What is normal “compensation” and what is not? Is it the time when I should not mind spending more money? This article describes how I assess these items.
Can you confirm that sponsor XYZ is being compensated fairly? Taking advantage of me? I’m new to real estate and alternative investments, and one of the most frequently asked questions I receive.
I use a method to determine the description of this article. I’m a conservative investor, so I’ll discuss how you might want to assess some aspects of this differently than I do if you’re more aggressive.
It’s critical to comprehend the different facets of the sponsor’s compensation before continuing with this.
Compensation for the Fees and waterfalls has two main ways (also called “profit splits,” promotes,” or “carry”).
Fees
You can pay fees whether the company makes a profit or loses money. Some charge once, while others are charged yearly, with the yearly ones having the most significant impact on the final return. I’ve listed some standard fees below (along with the averages I’m currently observing, considering perhaps 100 deals per month):
- Fees for Management:
It is usually 1 percent to 1.5 percent of the yearly subscription. Observe that some sponsors may initially appear to have a meager management fee. You will find o closer inspection that they are expressing it as a percentage of assets under management. It means that it considers both the amount of your subscription and the leverage used in the transaction. To make an accurate comparison, convert it to a percentage of the subscription amount (or ask them to correct it for you).
- Fees for Property and Management:
It is the annual fee for property management. NNN assets with low management effort average around 3-5 percent. Multifamily assets with medium effort yield around 4-6 percent. Mobile home parks, for example, have a 6-8 percent return on investment.
- Fees for Acquisition and Disposition:
It is a one-time fee for buying or selling the property. These range widely from 1%-6%. A few more significant funds have economies of scale and do not charge these fees.
- Fees for Other:
Other fees, like a financing fee (usually between 1 and 2 percent), are occasionally assessed. In general, these have minimal effect on the result.
On the other hand, fees are a topic that most sponsors seem to maintain reasonably close to the averages (we will discuss waterfalls in the next section). As a result, I don’t see many red flags here.
But I do it on occasion. If a one-time fee seems slightly more expensive than usual, but I still like the sponsor and the offer, I usually disregard it. After all, it’s unlikely to have much of an impact on the deal in the long run.
However, suppose a yearly fee is significantly higher (i.e., by half to one percentage point). That can add up over time. So I’ll see if I like the sponsor and the deal. If it is the former, I will make an exception; otherwise, I will decline.
Very rarely will a deal come along that is astronomically more expensive in terms of yearly fees (more than one percentage point). It’s difficult for me to see a reason to choose such a sponsor when so many other comparable options are more competitive. It can have a significant impact on the overall return. It is a deal-breaker for me when I see it.
The Fee Fallacy
Some sponsors will charge very little or no fees and then make up for it with an incredibly high waterfall (discussing waterfalls in the next section). Paying when the investor makes money, they frequently present this as being “better” for the investor. They assert that, compared to rivals, this “aligns” them more with you.
This concept, however, has two flaws.
For starters, in a severe downturn, such a sponsor will be paid little or nothing. If you want your sponsor to be able to afford to keep the lights on so that they can recover from the downtown and hopefully return your money, this is a bad thing. When considering the big picture, an investor would choose to pay (reasonable) fees in this case.
Second, the waterfall is not in line with the investor’s interests, which is the “dirty secret” of the real estate investing sector (at least not if the investor is conservative). I’ll go into greater detail about this in the following section. I’ll say for the time being that I turn away from sponsors whose fees are interpreted as “too low.” Fortunately, most costs are reasonable. So I proceed to the following step and gaze at the waterfall.
You refer to a waterfall, and I refer to a profit split (Or “promote.” Or “carry”…)
All terms can be changed, but all mean the same thing. They explain how an investor and sponsor will split the dealer’s profits. “waterfall” comes from the fact that rules are applied in a specific order. Each feeds into the following (pools of water in a waterfall).
A waterfall can be found in almost any real estate/private equity/alternative investing transaction. Unlike fees, there’s also a wide variety. Many people still follow the averages, but a significant number do not.
It’s crucial to comprehend the various components of the waterfall before discussing that so you can make sense of what you’re seeing. Here’s a quick recap.
Down The Waterfall, Sliding
As previously stated, the waterfall’s components occur in a specific order. It is how it usually works:
- “The preferred outcome”:
Before the sponsor is permitted to dip their hand into the profits via later tiers in the waterfall, this is the amount that the investor receives back first. According to the logic, the investor should receive a priority cut because they contributed the capital that made it possible. It is usually between 5% and 8%.
Most sponsors, in my experience, follow the script pretty closely, and there isn’t much to criticize. On occasion, though, I encounter a deal with no preferred return. It’s unusual and could indicate an agreement aimed at inexperienced investors. When I saw this, I immediately rejected the deal. (More on my thoughts on unsophisticated investor offerings can be found in the article’s conclusion.)
- “Capital Return” (optional):
It is an optional tier in which the sponsor must first return all of the investor’s capital before they can begin dipping into the profits via subsequent levels. It would be ideal for investors if it were the norm, but it isn’t. As a result, many transactions do not result in a capital return. It’s a big plus when they do.
- “ Catching Up With Sponsors” (optional):
This tier is not available in every deal. At the investor’s expense, it’s very advantageous to the sponsor. The “catch up” enables the sponsor to get their share of the profits from the previous two tiers (discussed next) (in effect, nullifying them).
