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.
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?
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
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!