A critical principle of investing in any asset class or investment structure is that the less you pay in fees, the more of your return you get to keep. The savvy real estate investor thus always pays attention to the private real estate fund fees she pays.
In the mutual fund space, this can be pretty darn straightforward. Assuming you avoid loaded mutual funds and funds that charge marketing (12b-1) fees, the main thing to look at is the expense ratio. This is the percentage of the fund's assets that goes toward paying the costs of the fund (including the manager) each year. For a large, well-run broadly-diversified index fund, expense ratios are now essentially zero, with a cost between 0.00% and 0.10% per year. Obviously the fund is not run for free. The mutual fund company is either subsidizing it as a loss leader or offsets the costs with income from lending securities in the fund to short sellers. In addition, there are costs that are not included in the expense ratio. For example, bid-ask spreads are not included and one of the reasons why low turnover funds tend to perform better than high turnover funds (they also tend to be more tax-efficient.) Brokerage costs are not included either. In addition, the expense ratio does not include the operating costs of any of the companies in the stock index.
This is an important point that causes a lot of confusion when people start looking at private real estate fees. Private real estate investing fees are clearly much higher than those in the mutual fund space, but a significant chunk of them are essentially “the operating costs of the underlying company or companies” which would not have been included in a mutual fund expense ratio.
In today's post, I'm going to discuss private real estate fees for both individual syndications and private funds. I will include both the guaranteed fees and performance-based fees. Unfortunately, unlike a mutual fund expense ratio, there is no standardization of these fees and a significant part of evaluating a private deal is simply understanding all of the different ways you are being charged, adding them up, and deciding whether you think it is a price worth paying for what you are getting.
Fees You Are Guaranteed to Pay
Let's start with a syndication. The classic example of a syndication is that you go in with 100 other investors and buy an apartment complex. The person putting together the deal (the syndicator, general partner, deal provider, manager, etc) is going to do all the work and the people providing the capital (the investors, limited partners, capital providers, etc) are going to provide at least most of the capital. As a general rule, the deal provider is going to receive an outsized portion of the return and fees to compensate them for taking on additional risk and putting in additional work and to incentivize them to do a good job.
That seems fair, but how much is enough? Unfortunately, there's a lot of variation. You want them to be able to make enough money to stay in business, hire good people, do a good job, and be incentivized to do it right. But you also know that every dollar you pay in fees is a dollar less you make in return. So there is always going to be a balancing act there.
Acquisition Fee
The first fee to think about is the acquisition fee. This is the amount charged by the deal provider to provide the deal. Bear in mind this isn't necessarily profit to them. There are a lot of costs involved in looking for deals, evaluating deals, and purchasing deals. A fairly typical acquisition fee is 1-2% of the deal size. However, this is usually an equity real estate deal, and the lion's share of the cost of the property is not equity. It's debt. So if 1/3 of the money is being put down and you're paying 1% of the cost of the deal in acquisition fees, that's really 3% of your invested capital. Either way, know whether this fee is being applied to equity or the whole deal (which is typical). 2% charged on equity is probably less than 1% charged on the entire deal. The more expensive the property, the lower the percentage you should expect to pay as an acquisition cost.
Set up Fees
The next fee is charged in order to set up and organize the company (usually an LLC). Why this isn't rolled into the acquisition fee is beyond me. In reality, it's just a way to justify more fees. Typical fees here are 0.5-2% of equity.
Asset Management Fee
Unlike the acquisition and set-up fees which are one time fees, this one is generally an annual fee. 0.5-1.5% of equity is typical. Again, pay attention to how the fee is worded. Is it charged on the total deal size or just on the equity?
Administrative Fee
This is another ticky-tack fee charged every year, although it is generally lower than the asset management fee. It is supposed to cover administration of the LLC and tax preparation. It might charge 0.1-0.2% per year. Again, in my opinion, this should be rolled into the asset management fee.
Disposition and Garbage Fees
Some deal providers also charge a fee when an asset is sold. Again, this can be based on either the equity or the value of the property but is typically 1-4% of the value of the property. Other one-time fees you may encounter during the life of the project include debt placement fees, refinancing fees, and marketing fees. While it is typical to pay a broker to get a loan or refinance a loan (and that broker should be paid), if the deal provider is adding on their own fee for this service I consider it a garbage fee. Needless to say, all these fees reduce your return.
