Why is your sponsor’s performance-based incentive not as beneficial to you as they promise?
(As always, I’m an investor giving my personal view and not a financial counselor; always consult your financial advisor before making investment decisions.)
Here is a summary of a conversation with investment author Paul Kaseburg. Paul is the author of an eBook on passive real estate investing, “Investing in Real Estate Private Equity.”
Although it’s late for me, I want you to grasp his knowledge early on—every bit of it. All pages until the end. I believe every beginner and pro should read Paul’s works. No matter what age and gender. After all, everyone deserves to know how to assess sponsors.
“Investing in Real Estate Private Equity” is a step-by-step manual for investing in real estate via private offerings with established corporations. Some institutional investors have historically used the passive investment strategies discussed in this book for wealth creation and income production. Overall, this manual will walk you through developing your diverse real estate portfolio by selecting and investing with reputable and seasoned private real estate operators. Pretty exciting!
Unless you have a professional interest in the topic or are looking for personal investment opportunities (such as crowdfunding), the information in this book will be too comprehensive for most people. However, it is worth the read.
Paul has sat on both sides of over $1.7 billion in real estate transactions. And his book covers everything a beginner needs to know, from asset selection to sponsor evaluation to capital structuring. For professionals, he challenges conventional wisdom and deconstructs sacred cows by uncovering hidden conflicts of interest and inconsistencies that many in the field refuse to acknowledge.
Part one of the interview will discuss how your sponsor’s performance-based incentive is likely not as aligned with you as they claim. He also addresses stress tests and the real benefits of those dreaded capital calls. Then, in part two, Paul will discuss evaluating a sponsor.
Interview:
1) TRECFR: A waterfall/promote structure is present in 95 percent of real estate transactions. Investors receive a preferred return (say, 8%), and if the investment performs better, the sponsor receives a split of the profits (example, 75% investor/25% sponsor). Almost every sponsor boasts about how terrific this arrangement is for investors because they only get paid if they are successful. They claim that this aligns their interests with ours, which appears rational, and most of us accept it. Why are we all mistaken?
Kaseburg: There are two types of compensation for sponsors: performance-based (paid when a transaction performs well) and fee-based (paid regardless of deal performance). The term “alignment of interest” was developed to refer to deals that included a substantial share of performance-based incentives, often paid through promotions, at some point in our industry’s history. This looks correct on the surface: if deals go well, the sponsor is reimbursed more. That appears to be adequate.
In truth, highly performance-based remuneration arrangements encourage sponsors to take on more risk with investors’ money. Consider promotion a call option on deal performance; there is an incentive to maximize returns but not to minimize losses. This framework does not align the interests of sponsors and investors without being prescriptive.
On the other hand, acquisition and management fees are not as awful as they are sometimes made out to be. True, they can drive sponsors to conduct more transactions (regardless of deal quality), but they also help compensate for misalignments caused by performance-based fees.
Because no fee structure precisely combines the objectives of sponsors and investors, the industry standard is a mix of performance and fee-based compensation. Excessive amounts of either will distort incentives toward risk-taking or deal volume. Finally, investors should prioritize picking competent sponsors with the experience to execute their goals and the motivation to sustain a lucrative platform over time.
Editor’s note: When Paul says “platform” in his book, he means something different from what some crowdfunding investors imply. Investors typically use the term “platform” to denote a real estate crowdfunding website that lists possible assets for sale.
Also, Paul refers to the staffing management and experience that the deal’s/sponsor funds have put in place to handle all of the investment’s primary management chores. These things involve property acquisition, management, and disposition, among other things. Some sponsors will outsource these tasks; therefore, they are not deemed to have their platform.
Because some sponsors outsource these tasks, they are not deemed to have their platform. Furthermore, effectively cycling such a platform shows increased skill and may also be an additional source of stability. It’s an additional revenue stream that may boost the sponsor’s ability to “keep the lights on” during difficult periods of the real estate cycle.
TRECFR: Many novice investors lack simple access to good sponsors who have done business across numerous cycles. Could the entire cost structure be a way for them, or anyone considering a “young” sponsor, to gather some extra information? For instance, I was recently pitched on two “young” funds, which claimed to be reasonably conservative core + investments. One was compensated mostly through backend performance fees, whereas the other did not. In such instances, may a fee structure biased against the fund’s professed strategy constitute a potential red flag?
I believe that having compensation that is excessively weighted toward either fees or promotion generates a conflict of interest. A little of both helps sponsors support their platforms while also motivating them to make deals perform. The remuneration structure also reflects how the sponsor regards their own company. There is no ideal remuneration plan, but I would try to avoid extremes, especially with a newer sponsor.
2) TRECFR: Your book has a graph that was a tremendous eye-opener for me. It depicts a multi-stage waterfall, with the sponsor’s return appearing virtually exponential compared to the investor’s linear return. This is not how alignment appears. Some investors may reason, “I’ll just avoid multi-stage waterfalls.” Is the same dynamic present in a one-stage waterfall?
Kaseburg: That example (seen below) contrasts the investment multiples for sponsors and investors in a typical investment.
In short, the acquisition charge generates a step up in returns for the sponsor in low/moderate return scenarios. In contrast, the disposition and promotion fees create a step down in returns.
