Published on: Aug 18, 2026 by Rhett Reuter, CPA, MT
Updated on: August 18, 2026
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Private real estate investments often involve multiple partners who contribute different amounts of capital, expertise, and work to a project. A waterfall structure establishes how the cash generated by that project will be distributed among those partners.
To explain how these arrangements work, we spoke with Rhett Reuter, CPA, MT, a Principal at SVA Certified Public Accountants. Rhett works closely with commercial and multifamily real estate businesses, advising clients on tax compliance, tax planning, deal structuring, and other accounting and tax matters.
In this Q&A, Rhett discusses the building blocks of a waterfall structure, how distributions may be calculated, and what both investors and developers should understand before moving forward with a deal.
A distribution waterfall governs the economic distribution of cash among the partners. It doesn’t necessarily determine how taxable income, gain, loss, or other tax items are allocated among the partners, which may be addressed separately in the partnership agreement.
The available cash comes from several sources, including operating cash flow generated by the property, proceeds from refinancing the property, and proceeds from the eventual sale of the property.
The operating agreement establishes who receives money, in what order, and under what conditions. Every waterfall is structured based on the economics of the deal, the contributions of the partners, and the objectives of the developer and investors.
The waterfall determines how investors receive their original capital and their return on investment.
For example, an investor may enter a deal based on a targeted investment return. To understand how that return may be achieved, the investor needs to look beyond the overall profitability of the property and examine how the available cash will move through the waterfall.
Available cash is generally determined after property-level obligations such as operating expenses, debt service, and required reserves have been addressed. The remaining distributable cash is then allocated among the partners according to the waterfall provisions in the operating agreement.
Because of these provisions, owning 10% of a partnership doesn’t automatically mean receiving 10% of every dollar distributed.
Although structures differ, many waterfalls include some combination of the following components.
This provision generally provides that investors receive their original contributions back before the remaining profits are divided.
If investors contributed $5 million to the project, the first $5 million of qualifying proceeds may be distributed back to those investors before the waterfall moves to the next level.
A preferred return gives certain partners priority when distributions are made. It is often calculated as a percentage of invested capital.
For example, an investor who contributed $1 million and receives a 5% preferred return may accrue a $50,000 preferred return for the year, subject to the specific terms of the operating agreement. Whether that amount is currently distributed or carries forward depends on the agreement and the availability of distributable cash.
That accumulated balance may have a significant effect on later distributions. When the property eventually generates cash, the outstanding preferred return may need to be paid before other partners receive anything.
This allows one party, often the developer or sponsor, to receive a larger portion of distributions after investors have received a specified return.
The catch-up can help bring the sponsor’s share of the total profits to the percentage negotiated in the operating agreement.
A promote is an additional share of profits awarded to the developer or sponsor, generally in recognition of the work and expertise involved in identifying, planning, and managing the project.
The sponsor may contribute a smaller percentage of the total equity while still receiving a disproportionately greater share of profits after specified return thresholds are satisfied.
For example, investors may contribute 90% of the capital while the developer contributes 10%. However, the agreement may allocate 80% of certain profits to the investors and 20% to the developer. The additional share compensates the developer for putting the deal together and creating value before other investors joined.
It varies by deal. Operating agreements may apply different distribution provisions to operating cash flow, refinancing proceeds, and capital-event proceeds such as a sale. Other agreements apply a single integrated waterfall to multiple types of distributions.
Those provisions may be similar, or they may result in very different allocations.
For instance, operating cash flow may be distributed primarily to investors based on their contributed capital. When the property is sold, the developer may receive a larger share of the remaining profit through a promote.
More complex investments may also contain multiple hurdles. As the project reaches higher levels of return, the percentage allocated to the sponsor may increase.
Assume investors contribute $5 million to purchase or develop a property. The property generates no distributable operating cash flow during the first five years and is then sold, producing $8 million in available proceeds.
The operating agreement provides for:
The investors would first receive their original $5 million.
An 8% preferred return on $5 million equals $400,000 per year. Over five years, the accumulated preferred return would total $2 million, assuming a simple, non-compounding calculation.
After paying the $5 million return of capital and the $2 million preferred return, $1 million would remain. That amount would be divided according to the 70/30 split:
This is a simplified example. Actual calculations depend on the wording of the operating agreement, the timing of the investments and distributions, whether returns compound, and other deal-specific provisions.
A simple profit split uses a fixed allocation. If two partners each own 50% of the partnership, they generally receive 50% of the available cash.
A waterfall allows the allocation to change depending on what has already been paid or what performance targets have been reached.
For example, two partners may each contribute capital, but one partner may also provide development experience and manage the project. Rather than dividing every dollar 50/50, the waterfall might provide that capital is returned equally before the managing partner receives 55% of certain back-end profits.
Simple allocations may work for smaller partnerships with only a few owners. As the number of investors grows, waterfalls are often used to account for different contribution amounts, investment dates, preferred positions, and development responsibilities.
Interest rates and construction costs are two major variables.
Higher interest rates increase the amount of cash needed to service the property’s debt, leaving less cash available for distributions.
Rising construction costs can also change the economics of a project. If a building was expected to cost $20 million but ultimately costs $25 million, the partnership may need to obtain additional debt or raise more equity. Both options can affect ownership percentages and projected returns.
A project’s projected internal rate of return, or IRR, may also rely heavily on a future refinance or sale. Those projections are based on assumptions about appreciation, interest rates, property performance, and market conditions. Even when those assumptions are reasonable at the beginning of the deal, conditions can change over a five-, 10-, or 15-year investment period.
Investors should understand where their projected return is expected to come from.
A project may generate regular operating distributions, or the majority of the return may be expected from a future refinance or sale. Neither approach is automatically better, but the timing and source of the return can affect the investment’s risk profile.
Questions to consider include:
One common misunderstanding is that a partner’s ownership percentage always matches their percentage of cash distributions.
An investor might assume that owning 10% of a partnership means receiving 10% of all cash flow. In practice, the operating agreement may allocate cash differently depending on the source of the proceeds, outstanding preferred returns, or performance hurdles.
The ownership percentage may still be relevant, but it’s only one part of the calculation.
Start by reading the operating agreement and investor materials closely. The agreement, rather than a summary presentation or informal discussion, generally controls how cash will be distributed.
Investors and developers should work with advisors who understand real estate partnership structures. Legal counsel can help evaluate the contractual provisions governing the waterfall, while a CPA can model the economic outcomes, analyze the related tax consequences, and explain how different distribution scenarios may affect the partners.
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Rhett is a Principal with SVA Certified Public Accountants and works closely with businesses advising them on tax and accounting issues that may arise throughout the year. He provides guidance and support on a variety of issues including IRS and state audits, various tax credits, like-kind exchanges, and structuring and exiting deals.
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