Diego's Canal School of Business. Charles joined us to help break down real estate waterfalls, proformas, and the common mistakes that investors make when reviewing them to learn more about Charles and the University of San Diego's Canal School of Business.

Be sure to check those show notes. With that, let's get to the conversation. Well, Charles, thank you so much. Taking some time here at the fall meeting. Um, tell us about the work that you do at the University of San Diego and some of the classes that you teach. 

[00:01:26] Charles Tu: I'm a professor and also the chair of the real estate department in the school of Business.

Uh, I teach primarily finance related classes. I'm also the director of our MS in real estate program. Mm-hmm. . 

[00:01:39] Adam Hooper: And how have you seen, I'm just curious from the educators perspective, where we've gone through some pretty crazy times mm-hmm. last couple years and, and heading into some uncertain times. , how has that changed any of your approach towards how you teach at the, at the university or, or what, what changes has that caused in the program or has it?

[00:01:57] Charles Tu: I think, um, higher education, one thing we try to focus on, Particularly at the undergraduate level is to help students build a foundation, a really solid foundation. So hopefully with the knowledge and skills they can apply in all kinds of different market conditions. Mm-hmm. . So the approach, or I, our focus is not to show them how to chase deals.

Right. But hopefully help them understand why the market is doing poorly or why people are making a lot of money. Mm-hmm. in the real estate market. At the graduate level, we try to combine more practical aspects. Mm-hmm. , uh, about half of our classes are taught by adjuncts who are. Who are very experienced from the business professionals.

Yeah. Um, many of them own their own real estate businesses. Mm-hmm. , and they come to share their knowledge and experience with students and we want students to see how. How, what they, uh, we want students to see what they learn in the classroom can quickly, easily be applied. Mm-hmm. , but they need to understand how to do it.

Is we, we can tell, teach them, uh, every single scenario in the market. Mm-hmm. in 2009, I teach financing investment. And capital markets now 2022. I still teach those two classes, , but I think how students utilize the, the information in their business, uh, when they pursue their career. Yeah, that's very different under the market conditions.

[00:03:37] Adam Hooper: Yeah, so the fundamentals. Uh, the approach and the fundamentals haven't really changed. It's, it's how building those foundations allow you to apply it to whatever the market conditions 


[00:03:46] Charles Tu: Yeah. Yeah. And also I think a key is to connect students with the real world. Mm-hmm. , because the classroom hours is limited mm-hmm.

but outside the classroom, the networking, additional learning, that's almost unlimited. Mm-hmm. . Taking students to an event like Urban Lending Institute. This forum meeting is one example. Students, uh, Students, they came to the conference and attend different sessions. Mm-hmm. talked to professionals and that is a great way to learn.

Yeah. And then, uh, that's part of the value of education. 

[00:04:25] Adam Hooper: Yeah, totally agree. And so you've been busy here. Uh, I think you did a full day session yesterday. You've done two more sessions. Uh, the one you were just at was talking about the, the basics of, uh, of the proforma or the waterfall structure. That was packed.

Right? There was, there was a lot of people listening about the waterfall structure and as we were talking on the way over, you look at a hundred different deals, you're gonna see a hundred different waterfalls. Right? Yeah. So tell us a little bit, maybe high level, when you're looking at a waterfall structure, what are some of the key things that you're, you're analyzing, um, and what are the, those foundations and fundamentals of a waterfall structure?

[00:04:58] Charles Tu: One thing interesting for me is to see, uh, I don't do any deals as an academic. Mm-hmm. , I have access to a lot of different, uh, deal structures. Mm-hmm. and our board members sometimes shares, uh, with share information about, uh, their deals. Mm-hmm. , so I look at them and then for me it's always try to, uh, take formation from each deal to see how I can incorporate that into my teaching.

Mm-hmm. and also try to understand the rationale. Each deal structure, right? Because you have maybe majority of the deals, 85% of the deal structure is almost identical. Mm-hmm. . But why would this. Company set up this particular, uh, provision or that company have this particular requirement. That is the interesting part.

Yeah. And understanding the rationale behind that, and also understanding the purpose of setting up waterfall structure, because I always bring my students waterfall structure. Does not generate any cash flows, it's just to split the cash flow among partners. Right. Right. And why would you structure this way to increase, why would company a focus on this aspect and company A, uh, company B, try to focus on something different?

