Sponsors do a fair amount of work to put a deal together, manage a deal throughout its life cycle, and execute on a business plan to produce a favorable outcome for stakeholders. So, it is no surprise that they should want to get paid for those efforts. For real estate projects, sponsors have two primary compensation methods: 1) a profits interest or “promote” and 2) fees. Much like other investment metrics, the way the fees are structured can help to paint a picture of the overall project. In this article, we discuss the difference between fees and profit interests as well as the differences and justifications for fees typical to commercial real estate investments.
Fee vs. Profit Interest
Sponsor compensation can take two forms: fees and promote. While a promote is realized after a project meets certain goals (see our article What is a Real Estate Sponsor Promote?), fees can be collected at different stages of a project regardless of whether or not it is meeting expectations. Also, fees are typically taken out before profits are calculated for purposes of an equity waterfall (see our article Understanding the Real Estate Capital Stack). Finally, fees are usually tied to specific tasks that the sponsor performs, such as negotiating and closing a property purchase, rather than overall project success.
Different types of fees
Because they are typically assessed for discrete tasks, the permutations of fees can be myriad, especially if a project is particularly complex. In addition, some fees may be set as a flat amount or a percentage of cost. Some of the fees, such as a property management fee, could be shopped out to a third party. If a sponsor has in-house capabilities (this is known as being “vertically integrated”), the sponsor can create efficiencies that result in lower costs. They then arbitrage the difference through their internal fees.
Below, we discuss some but, by no means all, of the typical sponsor fees.
Acquisition / Disposition: These fees relate specifically to the purchase and sale of property or land. It is usually a one-time transaction fee that is collected after the purchase or sale and may come in addition to or in lieu of a third-party broker commission, depending upon whether the sponsor has in-house broker capabilities. Although a sponsor may choose to split out a separate finding fee, the acquisition fee often helps to cover the costs associated with finding and evaluating potential assets. Sponsors often underwrite and pursue dozens of potential candidates for each actual acquisition, so the spirit of this fee is to help the sponsor to defray sunk costs on all the properties it did not acquire (known as “dead deal” costs). The logic behind an acquisition fee is that investors should want to incentivize a sponsor to acquire the best deals and not the first deal that lands in its lap. Disposition fees, when assessed, are often viewed as the other half of sharing deal costs. Market acquisition and disposition fees vary and can be up to 2% of the purchase or sale price.
Property Management: Sponsors may do their own in-house property management, meaning they are in charge of day-to-day operations, maintenance, leasing, and upkeep of a building or property. Having in-house property management is another way of showing vertical integration. Of course, many sponsors prefer to contract these responsibilities to 3rd-party firms. Market rates for property management fees range from 3% – 4% of gross revenues, typically paid monthly in arrears for the duration of the investment period.
Asset Management: The asset management fee is most closely associated with general investment management costs. Much as the property manager executes the day-to-day operations at the property level, the asset manager oversees operations and makes decisions regarding the asset itself, such as choosing a property manager, determining and adjusting the asset strategy, making key decisions on leasing and capital expenditures, reviewing and approving property-level expenditures above a certain threshold (typically $1,000), reviewing monthly accounting reports, and making recommendations to an investment committee on when to sell or refinance. Asset management fees are usually assessed monthly or quarterly during the investment period and are either a fixed amount or a percentage of the equity raised or a fixed percentage of gross revenues. Market rates average about 1 – 2% of gross revenues or equity annually.
Construction Management: Sponsors may charge construction fees if there is a significant renovation or ground-up construction as part of an asset business plan. In projects involving construction, the sponsor does a tremendous amount of project management, which can include working directly with a general contractor or subcontractors to determine the scope of work, gather and negotiate bids, hire and fire contractors, make key decisions along the way (e.g. interior finishes), review monthly cost reports, approve installment payments, make decisions on any change orders (usually with consent of Investment Committees), inspect progress, and approve completion. Construction management fees typically average 5% of hard construction costs or less (see our article Sources & Uses: Following the Real Estate Money Trail).
Development: Development fees pertain to the entirety of the building process and may involve a variety of pre-construction steps, such as environmental testing, securing zoning, obtaining building approvals and permits and hiring architects, engineers and contractors to complete the work. Sponsors typically charge development fees as a percentage of either hard costs or total development costs, including soft costs. They may also charge a flat rate if the project is relatively “cookie-cutter”. A project sponsor who lacks the expertise to manage pre-development or construction tasks may hire a third-party “fee developer” to manage the development process. Development fees vary and can range from 3% to 5% of total cost often with smaller percentages charged on larger projects.
The relative weight that a sponsor gives to fees rather than profits interest can give an investor insight into how the sponsor views itself. For instance, a vertically-integrated firm may charge more fees and rely less on profit interest, particularly if the sponsor is well-established with a proven track record. However, a smaller, more focused outfit might charge fewer fees during the project lifecycle but take a greater promote. Such a structure aligns well with investors when sponsors are less proven as it makes total compensation to the sponsor more dependent upon performance.
It is important to look at sponsor fees in the broader context of the whole deal, including the work a sponsor is doing and the complexity of a deal, along with the targeted returns. It is also important for investors to keep in mind that, while low fees are always a nicety in a deal, it is difficult to escape the idiom of “you get what you pay for”. Sponsors who charge higher than average fees have usually earned the right to do so, since, investors care most about net returns and care less about sponsor fees if returns are strong and consistent. When there are little to no fees involved, whether or not you think it is the case, you are likely trading a low fee structure for something else in a deal (e.g. lack of sponsor experience or a handsome promote structure where the sponsor likes the odds of the upside scenario). Ultimately, investors must rely on their judgement to determine whether a given fee is fair.
Sponsor fees can easily get lost or buried in the middle of offering documents. As part of its commitment to transparency, CrowdStreet required sponsors to list all fees on a dedicated tab in its detail pages. That way, investors can compare them across offerings.