Before deciding with whom to invest, investors should have a thorough understanding of the fees charged. A devoted team is essential for success in real estate investment, and fees help pay for that team.
Someone must locate the property, negotiate the price, create marketing materials and legal documents, raise equity, manage the property’s day-to-day operations, develop and execute the business plan, report to investors, provide K-1s, sell the asset, and distribute the proceeds. Fees assist managers in attracting and retaining high-caliber personnel.
In contrast to the public markets, real estate is not an industry where you should base decisions solely on fees. There is a significant disparity between price and value, and low-fee real estate transactions can be costly. Real estate investments are most influenced by the quality of the business plan and the asset manager who oversees it. Fees are proportional to the complexity of a business plan and should be proportional to the manager’s ability to create value.
In a private placement memorandum or marketing materials, fees should be outlined in detail. In addition to reading the materials, investors should inquire about all possible costs, as they are sometimes buried.
Real estate investment management has two primary fees: transaction fees and performance-based fees.
Property Transaction Fees
Fees for transactions are guaranteed. These payments are paid to the management regardless of the deal’s performance. The following are the most prevalent transactional fees:
Acquisitions Fee
This fee is often charged by managers that syndicate individual transactions. Typically, the acquisition fee is between 1% and 2% of the overall transaction value and is calculated on a sliding scale. The smaller the cost, the larger the transaction. This is a reasonable market-rate price, given that the manager likely reviewed fifty transactions to discover this. The management previously paid for all staff and dead deal expenses out of their pocket.
Unlike stock investment, acquisition fees are based on the entire transaction value. This is a substantial difference since a one percent purchase cost on a $30 million property is $300,000. Most properties are often leveraged with two-thirds debt; thus, the necessary equity may be as little as $10 million, equating to a 3 percent cost of equity investments for the $300,000 charge.
Asset Commitment Fee
Significant capital real estate funds often assess this fee and vary between 1% and 2% of committed equity. This charge is paid to the management regardless of whether the money is invested. If a committed capital fee is imposed, an acquisition fee should not also be collected since this is considered “double-dipping” in the financial business. Unfortunately, many managers that serve individual investors attempt to get away with double-dipping, so exercise caution.
Fund Management Fee
This fee is frequently referred to as the Asset Management Fee and is levied by fund managers and managers supporting individual transactions. This fee substitutes the committed capital fee for real estate funds after the money has been invested, so investors are not charged twice for the same capital. The commitment fee decreases proportionately as more funds are invested. This charge, which varies from 1% to 2% of invested capital, is used to pay for investment management services. This charge should be based on the amount of stock contributed, not the overall transaction size.
Cost of Organization and Setup
Both real estate funds and individual deal managers suffer setup expenses. Typically, these costs are transferred to the investment corporation and borne by all investors. Legal, marketing, technology, investor relations, and other expenditures involved with capital raising and the formation of the investment firm are incurred once. Typically, this charge ranges between 0.5% and 2% of total equity.
These fees are often not clearly identifiable in marketing brochures and are frequently bundled with the property’s buying price for individual transactions. To properly grasp the objective of this charge, investors should be aware of this line item and request a clear explanation of the circumstances from the management.
Administration Charge
These expenses include a third party’s tax reporting, audits, fund management, and software. Typically, they vary between 0.10 and 0.20 percent annually on the invested stock.
Loan Placement Fee
This fee is often paid to a third-party broker, as is typical in the debt placement sector. Depending on the magnitude of the transaction, the average cost is between 0.25 percent and 0.75 percent of total debt. A competent broker may save a project far more than this charge. However, some managers attempt to add their internal control of between 0.25 percent and 0.75 percent to the debt placement cost. This significantly influences equity since the amount of debt used in a typical transaction is double that of stock.
Financing Charge
Some managers charge between 0.25 percent and 1 percent for this service, comparable to a debt placement fee.
Wholesaler Promotion Fee
This charge is often paid by non-traded REITs to the broker-dealer for product distribution and corresponds to around 3 percent of equity.
Consultant/Syndication Fee
Some private REITs use broker-dealers to promote their goods through an advisory network. Typically, these consultants are paid an up-front, one-time charge between 4 and 7 percent. Some sponsors may charge a lower initial price but add acquisition or transaction fees. These commissions are sometimes buried in the tiny print that itemizes capital expenditures.
Joint Development Fees
Joint ventures do not add an additional layer of costs alone, but the investor pays two managers instead of one. If the investment manager is just giving access, then their fees should be far lower than a manager who provides value by executing the business strategy.
Selling Fees
It is always best practice to bring a project to market to maximize its worth. Typically, brokers are compensated between 1 and 3 percent of the sales price, depending on the project size. Some managers levy an additional internal fee of between 0.25 percent and 0.75 percent.
It may seem to be a significant number of expenses, but savvy management will reduce the kinds and fees they impose. The purpose of transaction fees is to keep the lights on, not to generate a profit for the business. While we do not feel that prices should influence a selection, they may provide insight into the management. Guaranteed transaction fees strongly indicate that a director does not have the investor’s best interests while attempting to collect every last cent from a contract.
Private Property Performance-Based Charges
Variable performance fees are dependent on the success of the real estate investment. They align the manager’s interests with the investor’s in practically all private equity investments, even not real estate-related ones. Typically, the performance/incentive fee allows the management to pay between 20% and 30% of earnings.
An investment waterfall is a strategy used in real estate investments to unequally distribute financial earnings between the management and the investor. In most waterfall structures, the management obtains a disproportionate share of the overall profits compared to their initial investment. For instance, a manager may contribute just 5% of the total investment capital yet be entitled to 20% of the earnings.
Often, performance fees are linked to what is known as a preferred return hurdle, which is the rate of return tier (typically specified by a specific IRR or equity multiple) that must be achieved before the manager shares in the profits. These levels determine the different profit distributions. The desired return is usually between 7 and 10 percent per year and may be considered an interest rate on investor cash, although it is not guaranteed.
Both real estate funds and individual transactions use European and American waterfall structures. In a European waterfall, investors are paid one hundred percent of each investment cash flow following the capital invested until they reach their desired rate of return plus one hundred percent of their initial investment.
Once these distributions are made, the manager’s share of the earnings will grow. This is the most prevalent real estate fund waterfall structure.
In the American waterfall, the management is entitled to a performance fee before investors obtain a return of 100 percent of their money, but often after they have received their chosen rate of return.
To safeguard investors, a clause often states that the manager is only permitted to collect this fee if he or she reasonably expects that the fund or transaction would yield a return more significant than the desired return. It’s unusual for income products with extended hold periods to be arranged using waterfalls or transactions with longer than 10-year periods.
Look for a fee structure that is heavily performance-based when evaluating private real estate investment prospects so that the management benefits when the investor prospers. There is a distinction between fees utilized to produce investment value and excessive fees that make private equity real estate fund managers rich at the cost of their investors.
However, in the end, fees should not dictate an investor’s choice of an investment advisor. After all, expenditures have been eliminated; what matters most is the return on investment and whether or not it is proportionate to the level of risk.
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