There are certain terms that are tossed around when you hear experienced investors doing due diligence on a passive real estate investing deal. The passive real estate investing I’m referring to are syndications and funds.
One such term is “alignment of interest” or in simple words, it's an arrangement in which all parties involved stand to benefit from one particular outcome.
There are numerous benefits to investing alongside a sponsor, from having access to larger investment opportunities as well as receiving returns completely passively. However, as a passive investor, it's imperative to ensure that your interests match the people running the deal.
As partnering with the right sponsor is the foundation for successful syndication, here are a few ways to make sure your sponsor's interests are in line with yours.
Business Plan and the Exit Strategy
Before you consider investing in syndication, it is essential to understand your sponsor's business plan and exit strategy as they're the ones actively managing an asset and making all the critical decisions. So, don't be afraid to ask them questions to evaluate if the investment is a good fit for you.
Here are some questions that you can ask – what's the expected cash flow? Will that be early on or later? Is the given strategy their core competency? What and where do they plan to invest? What is the investment duration? Etc.
Answers to such questions will help you determine your financial alignment to that of the sponsor. Also, it's important to keep an open mind as the previously agreed upon terms might need to pivot per market conditions, and those decisions will be in the hands of your sponsor.
The size of the co-investment a sponsor makes is possibly one of the greatest markers of alignment of interest. The more capital a sponsor invests in a deal, the higher risk they run, demonstrating their faith in the investment. And no amount of profits from their fees can compensate for that loss of capital.
Typically, sponsors invest anywhere between 5-10%, but given the number of deals a sponsor facilitates, investing 10% in every deal might not be feasible. However, I like to see substantial investment in absolute terms relative to the incentives and fee structure.
Balance Between Sponsor Compensation and the Fees
As part of their compensation, a sponsor receives fees for facilitating a deal. These fees will be outlined in the Private Placement Memorandum (PPM), a contract between sponsors and investors.
Here are a few types of fees you'll find in a syndication:
This fee is earned upon closing a property. Sponsors spend weeks, even months researching, sorting, underwriting a deal, and some of their co-investment isn't returned until the sale of a property. So, they charge a small amount of 1-2% of the purchase price to acquire an asset, which helps offset their effort in between deals.
Financing or Loan Fees
This fee compensates a sponsor for financing such large investment opportunities, which can be time and labor-intensive. It's usually 0.5-1% of the total loan amount.
Equity Placement Fees
The broker charges this upfront to cover costs associated with obtaining investors, marketing, coordination, and other backend aspects, which is usually 2-3% of the capital invested.
Asset Management Fee
This fee reimburses the sponsor for overseeing and managing the asset. Ensuring they're in line with their projections and business plan. This is between 1-3% of the collected rent or the projected gross income.
Construction Management Fee
This fee is charged for deals that require value add or significant renovation as sponsors spend a good deal of time overseeing the construction projects, ensuring they're within budget and completed on time. Their fee ranges between 3-5% of construction costs.
This is a simple reimbursement of prepaid legal and due diligence expenses made by the sponsor.
Promote or Hurdles Fee
This is paid as an incentive for exceeding specific milestones, going above and beyond the preferred return hurdle. This bonus is usually 1-2%.
Oftentimes, loans require a key partner or sponsor to pledge personal assets to guarantee the loan amount. A sponsor receives compensation of 1-2% for their pledge and support.
And finally, this fee covers the costs of marketing and selling a property, ensuring a smooth transition between syndication ownership and the next party, which comes out to 1% of the sale price.
When exploring syndications, learn about the fee structure to determine if there are any hidden costs. Understand if the fees seem reasonable compared to the net returns. If yes, then it's just a cost of doing business.
A sponsor should be well compensated as they're doing all the legwork, but you need to make sure they’re truly incentivized to perform well for their investors.
So, ask yourself if the fees alignment will drive performance, offer an attractive projected net return, and help you achieve your financial objectives?
The profit split is a primary indicator of how a sponsor values their investors. No two syndications are alike, so the profit split will vary per the type of investment, hold period, and the risks involved. There are two types of profit-sharing:
The Straight Split
As the name suggests, this profit split is quite simple. This system uses the same split structure across the board for all returns, including cash flow and future profits from the sale of an asset.
Say a deal uses an 80/20 or 70/30 split; the first number is the share that passive investors or limited partners receive through cash flow or sale profits. And the second number is what the sponsor or general partners receive in that deal.
The Preferred Return or the Waterfall Structure
This is a more popular profit share mechanism that offers a preferred annual return of 8-10%. This amount goes solely to the passive investors, which creates a significant alignment of interest as it ensures the sponsor works harder to fulfill this hurdle before they make any money on this deal.
Once the preferred return is met, the split structure can either activate the next preferred return hurdle or transition to a straight split of 80/20 or 70/30.
Sometimes, they might follow a waterfall structure where the split percentage evolves over time from the initial 80/20 or 70/30 to 50/50 between the investors and the sponsor.
Point to note, not all syndicators offer preferred returns, so it's in your best interest to find deals that provide preferred returns as it mitigates the risk associated with the investment.
Another possibility of profit share can be based on the Internal Rate of Return (IRR), an annualized compounded rate of return. The math behind it is a tad complicated, which can affect the equity split over time.
As a limited partner, an important thing to remember is that if a sponsor gets an enormous payout regardless of their performance or passes all the gains to the investor with none to self, that is a red flag. What you need is a sponsor who's invested in the deal's success with you.
What's your bigger mission?
When the interests of an investor and sponsor align, you build your real estate investing business that much faster and smoother. You're able to sidestep the common pitfalls and avoid thinking that you're in the real estate business. Because you're not, you're on a bigger mission of getting your time back. And real estate investing is just a vehicle to get you there.