We’ve talked before about how investors get paid when passively investing in a real estate syndication. But what about the people who run the deal – the sponsors? What’s in it for them and how do they earn an income from these opportunities?
Whether you want to be a sponsor yourself or you’re simply interested in understanding what sponsors are actually being paid for when you invest, this is the article for you.
We will look into:
- Sponsor Fees
- Acquisition Fees
- Asset Management Fees
- Disposition (or Capital Event) Fees
- Carried Interest (Sweat Equity)
- Waterfalls and Hurdles
Without a doubt, sponsors are integral to the success (or failure) of any syndication. They are the CEO, negotiate deals, place “at-risk capital” into the venture, manage the day-to-day mechanics of each deal, and much more. And they need to get paid for that effort.
By understanding the incentives for the sponsors you deal with, you’ll be able to determine if you feel your interests are aligned with the team running the deal.
Let’s look at the different types of fees and income arrangements involved.
The great thing about passive investing is that, as an investor, you don’t need to do anything once you’ve invested in the deal. The flip side is that the deal sponsors have to do the work to make the deal a success — and they need to be compensated for that effort. It’s a heavy load and we’ve looked at this before in What is a Syndication?
What we haven’t looked at in detail are the specific fees that the sponsors receive in return for these efforts. It’s important to understand these as they are a key component of the deal.
While a sponsor can charge a fee for anything that you both agree on, there are essentially 3 types of sponsor fees we typically see in a real estate syndication, charged at different stages in the lifecycle of a deal:
This is what the sponsorship group receives when the deal closes. Acquisition fees are usually a percentage of the purchase price and generally range between 1% to 3%.
As an investor, you’ll want to check that your sponsors have a good track record before handing over your hard-earned cash to invest in their deal. And scrutinize this even further to see if they can justify charging their acquisition fee. Remember, this fee gets paid immediately at closing, before the deal has made any sort of return.
I have seen brand-new sponsors, with zero experience, who want to charge large acquisition fees straight out of the gate. If you’ve never made a dime for an investor, can you really justify charging an acquisition fee?
Sponsors spend a lot of time and money developing relationships with Brokers and Property Managers, learning the market, and underwriting deals. For those that are established and have a track record of providing returns to their investors, I think an acquisition fee is justified. But if you’re new on the scene, it’s a hard sell.
FYI – I didn’t take any acquisition fee on the first two large syndication deals that I sponsored.
A low acquisition fee doesn’t guarantee that you’re getting into a good investment deal, but if that group has a good reputation, then a low acquisition fee could mean more money in your pocket at the end of the day.
Asset Management Fees
This compensates the sponsorship team for overseeing the operations of the property and is usually between 1% to 3% of the revenue collected each month. Though a property management company often handles the day-to-day operations (rent collections, maintenance, leasing), someone on the sponsor team should oversee this. On all the deals where I am the asset manager, I have (at minimum) weekly calls with the property management company and we review the finances on a monthly basis, and I share all of that information with the investors — it’s a lot of activity.
Disposition (or Capital Event) Fees
This is charged either on the sale or on the refinance of a property and is generally between 1% to 3% of the sale price. Disposition/capital event fees are not as common as acquisition fees.
As an investor, you might think that it’s much better to pay only a 1% versus a 3% acquisition fee. Sure, on the face of it, that makes sense.
But what if the 1% fee is for a sponsor group with little or no track record of successful deals versus the 3% deal for a sponsor group that’s highly experienced at operating solid deals? I know where my money’s going in that scenario.
The point here is that we can’t judge deals on fees alone: low sponsors’ fees are not a guarantee of greater profitability, but neither are high sponsors’ fees a guarantee of the success of a deal.
Carried Interest (Sweat Equity)
The lion’s share of most sponsors’ compensation is attached to the deal’s performance. The sponsors receive a portion of equity ownership in the property in return for all their hard work. This equity is referred to as their carried interest in the deal — also called sweat equity.
As the deal is in operation, excess cash flow is distributed to all owners of equity in the deal.
Despite all of the above, sponsors really make their profits at the end of a deal. It all depends on how the deal is set up but in the vast majority of cases, the process is:
– Investors are “made whole” by receiving 100% of their original investment back (as discussed when we looked at return on capital vs return of capital).
– All the remaining money after that is split based on each person’s equity in the deal. This typically means 20% to 30% of the profits go to the sponsors.
Waterfalls and Hurdles
Instead of a straight split between investors and sponsors, some deals are set up with more complex structures.
In a Waterfall, certain classes of investors can receive more or all of their capital back before other investors.
Hurdles can allow for the equity structure to change based on certain metrics. This means that if a deal performs better than expected, the sponsors could get a larger percentage of profits if certain results are achieved.
For example, if an IRR goes above, say, a 16% return point, anything above that is split in a different way that is more favorable to the sponsor.
Some people would argue that this is not fair for investors: they’ve taken a risk so why shouldn’t they cash in on that bonus performance? Why should sponsors take more of their lunch?
I can understand that point of view, but this arrangement is no different from a sales rep smashing their monthly targets and getting a much higher payout on those bonus sales that no one else was able to make. So long as the agreement was clear upfront, I don’t think this should be a problem.
And that’s the key point: all of this should be clearly disclosed in the Private Placement Memorandum (PPM) and company agreement upfront. You should be aware of what sponsors are charging so that you’re not caught by surprise with hidden fees. There are no surprises for careful readers!