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By Dr. Peter Kim of Passive Income MD, WCI Network Partner
Let’s face it: no one likes the idea of paying fees. If we all had it our way, every deal or transaction would be cost-free.
However, we all know that isn’t realistic. After all, the business or service has to make money in order to operate; be sustainable; and honestly, make a profit. One of the ways that’s achieved is through charging fees, whether they’re overtly obvious or not.
Anyone who has bought a home will probably remember all the fees outlined on the settlement statement. In fact, whenever I even order food through a delivery service, the fees jump out at me.
It never feels good, but part of the reason I usually feel that way is that I’m focusing on the loss instead of the gain. It hurts to pay any extra dollars, but what if I knew that for every extra dollar I paid, I’d receive $10 in value in return? Then, it would feel like I’m getting a bargain.
So, in dealing with fees, the key is to understand what the true value of the fees is. Is there a clear return on investment, or is it a waste of money?
When investing passively in real estate through syndications (other people’s deals), fees are an important part of the deal. It’s important to understand what's being charged, for what purpose, and what’s reasonable according to industry standards or the value received.
When doing my due diligence on a deal, I look at fees and what I expect to receive in net fees, take into account the level of risk involved, and see if it all fits my goals and objectives.
Every deal is completely different and they can carry different types of fees, but I’ve decided to list five of the most common fees in syndications that you need to know.
#1 Acquisition Fee
There is a significant amount of work that happens prior to a deal being secured and presented to investors.
Sponsors must create broker connections, follow up on leads, do proper due diligence on the investment, come up with a business plan, win the deal, work with lawyers to set up legal documents, pay for investor portals, and ultimately acquire the property.
All of this happens before a deal is even presented to anyone. Likely, the sponsors have had to go through this process for multiple properties before even securing a deal.
Hence, this fee is typically in place to compensate the sponsors for making the deal a reality. It is not considered a huge profit center for them but instead a way to keep the business running.
This fee is typically 1%-2.5% of the purchase price of the property.
#2 Loan Fee
The size of these deals is in the millions and, sometimes, hundreds of millions. It takes a significant amount of effort to secure a loan this size. They work with many lenders submitting paperwork and shopping to get the best deal.
Many of them will provide loan guarantees (which might incur another separate fee) and take on the liability for the loan.
The loan fee is typically 1% of the total loan amount.
#3 Asset Management Fee
Part of the responsibility of the sponsors is to make sure the property is operating according to the business plan and to make adjustments as necessary. This requires bookkeeping, analysis of the data, market analysis, business plan implementation, setting up distributions, and communication to investors.
All of this is compensated by the asset management fee. They are managing the asset on behalf of the investors in order to create profit for all involved.
The typical asset management fee is 1%-2% of the capital invested or gross income of the asset. Make sure you note what it is.
#4 Property Management Fee
This is the fee to manage the day-to-day responsibilities to operate the property. This includes marketing and finding tenants for the property, collecting rent, dealing with repairs, paying utilities, and making sure tenants have the very best experience as renters.
The typical property management fee is usually 3%-5% at the size of the properties in syndications (usually in the hundreds of units). The sponsors may have the resources to manage the property on their own or they might outsource it to another property management company.
#5 Disposition Fee
This fee is somewhat of a catch-all fee that isn't necessarily seen on every deal. If it is there, it is important to note. It is charged at the sale and is usually 1%-2% of the sales price of the property. It is to cover the work and cost of preparing a property for sale, including marketing, working with brokers, lawyers, and other costs incurred while holding the asset.
While not officially a fee, I felt it was important to mention what’s called the “promote.” It is the profit split and main compensation for sponsors to run and operate a deal.
While no deal is exactly the same, you might see something like a 60/40 split (Limited Partners/General Partners) or 70/30 (LP/GP) mentioned in the offering.
This means that after fees and preferred returns, the remaining cash is split according to this pre-determined percentage.
For example: after all fees and preferred returns are paid out, if there is $1 million in cash left over and the split was 70/30 (LP/GP), then limited partners would receive $700,000 and general partners would receive $300,000. The “promote” is the $300,000 profit that the general partners receive.
No two promote structures are necessarily the same so it's important to look carefully to understand what it is. If it's not outlined in the offering memorandum, make sure to ask the sponsor to clarify what it is or find it in the PPM (Private Placement Memorandum).
The promote is the sponsor's main incentive to put together the deal and creates the vehicle for you to leverage the sponsor's experience, knowledge, connection, resources, etc.
How to Think About Fees
It’s absolutely important, as part of your due diligence process, to identify and understand all major fees involved.
These are the questions I ask myself:
- What are the fees, and are they within normal ranges?
- Collectively, are they on the higher or lower side?
- What’s the preferred return and the promote?
- What are the projected returns, and what’s the level of risk to achieve those returns (low, medium, high)?
- How confident am I that this sponsor can achieve these returns?
- Considering fees and the promote, do I feel that the interests of the sponsor are aligned with mine?
You have to ask yourself all these questions because it’s important to recognize when fees seem out of line considering the level of risk and benefit involved. The other key is to understand whether the fees and the promote structure are set up in a way that creates an alignment of interest.
How do you know when you can trust someone? When your interests are aligned, meaning that the sponsors will only do well when you do well. Or are the fees so heavy that no matter how the deal performs, the sponsor will do quite well?
Without fees, these deals wouldn’t exist, and to be honest, you want the sponsor to be compensated well for what they’re doing—which is helping you create passive income.
It’s all a balance and it starts with understanding the fees and how everything comes together to help you reach your financial goals.
How much do fees play a role in whether you buy into a deal? Are there other fees not mentioned above that have impacted your decisions? Comment below!