Waterfall Distribution and how to calculate

An excellent book on this topic is "Foundations of Real Estate Financial Modelling By Roger Staiger". 

The Waterfall is the method of distributing profits among partners within a transaction. In more complex
transactions profits do not follow an even distribution, i.e. profits are not distributed Pari Passu. (Pari Passu
is the proportional distribution of profits in accordance with percentage of capital provided for an
investment. That is, an investor that provides 80% of capital receives 80% of profit if distribution follows
Pari Passu.). A graphic depiction of a general waterfall structure is below. Please note that rates discussed are internal rates of return, i.e. accrual rates on capital, and not simple interest rates. The distribution of profits by investor can be different at each ‘tier’ and is prenegotiated from project onset.

Waterfall Construction Steps:

1. Step 1 – Quantify Equity Contributions:  These are quantified within the project pro forma. The values are quantified and separated by investor on the “Inflow/Outflow” page. The separation will be as follows:
• Sponsor
• Investor(s)
2. Step 2 – Quantify Project Cash Flows: These are the quantified cash flows from the project pro forma. This is not the project ‘income’ which is an accounting number. These values will be quantified by major classification on the “Inflow/Outflow” page.
3. Step 3 – Quantify Project Characteristics:  This quantification for the project characteristics determines if the project is viable prior to investor distributions. The short-list of project metrics which determine viability include, but are not limited to, the following:
• Total Profit (nominal)
• Internal Rate of Return (IRR)
•  Multiple (Profit/Invested Capital)
4. Step 4 – Calculate the 1st Waterfall (“Pref” Rate), i.e. Tier 1. The recommended structure uses the following line items:
• Beginning of Period Balance (BoP)
• Total equity contribution/period
• Accrual (calculate daily rate to use XIRR)
• Paydown (distributed capital at stated rate)
• End of Period Balance (EoP)
• Remaining cash
• IRR Check
5. Step 5 – Separate cash flows by tier by investor: This quantification proportions the cash flows by tier by investor, i.e. separates cash flows according to division. The percentage allocation is specified in the agreement between the Equity/Sponsor and Investors. Note that Tier 2 and above require the delta to be calculated as each Tier is cumulative of the cash flows above it.
6. Step 6 – Analyze Investor Cash Flows: Aggregate the cash flow by investor to analyze individual returns.