Okay, let's move on to the fees that funds charge. Bear in mind, of course, that some funds charge these fees in addition to the fees above that are charged by each property in the fund and that for some funds these are the only fees. Multiple layers of fees can add up quickly. Two layers of fees are frequently present in a fund or REIT put together by a crowdfunding platform. Two layers of fees aren't necessarily a deal-breaker, but you do need to add up the total fees. Note that fund fees are generally based on equity, not the value of the properties in the fund.
Fund Upfront Fee
This one time can range from 1.5-3% and cover technology, legal, marketing, capital raising, and other fund formation costs.
Fund Management Fee
This annual fee typically ranges from 0.5-2%. Sometimes it is charged on committed capital rather than on just invested capital. If that is the case, that upfront fund fee better be lower to compensate for it.
Fund Administrative Fee
This annual fee is usually less than 0.5% per year.
Adding Up the Fees
Every single syndicator and fund manager has a different set-up with regards to these fees. The only way to deal with them in my opinion is to compare them apples to apples. Adjust all the fees so they apply to your equity (not the property value) and then add up all of the upfront fees, all of the annual fees, and all of the backend fees. Now annualize all of the front end and back end fees and add them to the annual fees. That is to say, if the front end fees are 4% and you expect to have the investment for 8 years, that is 0.5% per year. Now you know what the guaranteed fees are.
I wish I could give you a guideline (“If the per year fees are more than 2.5% avoid the investment”) but it's a lot more complicated than that. You see, one deal provider might charge low guaranteed fees while charging high performance-based fees and vice versa. But suffice to say, the higher the guaranteed fees, the more of your return that will be going to the deal provider.
Private Real Estate Fund Performance-Based Fees
Mutual fund investors, especially those who believe in the value of active management, are often frustrated that mutual fund managers are basically paid to gather assets, not outperform the market. This often leads to fund bloat where there is so much capital in the fund (especially after a period of good performance) that future outperformance is almost impossible. Private real estate, on the other hand, usually heavily incentivizes the deal provider to perform. The performance-based fee structure is typically described in a “waterfall.” As one “pool” fills, the water (money) spills into the next pool until it is full, etc.
A Typical Waterfall
All the real estate I love with none of the fees. Summiting The Grand Teton with my wife and daughter.
The first money, of course, goes to pay the guaranteed fees. Those are always paid. If a fund manager is savvy enough to get investors to sign-up for high enough guaranteed fees, all of their expenses may already be covered without performing very well at all.
Second, capital is returned. This includes all investor capital, including the money the deal provider put into the deal. In that respect, they are treated just like the capital providers.
Third, a preferred return is paid out. These can range anywhere from 6% to 15% per year.
Fourth, the remainder of profit is split between the capital providers (including the deal provider with respect to contributed capital) and the deal provider. 80/20 is pretty typical, but this “promote” can range from 60/40 to 90/10.
European vs American Waterfalls
Michael Episcope explains a European Waterfall Structure:
In a European waterfall, 100% of all investment cash flow is paid out to investors on a pro rata basis until the preferred return and 100% of invested capital is paid back. Pro rata means that all capital is treated equally and distributions are paid out in proportion to the amount of capital invested. An individual who invested 10% of the required capital would be entitled to 10% of the distributions until they’ve received 100% of their investment back plus the preferred return. Once these distributions have been satisfied, then the manager’s portion of the profits will increase accordingly. This is both a common and appropriate structure in equity funds where an investor’s capital might be spread across 20 different investments. All distributions will go to investors and the manager won’t participate in any profits until the investor’s capital and preferred return have been fully satisfied.
This particular structure is nice for investors, but not so nice for managers since they may not get much cash flow at all for years until the deal is complete. As a result, they may have a conflict of interest to sell a property sooner than maybe they otherwise would.
With an American waterfall, the deal provider gets paid earlier, receiving their disproportionate share of cash flow from the beginning. The capital provider still gets their preferred return in the end, but they don't get all of their return before the deal provider gets anything at all. Usually, there is a caveat in place that says the deal has to be performing well for the deal provider to get this payment. This type of structure is a little more common (and appropriate) in a debt fund (or other income-focused fund), especially an open-ended fund structure, where income is ongoing.