Mm-hmm. , that is the fascinating part. Yeah. I don't have an answer because sometimes, uh, even. The information provided by companies, they don't necessarily share their trade secrets Yeah. With me. But just by looking at the numbers, that's uh, that's always 

[00:06:41] Adam Hooper: fun for me. Yeah. It's like most things in real estate, it depends.

Right? , it depends. Exactly. So do you see, in terms of what drives those factors and what those variables are, is that more opportunity and project driven, or is it more capital requirement driven? Or, or which, which I guess which would. I mean, obviously it goes both ways, right? Yeah. But which would you, which do you think is more of a fundamental approach?

Is it structuring, structuring the capital for the deal in the most appropriate fashion and then finding the capital that agrees with that? Or is it structuring a deal for a specific capital partner and then pushing that into a, a deal? Which, which, which drives those decisions, I guess. . 

[00:07:22] Charles Tu: Even this question, it seems that it depends.

Depends maybe the right answer. Because waterfall structure can be applied in many types of deals, right? Yeah. Real estate indication may use waterfall. Mm-hmm. and you see joint ventures, one operator and a, an institution investor and may create a waterfall structure and real estate funds. Mm-hmm. , they utilize waterfall structure and I think.

type of platform may have a different priority. Mm-hmm. and I, I've seen syndicators because they have found a deal now they need the capital quickly. Mm-hmm. , otherwise they might lose the deal. Right. So, um, it's more. The ability to raise capital, that's critical. Mm-hmm. . But then raising a fund that is a little bit different, a lot of time they, this is a long process, a 12, 18 month process so that, uh, getting all the money right away.

Not necessarily the priority. Right. So it seems that there are a lot of different factors that mm-hmm. in the waterfall structure people will consider. And then 

[00:08:30] Adam Hooper: even within a fund, your early investors might have a side letter, so they're gonna get a little different preferential terms in some of your later investors.

So yeah, it's, it can be very complex and very complicated. Yeah. And I think all that comes down to, again, your second panel, which is around building a proforma and building a model. Um, they can be as complex as the day is long. Right? Yeah. So I guess when you're, when you're. Going about building a new model or when you're reviewing a model, what are some of the steps or some of the key areas that people should be looking for when they're reviewing or building a model?

I know that's a bit, that's everything. I think 

[00:09:05] Charles Tu: thing, just look at everything. The first thing is to make sure there's no errors. And I think, um, the panel, I talk about common mistakes students made, right? Um, , a lot of time those mistakes don't change the result. Mm-hmm. don't change the financial outcome of your perform.

Mm-hmm. , just the model is not as flexible. It's not as user friendly. Mm-hmm. , that's what I usually talk about in that short session, talking about mistakes students make. Mm-hmm. , but. . It's also possible I have seen models that just have major errors. Mm-hmm. , that's, that's the first thing you, you have to avoid that.

That's a pretty 

[00:09:48] Adam Hooper: low bar , but it happens, right? Yeah. I mean, it 

[00:09:51] Charles Tu: definitely happens. And then the next thing, um, assuming all the numbers are right mm-hmm. . And I always remind my students just, uh, two things. One, whether the numbers make sense. Mm-hmm. , um, unfortunately young professionals or students just started learning real estate don't necessarily have the ability to tell whether or not they don't have the context necessarily.

Yeah. But after a while, if you see going in Capra, that's 20% or, um, a deal that has the multiple that is extremely high. Mm-hmm. something either that's too good. Really, really a good, uh, a deal that um, once in a lifetime mm-hmm. opportunity. Or maybe there's some error, or maybe the assumption may be a typo.

So, Make sure the numbers make sense. And then when you think about some of the deal structures modeling, um, it is really key to make sure your financial model is consistent with, uh, the read, uh, the written legal documents. Mm-hmm. . And that is, uh, always a potential issue. Yeah. And we have seen a. Deals, uh, at least for example, for Waterfall structured, um, the partnership agreement, uh, drafted by attorneys, but then you have the financial models put together by, and they don't talk to each other.

