There are certain terms that get tossed around when you hear seasoned investors doing due diligence on a passive real estate investment business. The passive real estate investments I am referring to are syndications and funds.
One such term is “alignment of interest” or, in simple terms, an agreement in which all parties benefit from a certain outcome.
There are numerous benefits to investing with a sponsor, from accessing greater investment opportunities to receiving returns entirely passively. However, as a passive investor, it is imperative to make sure that your interests align with the people who run the business.
Since partnering with the right sponsor is the foundation of successful syndication, here are a few ways to ensure that your sponsor’s interests align with yours.
Business plan and exit strategy
Before considering investing in a syndication, it is important to understand your sponsor’s business plan and exit strategy, as they are actively managing an asset and making all the major decisions. So don’t be afraid to ask them questions to assess whether the investment is right for you.
Here are some questions you can ask – what is the expected cash flow? Will that be sooner or later? Is the given strategy your core competence? What and where do you want to invest? How long is the investment period? Etc.
Answers to such questions will help you determine your financial alignment with that of the sponsor. It is also important to stay open-minded as the terms previously agreed upon may need to be changed based on market conditions and those decisions are in the hands of your sponsor.
The amount of co-investment a sponsor makes is possibly one of the biggest markers in matching interests. The more capital a sponsor invests in a business, the higher the risk they are taking, which demonstrates their confidence in the investment. And no gain on their fees can make up for that loss of capital.
Usually sponsors invest between 5 and 10%, but given the number of deals a sponsor enables, it may not be possible to invest 10% in every deal. However, in absolute terms I see significant investment in terms of the incentives and fee structure.
Balance between sponsor fees and fees
As part of their compensation, a sponsor receives fees for brokering a business. These fees are set out in the Private Placement Memorandum (PPM), a contract between sponsors and investors.
Here are some types of fees you can find in a syndication:
This fee is earned when closing a property. Sponsors spend weeks, even months, researching, sorting, closing a deal, and part of their co-investment isn’t paid back until a property is sold. Hence, they charge a small amount of 1-2% of the purchase price to purchase an asset, which helps to balance their expense between transactions.
Financing or loan fees
This fee compensates a sponsor for funding such large investment opportunities, which can be time and labor intensive. It is usually 0.5-1% of the total loan amount.
Equity Placement Fees
The broker calculates these in advance to cover the costs related to attracting investors, marketing, coordination and other backend aspects, which typically represent 2-3% of the invested capital.
Asset management fee
This fee reimburses the sponsor for monitoring and managing the asset. Make sure they are in line with their projections and business plan. This amounts to between 1-3% of the rent received or the forecast gross income.
Construction management fee
This fee is applied to businesses that require added value or significant renovation as sponsors spend a lot of time overseeing construction projects and making sure they are on budget and completed on time. Your fee is between 3-5% of the construction costs.
This is a simple reimbursement of sponsor’s prepaid legal and due diligence fees.
Promotion or hurdle fee
This is paid as an incentive for exceeding certain milestones that go beyond the preferred return hurdle. This bonus is usually 1-2%.
Loans often require that a key partner or sponsor mortgage personal assets to guarantee the loan amount. A sponsor receives 1-2% remuneration for his commitment and support.
And finally, this fee covers the cost of marketing and selling a property and ensures a smooth transition between ownership of the syndicated and the next party, which is 1% of the sale price.
As you explore syndication, learn the fee structure to see if there are any hidden costs. Understand whether the fees seem reasonable compared to the net returns. If so, then it’s just a business expense.
A sponsor should be well rewarded for doing all the work, but you need to make sure that they really have an incentive to do well for their investors.
So, are you wondering if fee alignment will increase performance, provide an attractive net projected return, and help you meet your financial goals?
Profit sharing is a primary indicator of how a sponsor rates its investors. No two syndications are alike, so the distribution of profits varies depending on the type of investment, the holding period and the risks involved. There are two types of profit sharing:
The straight split
As the name suggests, this profit sharing is quite simple. This system uses the same split structure throughout for all returns, including cash flow and future profits from the sale of an asset.
For example, suppose a deal uses an 80/20 or 70/30 split; the first number is the portion that passive investors or limited partners receive through cash flow or sales profits. And the second number is what the sponsor or general partners get on that deal.
The preferred rate of return or the waterfall structure
This is a more popular profit-sharing mechanism that offers a preferred annual return of 8-10%. This amount goes exclusively to the passive investors, which creates a significant parity of interests by ensuring that the sponsor works harder to clear this hurdle before making any money on this business.
Once the preferred return is achieved, the split structure can either activate the next preferred return hurdle or move to a straight split of 80/20 or 70/30.
Sometimes they can follow a waterfall structure where the split percentage evolves over time from the initial 80/20 or 70/30 to 50/50 between the investors and the sponsor.
Note that not all syndicators offer preferential returns. Therefore, it is in your best interest to find deals that offer preferential returns as they reduce the risk associated with investing.
Another option for profit sharing can be based on the Internal Rate of Return (IRR), an annualized cumulative rate of return. The math behind this is a bit tricky, which can affect the stock split over time.
As a limited partner, it is important to remember that it is a red flag when a sponsor receives a huge payout regardless of their performance or passes all profits on to the investor without owing to themselves. What you need is a sponsor who has invested in the success of the deal with you.
When the interests of an investor and a sponsor match, you will build your real estate investment business much faster and smoother. You will be able to work around the common pitfalls and avoid thinking that you are in the real estate business. Because you aren’t, you have a bigger mission to reclaim your time. And real estate investments are just a vehicle to get you there.
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