Having neither a preferred return nor a capital tiers return is worse than this, but it’s still not ideal. Before the sponsor can do this, the deal must perform well enough to reimburse the investor for the earlier stages. However, if the value goes through, the previous two tiers will vanish after completing this tier.
- “Splitting of Profit”:
The remaining cash flow is split here between the investor and the sponsor. For example, the investor could receive 80%, and the sponsor could receive 20% (an “80/20 split”). It is where the majority of the sponsor’s compensation is usually made and thus where I spend the majority of my time looking. In the following section, I’ll review what’s typical and what isn’t.
- More splits on profits(optional):
Although there is typically only one split per deal, there may be one or more splits in some sales. Most of the time, these additional tiers are set up so that the sponsor can keep a more significant portion of the profit (at the investor’s expense). For example, the agreement could state that once the return exceeds 15%, the split will be 60/40. The most profit split tiers I’ve seen are often in the least competitive deals.
Profit-sharing thus involves a lot of moving parts. As you might expect, there are numerous configuration options. Waterfalls are available in a variety of shapes and colors.
It brings up the original query, “How can I tell if a specific waterfall is fair or not?”
Joe Average, Thank you.
I compare the waterfall to the asset class and strategy’s average.
What is the average? I probably look at 100 deals a month to quickly assess something and determine where it falls. However, if you’re brand new, you won’t know. Here is some assistance based on what I’ve observed recently in the market:
- Multifamily with value-added:
I’ll start with this one because it describes 85 percent or more of the deals available today. The typical profit split, in this case, is a single tier of 75%–85% for the investor and 15%–25% for the sponsor.
- The other major asset classes (office, retail, hotel, and self-storage) are the same as described above.
- The asset classes with limited supply (mobile home parks):
These asset classes tend to have higher splits and present more significant challenges for sponsors in terms of deal sourcing and deal management.
Mobile home parks are classified into two types.
First is with no equivalent to the MLS for apartments to buy.
And the other with many sponsors that develop property management expertise in-house.
As a result, I currently observe that the investor typically receives 60–65% (with the sponsor receiving 35–40%).
- Strategies for the core and core-plus:
The profit splits are typically the same as value-added, but the preferred return will be lower (5-6% as opposed to 5-8%). It makes sense because they typically have a lower return and less execution risk. The sponsor needs to be pretty compensated to keep the lights on.
In light of the previous, you can determine whether or not something is out of place.
If it falls within averages, I’m satisfied and will proceed with my due diligence. (Refer to the Conservative Investors Guide to Choosing Real Estate Investments.)
But what if it’s not in the middle?
At that point, some people might decide to turn around and go the other way. I take a closer look and occasionally make an exception. It is how I go about it:
It’s either “highway robbery” or “uncompetitive.”
The first thing I look at is how badly the deal is out of line.
If it’s not off (the split is within five percentage points of the bottom of the average), I look to see how I feel about the sponsor and the deal. If I like both, I’ll often overlook the flaw in the profit split.
For example, consider value-added multifamily with a 70 percent (investor)/30 percent (sponsor) split. That is exceptionally uncompetitive when compared to other options. However, the sponsor may have had multiple real estate cycles with no money lost (99 percent of the other offerings do not have). And, because I believe we are nearing the end of the process, I prefer to avoid green sponsors as a conservative investor. (I don’t want them to learn costly lessons with my money during the next recession.) The payment of uncompetitive split if I adored the sponsor and the deal. It would be worthwhile to me.
If they only pass muster with me, on the other hand, I discard the offer and move on to something more worthwhile.
Uncompetitive splits have the potential to significantly skew the risk/reward profile of an investment, which is one of their crucial side effects. And this can influence how a sponsor acts. Paul Kaseberg discussed this dynamic in his interview about sponsor alignment.
Real estate investing’s “dirty little secret” business, according to Kaseberg, is that sponsors are financially motivated to take on more risk by the profit split. And the more significant the division with the sponsor, the more likely they will take risks.
It is the exact opposite of what I want my sponsor to do as a cautious investor. As a result, I scrutinize these transactions even more cautiously. An aggressive investor wants the sponsor to push the risk envelope as far as possible (to have the best option of meeting the high projected returns). Therefore, a bold investor may be okay with an uncompetitive split (and even prefer it).
“Aim for the stars!”
The split is occasionally severely out of whack (worse than five percentage points off the bottom of the average). Some investors label them as “exploitive” or “highway robbery.” It’s difficult for me to imagine liking any sponsor or deal so much, given the range of alternatives available. It immediately alarms me, and I turn around and leave.
I’ve also discovered that a deal structured in this manner is often indicative of a sponsor aiming for inexperienced investors. Furthermore, based on my past experiences, these sponsors won’t present me with a worthwhile deal.
Aside from being significantly more expensive, many sponsors take more significant risks than I am comfortable. (for example, higher leverage, lower skin in the game, etc.) and overly-optimistic Pro-forma. Thru the help of these strategies, they can advertise the high projected returns that less knowledgeable investors typically adore and more knowledgeable investors view with suspicion. When I sense a sponsor is targeting inexperienced investors, I raise a red flag and move on.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.