Understanding the motivations of the parties involved in a real estate transaction is critical when evaluating a new sponsor. Investing in real estate is a passion for great sponsors. They will be able to properly communicate the benefits and drawbacks of the opportunity and show that they are specialists at creating value through real estate purchases. Also, their primary purpose is to generate profits for their investors.
Fees are a necessary part of running a real estate development company. But it is not in the best interest of investors for fees to be the main thing that drives developers. However, some sponsors’ business models are influenced by fees, which is also true of business models in other industries.
The cost of a project can be evaluated from various perspectives, and the focus of this article is on how investors can assess the operational methodology of the underlying developer.
The Acquisition Fees
Ensuring that the interests of the investors and the sponsors are aligned involves striking a balance between the various fees and performance-based incentives. Co-investment is a component of this, as well.
Investors wish to see evidence that the sponsor has some financial stake in the enterprise, the amount of which should be proportional to both the transaction’s size and its sponsor’s wealth. When a sponsor has more real money at stake in real estate, they will be more likely to see it through to the end.
Net sponsor co-investment in a negotiation or a purchase measures alignment of interest. Therefore, fees and co-investment are linked. An acceptable co-investment may seem like a sponsor’s announcement that they will contribute 10% of the equity. When you dig deeper, you may find that the acquisition charge is equivalent to or exceeds the co-investment amount.
As a result, the sponsor not only puts money into the agreement but also takes money out of it right away. Sponsors in these situations may have no net investment in the transaction.
When trying to find if the investors’ and the sponsor’s interests are the same, it helps to look at any acquisition fees and compare them to the amount of money the sponsor is investing into the deal.
The Asset Management Fees
Asset management fees are another usual expense. There are many ways to calculate this charge, including a percentage of the total asset value, a percentage of equity under management, or a percentage of the final asset value. It will be much higher than a percentage of equity because it includes the cost of managing any debt.
Fees based on performance are more in line with the interests of investors, although they are not as familiar. For example, it could be calculated based on a percentage of the company’s helpful gross income rather than a standard percentage of the equity.
Because the sponsor gets a smaller asset management fee if the asset performance goes down and making dividends and doing a fine job for their investors, it climbs higher when the asset’s performance goes up and making payouts and doing a good job. A fee structure that considers this and rewards it is better than one that only looks at the number of assets managed.
Similarly, investors may believe that big promotion to a sponsor, rather than a disposition charge, is in their best interests. In the case of a disposition fee, even if the property is traded at a loss, the sponsor will still make money because they will receive a portion of the selling earnings. In case of a bonus, they must meet a threshold to be reimbursed.
The Origins and Uses
There should be a section in the offering documentation that explicitly discloses any fees that sponsors will be earning. Regardless of the source, to provide complete openness when seeking cash for a real estate investment opportunity.
To figure out where the costs are kept if there is no fee summary included in the offering documents, an investor will have to read through the documentation. In addition to operating paperwork, this treasure hunt could include examining property management agreements. This is why: Escrow companies hold funds until the end of the project acquisition process until they release the funds to the parties involved.
Sponsors with a good reputation for being open and honest will offer investors a detailed breakdown of all closing costs, including the sources and uses of funds. Investors can compare this summary to the settlement statement from the escrow company to make sure the two are the same.
A component of any investor’s due diligence in a deal is looking at how the fees match with ensuring that the sponsor executes and maximizes investment returns. Even though payments are necessary and expected, they should not be the primary motivator for the sponsor.
Investors’ interests will be better aligned if there is a nice balance of sponsor co-investment, performance-based rewards, and fees.
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