Catch-Ups and Clawbacks
This is another important concept to understand in relation to waterfalls. In my experience, a catch-up provision is present about half the time and is probably best explained with an example. If there is no catch-up provision, the waterfall is structured with an 8% preferred return and an 80/20 promote, and the investment returns 13%, then the capital provider gets a 12% return and the deal provider gets a 1% return. If there is a catch-up with the same waterfall structure and overall return, the capital provider gets a 10.4% return and the deal provider gets a 2.6% return. Essentially, after the 8% preferred is paid out, the deal provider gets their 20% of that 8%. Sometimes the money is split 50/50 from the time the preferred return is paid until the deal provider has caught up. In essence, the difference between having a catch-up and not having a catch-up is whether or not the deal provider earns a promote on the preferred return or not. Tricky stuff eh? As usual, additional complexity does not usually favor the investor.
A clawback occurs in an American waterfall system. If the deal goes bad late in the deal, a clawback allows the capital provider to “claw-back” some of the money paid earlier in the deal to the deal provider. Unfortunately, whether this clause is worth anything or not depends on the deal provider's financial standing. A claw-back isn't worth anything if the deal provider no longer has the money.
If you have managed to keep reading all the way to here, you are probably left with the question of “How can I tell if a fee structure is ‘good' or ‘fair to me' versus a bad one?” Well, there is no absolute. There is only comparing one deal to another. All else being equal, a deal with lower fees is a better deal. Unfortunately, all else is never equal. Welcome to the murky world of private real estate. Now you know why you have to be an accredited investor to get into these investments. Caveat emptor.
What do you think about private real estate fund fees? How much is too much up-front or each year? What is your preferred waterfall structure? What is fair for both parties? Comment below!
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Tricky stuff! In general, like you said, the more complicated the structure the less likely it is to benefit the investor. In this sense, I like the increased control with direct real estate investing. The trade off is more work but I am the one vetting properties, running the numbers, taking on risk , but also the waterfall is 100% to me. That just what fits me best but is not for me. If you are planning to go the more passive fund/syndication route and couldn’t get through this post, it may not be for you. Getting into and understanding the nitty gritty and small print is the name of the game!
The Prudent Plastic Surgeon
The level of knowledge and time required may rival that needed for fundamental stock analysis or being a venture capitalist.
The level of knowledge and time required may rival that needed for fundamental stock analysis or being a venture capitalist. If you do decide to devote the necessary resources to private real estate, will you be more likely to achieve your financial goals, than you would with a much less time intensive passive strategy?
Passive real estate investing is complex- and not just in the fee structure. Vetting sponsors and deals is probably just as hard to understand, if not more. That said, it’s the returns in your pocket, net of all fees, that matters. I am finally dipping my toes in, to diversify into RE. The active route doesn’t work for our family, busy as we are. I’m learning from the best, though- and I couldn’t have gotten comfortable enough to do it without the mentorship. Also, we hit CoastFI this year- and that makes me breathe a little easier into taking a little more chance with some of our money.
Best,
PFB
CoastFI. Fun term. But also carries an inherent assumption that you really know how much you will spend in the future.
Isn’t it (a fun term)? I kept thinking that we’ve hit “done with retirement savings “ milestone and it didn’t tickle me half as much.
As for future expenses, do you mean between now and retirement? That isn’t much of an issue. We’re not making any changes to work/income. Super early retirement is not really our goal. Plus, the milestone has lit a fire in us to get to full FI sooner than later- so we’re still going full steam ahead with savings. It just lets us loosen the purse strings a bit and enjoy the journey.
Here’s the post, if the term is new to someone: https://physicianfinancebasics.com/coast-fi-our-2020-milestone/
Best,
PFB
Just wanted to add a little context on the concept of a catch-up.
The catch-up typically shows up in a situation where the person being caught up was unable to participate in the previous step of the waterfall, whether that person was prohibited from participating for tax reasons or contractually.
One example might be during the return of capital step. If you put in 100% of the capital ($100) but we agreed to split the returns 90/10 thanks to my “sweat equity”, the first step of the waterfall would require the return of $100 of capital to you for tax purposes, otherwise there would be a capital shift to me (taxable event). To achieve our original agreement, there could be a provision to catch me up as if I had put in $10 of capital but that catch up would only apply once the venture returned a profit above the original $100 capital contribution. This protects you and ensures I don’t get any money until the venture has made a profit and you’ve gotten your capital back.
Another example might be if you put in 100% of the capital ($100) and we agreed that you would get a 3x return of your capital before I started participating 90/10. After you were paid $300, conceivably there could be a provision that caught me up as if I had put in $10 of capital from the beginning. The rationale for you accepting such an outcome is that I’m only getting paid in a scenario where you’ve already received $300.