The multiple is lower in this situation, but the difference between sponsor and investor remains. In addition, a higher split to the sponsor in a single-level promotion will have the same results as a multi-level promotion, as will a lower monetary co-investment.
Misalignments in incentives are, of course, common in life. The only fully aligned structure would be if investors could participate without paying fees or promotions – not an ideal position for sponsors!
There is nothing intrinsically wrong with these structures; it is just vital for investors to understand how they function and know that they cannot rely on sponsor alignment of interest without conducting independent research on the sponsor and investment.
1b) TRECFR: If a sponsor aggressively pushes the risk curve on every project, investors will discover out quickly and leave. Is there a larger risk of sponsors subtly shifting the curve? What should prudent investors look for if this is the case?
Kaseburg: It’s a good idea to go over the agreement assumptions. These are some examples: (rent growth, exit caps, value-add plans, and operating assumptions vs. historicals).
Beyond the primary revealed assumptions, objectively evaluating underwriting can be complex. Because of the intricacy of modeling real estate and the sensitivity of pro forma returns to tiny changes in assumptions, evaluating underwriting without running your models is nearly tricky (which is impractical).
Finally, the most critical task is to find a suitable sponsor. Good sponsors have strong investor demand and do not need to make unrealistic assumptions to underwrite returns and encourage investment.
Part two of this essay will go through choosing a solid sponsor.
Most investors despise funds that make capital calls. Instead of giving all your cash at once, they spread it over time when they come across a new property or opportunity. It’s difficult to watch much of your capital sit idle, producing little money, and not knowing when things will improve. However, you state in your book that capital calls can benefit investors. How?
Kaseburg: Because agreements are often sourced and closed over time, investor money in funds is lying idle in any case. If it is not called promptly, it sits dormant in investors’ accounts. If it is not called immediately, it sits in the sponsor’s account until it is required to close an acquisition. Often, the distinction is that when the money is called, the preferred return begins to accrue for investors.
While this appears beneficial to investors, the combination of accruing preference and idle cash generates a significant incentive for sponsors to purchase agreements as quickly as feasible. This could imply that they are less demanding about deals than they would otherwise be.
Also, the accruing preference does not imply that your money is being productively invested; rather, it affects how money exiting the fund is shared between the sponsor and the investor. If your investment generates 0% economically, you will receive 0% return (minus fees) regardless of your preferred rate.
3) You wrote your book since so many of your friends came to you for investing guidance and frequently stated that the offers they brought you were not that terrific. What are the top two mistakes you’ve witnessed friends make that investors should avoid?
Kaseburg: If I had to pick one error, it would be choosing the incorrect sponsor to invest with. The sponsor’s choice influences practically every part of the transaction because good sponsors are more likely to select good properties, carry out their business strategies, and so on. Chasing marginally higher underwriting returns or an intriguing deal narrative without a strong sponsor is usually not worth the risk.
Another common regret I hear is engaging in transactions with excessive debt. Even if the property is sound and the business model is sound, taking on too much debt can transform a temporary slump into a lasting disaster.
I appreciate deals that are strong enough to withstand unanticipated surprises. If you have already returned the property to the lender, the market cannot help you in a cyclical recovery!
3b) TRECFR: You said on another podcast that you do a “stress test” to assess the risk of debt default. You calculate the ratio of final cash distributions (NOI – capital expenditures, reserves, and so forth) to revenue. This ratio indicates how much revenue can be lost before debt payments can no longer be made and equity is wiped away. What else should an investor look at after receiving this figure?”
The primary assumption is that if you acquire decent real estate and can hold on through a cycle, you will usually do okay in the medium/long term.
Bad things frequently occur when a property cannot pay debt service during the hold period or cannot be refinanced at the end of a short debt term.
The stress test is helpful since it is an intuitive metric directly related to deal underwriting. It assists investors in assessing the risk of default during the holding term. Once you understand the stress test, consider what could happen in the market or with the property to cause revenue to fall.
Is there a substantial single-tenant (or numerous tenants with coterminous leases) who could leave? Is the property located in an area vulnerable to market downturns? Is new construction likely to influence leasing rates? Is the property functionally obsolete as a result of current tenant demands? Consider possible issues and read the “Risks” section of the PPM; serious potential difficulties are usually disclosed there.
Continue reading to part two, where Paul will discuss how to examine a sponsor.
In the easiest sense, a real estate sponsor is an individual or team who acquires and manages property for their investor. Real estate sponsors can be a crucial part of a real estate syndication deal, responsible for essential responsibilities such as selecting a suitable property, arranging finance, and seeing the project through to sale or termination. This individual or team, often known as a General Partner (GP), is responsible for all acquired properties’ leasing, management, and day-to-day operations. They may, however, contract a third party to perform managerial functions, which they must supervise.
Sponsors are commonly utilized in commercial real estate. For example, the sponsor discovers an apartment building needing renovation that is either on the market or not. They conduct comprehensive research to calculate the amount of money that must be invested or financed and then make an offer to the owner. After recruiting investors on their own or through a site like crowdfunding and finalizing the sale, the sponsor retakes control and performs all of the necessary due diligence to rehabilitate the property.
The sponsor is in charge of the entire transaction and technically owns the property. Their name appears on every paper. Their investors are “silent investors” and “limited partners,” who have far less risk and responsibility.
See you in part 2!
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