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Real Estate Sponsor Fees and the Role They Play

By Adam Gower Ph.D.

 

When looking at any real estate deal with a new sponsor, understanding the principals’ motivation for why they are doing a particular transaction is a key consideration. The best sponsors will be able to articulate clearly the strengths and weaknesses of the opportunity and will demonstrate to investors that real estate is their passion, that they are experts at creating value by buying real estate, and that their overriding goal is to create value for their investors.

 

In common with other industries, however, some sponsors’ business models are driven largely by fees and while charging fees is an important part of running a real estate development business, it is not in investors’ best interest that they drive developer motivation. 

 

There are many fees that can be charged to a project and this article considers how investors may assess the underlying developer modus operandi.

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Acquisition Fees

 

Looking at a balance between fees and performance motivators is the process of making sure that sponsors’ interests are aligned with the investors. And part of that is co-investment.

 

Investors want to see that the sponsor has skin in the game proportionate with the size of the deal and the wealth of the sponsor. A sponsor is going to be increasingly motivated the more actual money that it has in the real estate deal.

 

But fees and co-investment are related because it is the net sponsor co-investment in a transaction or an acquisition that measure alignment of interest. If a sponsor signals that they are going to put in 10% of the equity that might seem like a respectable co-invest.  However, looking deeper, there may be an acquisition fee that equals or exceeds the co-investment amount.

 

The net effect of this is that while the sponsor is putting money in to the deal, on day one, they’re also taking money out immediately. In these cases, the sponsor may not have any net co-investment in the deal.

 

Looking at any acquisition fees and comparing it to how much money the sponsor is actually putting in the deal is a good indicator of the alignment of interest between investors and sponsor.

Asset Management Fees

 

Another type of fee often charged is the asset management fee.  This can be based on a percentage of equity under management, which is common, and sometimes the fee is based on percentage of total asset value. This will be a lot higher than percentage of equity because it also includes a fee for managing any debt.

 

More aligned with investor interest, but less often seen, are fees that are performance based.  For example where it is calculated on a percentage of effective gross income instead of just a flat percentage of equity.

 

It is generally in investor best interest to tie fees to some performance metric because if the performance of the asset goes down the sponsor gets a lower asset management fee but when it goes up and they're making distributions and doing a great job for their investors, it goes higher.  Fees that reward this mentality are more desirable than those based solely on sheer volume of assets under management.

 

Similarly, investors might consider interests better aligned with a higher promote to a sponsor in lieu of a disposition fee. A disposition fee will yield a sponsor revenue even if they sell a property at a loss because they still get a percentage of the sale proceeds whereas if it's a bonus driven by a promote they have to exceed a hurdle in order to get compensated.

Sources and Uses

 

Ideally when raising capital for a real estate investment opportunity, sponsors will provide a section in the offering documents that clearly lays out all the fees they are going to be earning, no matter what the source, to ensure complete transparency. 

 

However, offering documents can be long and complicated and if such a summary is absent, a diligent investor will need to dig to find where fees may be buried.  This treasure hunt could include looking not only at the operating documents but also in property management agreements and this is why:  Prior to a project acquisition closing, people submit invoices to the escrow company and then once it closes, money is dispersed.

 

Reputable, transparent sponsors will provide a full accounting of all closing expenses and summarize exactly what they will be ahead of time for investors in a summary of sources and uses of funds.  Investors can compare this summary with the settlement statement the escrow company provides to make sure they are consistent.

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Looking at how the fees in a deal are aligned with making sure that the sponsor’s actually going to execute and maximize investor returns is a key part of any investor’s deal due diligence. Fees are necessary and to be expected but they shouldn’t be the driving motivation for the sponsor.

 

Seeking a balance between sponsor co-invest, performance based rewards, and fees will better align interests with investors.

 

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