Like all things, a catch up can cut either way, but most sophisticated investors use it to protect themselves as a mechanism for only paying the other party once the investor has met his required returns.
Nice article! I’ve been seeking other’s thoughts on syndication fees. Super helpful. Also I’d love to read more about how you or others vet syndication sponsors.
You might try this online course: https://passiveincomemd.mykajabi.com/a/22219/TEoW4Zzo
Honestly though, true vetting might only be cost-effective for mid six figure investment amounts. I mean, just consider the cost of taking a couple of days off to fly out, see the property, and meet the team plus the cost of running background checks on all of the principals. That’s probably $10K. On a $100K investment, that’s 10%. So that leaves you to do less than optimal due diligence for smaller amounts. A bit of a gamble that. But at a minimum, speak to some of the sponsor’s other investors, look at all their past deals, and Google all of the principals with “Name + scam”, “Name + conviction” etc. Heck, just reading the PPM thoroughly would be a good start for a lot of investors!
This is very helpful concrete information for us CRE investors. Would be great for you to interview some RE syndicators on your podcast for their insight on how they choose the particular deal structure depending on their pro forma and property type. For example, is there a norm for the deal-level return vs investor return (sometimes platforms report this metric) and is that equivalent to ‘all-in’ fees for the deal.
Nearly every RE syndicator out there would love to come on my podcast. I get a lot of criticism from listeners every time I put one on however. Besides, it’s like talking to a financial advisor. They all feel like their particular deal/compensation structure is the best way. So the info isn’t exactly unbiased. It might be fun to get a panel on there to argue about it though.
It is hard for the average investor to compare apples to apples. The percentages/ fees differ between similar investments and it is difficult to get to the fine print. Dont know if this is something the syndicator/ Genral partners do not want the investors to know.
Reading this article helped me understand few more things that I will be asking my next investment syndicator.
Very interesting. I am newbie here (and recently out of fellowship with a little money in my pocket to invest) and have a couple of colleagues who have invested in 37th parallel-it seems many doctors have as they have doctors on staff… Do you have any experience with this company? If so, can you expound on your experience with them and how this syndication accounts for the various fees you mention? If you have no experience with them, perhaps one of your readers could pipe in. Thank-you.
I only know of one doc on staff, Dennis Bethel, who does their education/marketing particularly to docs.
I have two 37th Parallel investments. So far both have underperformed pro-forma but it’s relatively early for both. In fact, one of them hasn’t even called all its capital yet.
With respect to index fund fees, it is not true that the low costs reflect either loss leaders or keeping the securities lending revenue. Vanguard charges what it costs and returns all the lending revenue to the fund, yet runs funds with ER’s under 0.05%. The efficiencies scale and on large portfolios of stocks, the percentage cost is very low.
That makes real estate a high hurdle since one has to pay, perhaps, much higher costs.
Of course, not included in this are all the costs of running the underlying businesses. Those costs would be the same no matter how one held the securities. With any sort of direct ownership of real estate one has to figure the total costs and decide whether they justify this approach versus a REIT, assuming one wants more than market weight of real estate in the first place.
Non-Vanguard index funds do use index funds as loss leaders (witness fidelity’s “Zero” funds) and keep the securities lending revenue.
Fidelity has been coy about admitting that is it losing money on the funds. It does claim to give the fund all the securities lending revenue, net of lending agent and custodial fees. Vanguard does the same.
Vanguard reports and charges what it costs to run the fund. Then it adds the securities lending revenue to the fund. This does not serve to reduce the expense ratio. It just goes to increase the return. Since the lending revenue is more than the cost of the fund, the overall net cost is negative by a basis point or two.
My point was that, in discussing what it costs to run a stock fund, Vanguard shows that 3 basis points, or whatever, is about the actual cost. No need to loss leader it. If a shop cannot deliver the service at that price, then they would lose money if they competed on price.
But running a cap weighted index fund really is that cheap. With securities lending revenue included, they pay you to invest with them. Hard to do this in just about any other investment, real estate included.
That is what pushes VTI ahead of sliced bread on the list of “greatest things ever”.
There is some other fees not listed including refinance fees for obtaining a supplemental loan or new loan and construction fees for rehabbing units.
The more deceptive fees are funds that are invested in multiple other operators. Its basically paying two layers of fees with the first layer not transparent since it is a blind pool.