It seems that they don't understand each other's. Uh uh, um, Terminology or the concepts may be inconsistent. Yeah. And you put together a document promoting a deal, showing the financial results turn out to be inconsistent with your, uh, legal document. Mm-hmm. . And that becomes a major issue. And that is something I always re try to remind my students.

When you start your own business, you make sure. Get the right help mm-hmm. , and then work with them to make sure everyone understands their responsibilities and everything is 

[00:12:01] Adam Hooper: consistent. Yeah. The consistency amongst the documents is definitely something that, that we've certainly seen and, and as you said, different parties, maybe they're.

The speaking diff, you know, different terms, or they think the same terms mean a different thing, right? So making sure that that all ties out between operating agreement, ppm, initial marketing materials, and as you mentioned on your panel when everything's going great and everyone's making gobs and gobs of money.

Usually those things work out okay. But it's, when we get into those markets where it becomes a little bit more challenging is when those, those very specifics mm-hmm. , those are important and those matter. Right. Yeah. So maybe, um, when you're looking at those common errors or mistakes that you might find in the models or in the the structures, um, what are some of those common errors that are maybe less impactful and what are some of the bigger ones to look out for that maybe do have a bigger impact on the, on the performance?

[00:12:48] Charles Tu: I think simple things like, um, when I talk to. other people Actually, uh, one example was a few years ago, one of the students learned, um, waterfall in my class. Mm-hmm. . And then when he talked to his supervisor at his internship, um, and explained, oh yeah, professor two, describe the waterfall. We have this case study this way because the structure was different from the.

Usually structure their deals. Mm-hmm. and then he supervises it. Oh, that is too theoretical. Um, it's just because that company doesn't. Structure deal specific that way, that doesn't mean it's not common. Mm-hmm. in business. Mm-hmm. . So I'd look at that and feel that, yeah. A lot of times, small things, whether a preferred return on pay, preferred return will be compounded.

Yeah. Or any preferred. The unpaid for return will be carried forward, or if you have surplus, would that be used to immediately return? Right. Cash open 

[00:13:55] Adam Hooper: operations versus capital events? 

[00:13:57] Charles Tu: Yeah. Yeah. And when you have a capital event, um, how that will be the, the cash will help. Would that be distributed?

Mm-hmm. , those are the things that, uh, can easily be identified in the legal document. But if it's not structured correctly, could have a major implication. Uh, especially I think capital event that is something. Mm-hmm. , uh, definitely important when you look at a lot of the deal structures that either the refinancing or recapitalization and the implications need to be considered.

Mm-hmm. and 

[00:14:30] Adam Hooper: then given. Access and position to be able to see so many different models and different structures. Um, again, kind of, it gets back to, it depends, right? But are there generally some. parameters that you see are, are more standard than others. I mean, I think again, on our marketplace, we've seen a little bit of everything, right?

Mm-hmm. , yeah. Generally simpler the better in most investors' eyes. Mm-hmm. , right? A simple, a simple promote over a preferred return is kind of like, that's the easiest it's gonna get if, you know, once you're past the, the perue level, and then we've seen waterfalls that are 3, 4, 5 tiers deep, right? Yeah. So, I guess in your, in your exposure and practice, Do you see common parameters?

Do you see kind of standard structures coming through there? Or like what do you tell your students when they're thinking about how do I, how do I come up with a structure out of the air? Yeah. What's your guidance 

[00:15:19] Charles Tu: there? I, I definitely agree with you because when. when you deal with unsophisticated investors mm-hmm.

who are relatively new to real estate, you want to keep the structure simple. Mm-hmm. , because otherwise they, they may be wondering, are you trying to hide something mm-hmm. . Right? You're trying to take advantage of them. So making a simple and, uh, easy to explain. Mm-hmm. , because I think investors, they would love to underst.

The waterfall model. Mm-hmm. , even though it's not easy, but with a simple model without too many different tiers of irr look back. Mm-hmm. , that will make it easier. And I think that is usually my recommendation to students. Hey, think about a simple structure that give yourself a reasonable compensation.

Mm-hmm. , give yourself reasonable incentive. To put together a good deal. Mm-hmm. , but also allows you to attract capital and people are happy. And then initially your contribution may need to be higher than 10, 15% because when you don't have. Track record. Uh, your investors want to see you have some ski in the game, right?

