The biggest determinants of success in a real estate deal is the quality of the operator and market timing. The quality of the operator dictates deal-sourcing and structuring ability (relationships), analysis (experience and market knowledge), and execution (more experience) whereas market timing is predicated largely on luck. Investor’s, especially those with no real estate expertise, should pick opportunities based on the quality of the sponsor, taking into account track record, financial strength, performance across cycles, and expertise within a specific submarket and asset class.
However, for a passive investor, just picking a quality operator and getting lucky with timing, doesn’t guarantee a great investment. Yes, if a deal goes well, the investor will do well, but the net return to investors are driven largely by the fee structure and cash flow splits.
The small balance real estate syndication space is fragmented and entirely unregulated, so deal structures vary wildly. While there’s no market standard, each deal typically includes an acquisition fee paid to the sponsor for putting the deal together, asset management fee for running the deal, and some sort of profit split above a preferred return (Promote) as compensation for deal success.
Here are the key fees to be aware of in any real estate syndication:
Acquisition Fee: Typically 1%-2% of total purchase price depending on deal size. It’s paid upfront to the Sponsor and earned for putting the deal together.
Asset Management Fee: Typically 1% – 2% paid to the Sponsor. The fee can be calculated on initial equity raised or gross revenue and is calculated annually, but typically paid out quarterly.
Preferred Return (Tier I): Typically 7% – 10% paid pari-passu (pro rata) and can either be compounding or non-compounding. Typically Sponsor’s put in 5%-10% of the equity and limited partner investors contribute the remaining 90%-95%.
Promote (Tier II): Above the Preferred Return (Pref) the cash flow is split disproportionality to the Sponsor. Typically the Sponsor will receive 20% – 40% of the remaining cash flow after the Pref is paid.
Promote (Tier III): Some deals have a 2nd hurdle, typically 15% – 20% IRR. The Sponsor will receive 30% – 50% of the remaining cash flow after the Pref and first hurdle of the Promote are reached.
Return of Capital: One of the major differences in structures is the timing of the return of capital. In some structures, every dollar above the Pref is paid to investors until 100% of their initial investment is returned. In other structures, Promote is paid on cash flow and investor equity is returned following a capital event; either a refinance or sale.
For a more detailed explanation of deal structuring, check out this post by REFM.
To illustrate the impact deal structure can have on investor-level returns, I ran to a deal through two waterfall scenarios. The project-level returns are the same for each investment, however the investor-level returns vary because of the structure:
- Sponsor contributes 5% of the equity and LP’s contribute 95%
- Hold Period: 5-years
- Year 1 Cash-on-Cash: 8.5%
- 5-Year Avg. ConC: 9.4%
- IRR: 44%
- Equity Multiple: 3.2x
- Preferred Return: 8% (paid quarterly)
- Tier II Promote: All cash flow above 8% Pref is split 35% to Sponsor and 65% to investors.
- Tier III Promote: All cash flow above a 15% IRR is split 50% to the Sponsor and 50% to investors.
- Return of Capital: All initial equity is returned upon the sale of the property.
Structure 1: Investor-Level Returns:
- IRR – 28%
- Equity Multiple – 2.2x
- Preferred Return: 9% (paid quarterly)
- Return of Capital: All remaining cash flow above the Pref is used to pay down investors’ original investment.
- Tier II Promote: All cash flow above 10% Pref is split 25% to Sponsor and 75% to investors.
Structure 2 Investor-Level Returns:
- IRR – 36%
- Equity Multiple – 2.8x
Under both scenarios investors’ do well, however the difference in deal structures lead to different returns. On a $100K investment, structure 1 returns $220K to the investor while structure 2 returns $280K to the investor, a 27% difference in total cash returned.
Although this is an extreme example, both structures are realistic and used by Sponsors in the small balance real estate space. While the most important aspect of a quality investment is choosing the right Sponsor, the deal structure is also a key component of investment success. As a reminder, here are the return metrics that matter when underwriting a potential real estate investment.
What structures have you seen used in private real estate deals?