Understanding the fee structure and how all parties get compensated is important in any investment strategy, including real estate syndications. I am always happy to discuss fees and answer every question to my best ability. You need to understand the fees, and we’ll help with that. But if fees are the main reason holding you back from participating in a syndication, investing in real estate as a limited partner may not be the right fit for you.
If you’re thinking, “I could do this myself and keep these fees,” you may very well be right and active management of real estate is for you. As passive investors, we’re paying fees for work performed by others, expecting great performance, but letting go of control. Whether you’re comfortable with that is of course your decision to make.
I get the concern. The fees have to be justified. We all know investment “managers” who are taking hefty asset management fees for putting their clients’ money in auto balancing target funds. The (relatively small) amount of money I have in the stock market is in the very low fee index funds. When I see the fees I pay to my self-directed IRA company, I get a bit of heartburn thinking to myself that they’re just record keepers.
But real estate is not that. I own rentals. I’ve self managed and I use property managers. Neither one is totally hands off. Operating real estate demands a lot of work. Commercial syndications require a dedicated team, and that team needs to be compensated fairly for finding the deal, performing the due diligence, assembling the investor pool, executing the business plan, and dealing with the surprises that inevitably pop up along the way. As limited partners, we contribute our capital and let others do the dirty work. For me, I see that as a great seat to be in because it allows me more time to be with my family and other activities I enjoy more than real estate operations.
Fees need to be adequate for the general partnership team to comfortably maintain their operations from pre-acquisition to disposition of the property. Keep in mind that all of our deals offer preferred returns to the limited partners, 7 or 8% being pretty typical. That means the operators don’t receive any proceeds from the investment itself until that hurdle has been met, which may be a couple of years while the property operations are being optimized. The fees therefore are an important component of their operational viability. But of course those fees need to be reasonable. Let’s discuss the fees and what reasonable means.
You’re always going to see an acquisition fee and an asset management fee. Acquisition fee is paid to the syndicator upon completing the purchase of the property. This is paid at closing. Considering that the syndicator has spent time looking at hundreds of deals, performed high level due diligence on dozens, and complete due diligence on the property they’re purchasing, which requires a lot of hard costs, the acquisition fee recoups those expenses and provides the first incentive to the GP group for having put the deal together. 1-2% of the purchase price is typical.
The asset management fee is compensation for managing the managers and executing the business plan. Again, this is how they keep their lights on during the hold period and before they’re permitted to receive any distributions from the investment cash flows. 1-2% of the collected revenues is typical, and this is generally paid out quarterly.
Occasionally you may also see a loan guarantee fee. This is paid to key principals in the deal or a wealthy third party that has essentially “co-signed” on the bank loan. This one is less frequent, paid only once, and should be relatively small, such as .5%. Since these are non-recourse loans (meaning, the bank can’t go after individuals, only the asset itself), this “guarantee” is only activated in times where general partners have committed fraud or willingly not paid the loan. (Hot tip: if you’re a high wealth individual, this loan “guarantor” position can be quite lucrative with fairly limited risk.)
Some of our operators have an in-house construction team that will function as the general contractor. In those cases you’ll see a construction management fee, but the net result is a much lower construction cost than is the case when an independent general contractor is used.
If you spot other fees in the investment summary or PPM, definitely ask about those and make sure you understand why they’re included, and that you feel comfortable with them.
No syndicator gets into this business for the fees. Much more important and lucrative is the equity split. These should be structured so that operator and investor incentives are aligned. They’re primarily back end loaded (the biggest portion of proceeds being earned upon the sale of the property) and tied to performance…the better the operator executes the business plan, the more money they earn. This will of course benefit the investors as well during and at the conclusion of the investment. The limited partners will be taking the lion’s share of the returns in the early and middle stages of the investments to ensure they receive their preferred return rate.
After the preferred return is achieved, there is generally a sharing of the cash flow distributions, again with the bulk going to the limited partners. 70% to the LPs and 30% to the GPs is our most common structure. From there, you may see another target hurdle, for an example, let’s say 18% IRR, after which the distribution ratio shifts towards the syndicator’s favor, perhaps now 50/50. (This is what’s called a waterfall structure.)
I do see some operators getting a bit over complicated with these hurdles and waterfalls. But one waterfall hurdle may make sense, as it essentially serves as a carrot being dangled in front of the operator to maximize the operational success of the property, while putting the limited partners’ interests in first position. Note: the waterfall does not cap the investors’ earning potential. It can just further motivate the operator to provide phenomenal outcomes.
The preferred returns, equity splits, hurdles, waterfalls, fees etc, are covered in our investment summaries (as a best practice) and explained in complete detail in the Private Placement Memorandum (as required by SEC regulations). Please be sure to review these details in particular. Make sure you understand them, make sure they align GP/LP interests, and make sure you feel comfortable with them. My job is to answer any and all of your questions, so fire away.
And do please keep in mind that when you see preferred returns, projected returns, and returns from previous projects, these are net of fees. Keep your focus on the big picture, and don’t let fees be the reason you miss out on a phenomenal investment opportunity.