Yeah. But once you are, you build your portfolio, you have a track record, you have your customer base, then you can change your per parameters. Don't try to make too fancy outta the gate, right? Yeah. Yeah. Because this is a, it's a marathon, right? Mm-hmm. building your career and starting from a. Single deal syndicator and hopefully graduate to a fund manager.

Mm-hmm. . Those are the, the type of things you have to think the long run. And that's usually my recommendation to students. 

[00:17:00] Adam Hooper: Yeah. And what are some of the factors that might cause someone to create a more complex 

[00:17:04] Charles Tu: structure? I'm thinking maybe if you have that, just thinking sometimes. If the outcome is so uncertain mm-hmm.

right? Um, just breaking that 8% preferred return barrier. Um, but would that be if the, the 8% will be the minimum, but you have that possibility to get to 25, 30%, but. Right after 8% preferred return, you give yourself a huge promote. Mm-hmm. that may look that great from the investors. Mm-hmm. your partner's perspective, but you also want to set up this compensation structure in a way that if you do, if your project does perform extremely well, you give yourself the reasonable compensation.

So maybe that, that multiple tiers make sense because. When you go from eight to 12 to 15 to 18 to 25 , that give you a good reason to convince, to try to outperform and yeah. Your partners that you deserve that mm-hmm. additional promote. And it seems that potentially could also show that you have that, um, confidence mm-hmm.

in your deal that they see, oh yeah. You actually set up, uh, a hurdle that's 25%. That seems, that seems to be. The great potential, and I think sometimes it's just psychological. Mm-hmm. . 

[00:18:44] Adam Hooper: And now maybe wrap this up with this of, we're, we're recording here in fall of 2022. Yeah. You just mentioned out uncertain outcomes.

I think we're heading into maybe some uncertain times. Um, do you, do you have any. We can crystal ball a little bit here, but, um, any indications or, or kind of guesses as to where structures may change given that we're heading into some, some uncertain times? 

[00:19:05] Charles Tu: Um, that is something I will leave to experts like you, Evan , because I think you, you do ask the questions 

[00:19:13] Adam Hooper: here.

I ask the questions. , , 

[00:19:15] Charles Tu: I, um, Okay. Actually this is something, uh, I've been talking to some of my, uh, associates, um, when, when I talk to professionals, um, Because I'm in real estate education. Mm-hmm. , I always look at this, uh, doesn't matter what the market conditions are. Yeah. There's always the opportunity to learn and then try to improve.

So I don't have an answer to that question directly, but I'm looking at this, uh, the market is that, um, definitely the interesting thing I feel is that Waterfall s. That is the right way to provide the incentive and compensation to real estate professionals, developers, and operators, because you don. Get a flat fee or flat compensation, your compensation depends on the performance.

Mm-hmm. . So now in this market, I think it becomes even more important to show your potential partners that you are willing to take chances. Mm-hmm. . On yourself, you're betting on yourself instead of asking them to pay you a very high fee. Right? Because when the market goes down, you want to show that you are willing to share the risk with them.

Mm-hmm. or even more. That is a way to encourage and, um, I think convince your po potential investors to join your deal. I think the waterfall structure allows that alignment, right. Of. Pretty 

[00:20:52] Adam Hooper: well. Perfect. Well, Charles, that's a great place to end it. Appreciate you, uh, spending your time here at the fall meeting with us.

So why don't you let the listeners know how they can learn more about what you're up to, uh, with the University of San 

[00:21:01] Charles Tu: Diego? Great. So at University of San Diego in our Canal School of Business, our real estate program, uh, you can find our information at s d Real Estate dot. Perfect. So it's one word, usd real, and information about our academic programs, our center, our event.

Our services to students can all be found on their website. 

[00:21:26] Adam Hooper: Thank you, Charles. Remember, you can learn more about Charles and the University of San Diego's Canal School of Business by checking in the show notes. Thank you again to Urban Land Institute for helping us share highlights from the fall meeting with all of our listeners.

To learn more about the Urban Land Institute, head to With that, we'll catch you on the next one.

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