Is the Sponsor Taking Fair Compensation? Or Ripping Me Off?
Updated: Apr 2, 2020
What's normal and what's out of line? Are there times when I should be willing to pay more? This article explains how I evaluate these things.
(Usual disclaimer: I'm just an investor expressing my personal opinion and not a registered financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. Code of Ethics: We do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.).
One of the most common questions I get is: "I'm brand-new to real estate/alternative investing. Can you tell me if sponsor XYZ is getting paid fairly or ripping me off?"
This article will explain how I figure that out for myself. I'm a conservative investor, so if you're more aggressive, I'll talk about how you might want to evaluate some parts of this differently than I do.
Before talking about this, it's important to understand the various aspects of the sponsor's compensation.
Sponsors are paid in two main ways: fees and waterfalls (also called "profit splits,""promotes" or "carry").
Fees are paid regardless of profit or loss. Some are charged one time and others are charged yearly, and generally, the yearly ones have the most effect on the final return. Below, I list some typical fees (along with the averages that I'm currently seeing, looking at perhaps 100 deals per month):
Management fee: Typically, it's 1%-1.5%/year of the subscription amount. Note that some sponsors will appear to have a very low management fee, but when you dig in, they are expressing it as a percent of assets under management (meaning that it includes not just your subscription amount but also the leverage that's put into the deal). To do a fair comparison, you will need to convert it to a percent of subscription amount (or ask them to convert it for you).
Property management fees: This is the yearly fee for managing the property/ies. Low management effort assets like NNN average around 3-5%. Medium effort assets like multifamily average about 4-6%. High effort assets like mobile home parks average about 6-8%.
Acquisition and disposition fees: This is a one-time fee for buying or selling the property. These range widely from 1%-6%. A few of the larger funds such as Broadstone Net Lease have economies of scale and do not charge these fees at all.
Other fees: There are other fees that are sometimes charged such as a financing fee (typically 1 to 2%) etc. Generally, these make very little impact on the final result.
Unlike waterfalls (which we will talk about in the next section), fees are an area where most sponsors seem to keep pretty close to the averages. So I usually don't find many red flags here.
But occasionally I do. If I find a one-time fee a bit more expensive than average, but still like the sponsor and deal, I usually overlook it. After all, it probably won't impact the deal that much in the long run.
On the other hand, if a yearly fee is significantly more (i.e half to 1 percentage point more expensive), that can add up over time. So I will look and see if I really love the sponsor and the deal or not. If it's the former, I'll make an exception, but if not, I'll pass.
Very occasionally, there will be a deal that is outrageously more expensive on yearly fees (more than one percentage point). This can have a significant effect on the final return, and it's hard for me to find a reason to pick such a sponsor when there are so many other equivalents who are more competitive. When I see this, it's a dealbreaker for me.
The Fee Fallacy
There are a few sponsors who will charge extremely low or no fees, and then make up for it with an extraordinarily high waterfall (waterfalls are discussed in the next section). They will often pitch this as being "better" for the investor, because they only get paid when the investor profits. And they claim this makes them "more aligned" with you, compared to competitors.
Unfortunately, there are two problems with this idea.
First, in an extreme downturn, such a sponsor will be getting paid little or no money. This is actually a bad thing if you prefer your sponsor to be able to afford to keep the lights on, so that they can recover from downtowns and hopefully return your money. In this situation, an investor who looks at the bigger picture will prefer to pay (reasonable) fees.
Second, the "dirty secret" of the real estate investing industry is that a waterfall is not actually aligned with the investor's interests (at least not if the investor is conservative). I'll talk about this more in the next section. But for now I'll just say that when I see a sponsor with fees that are "too low", I walk the other way. Fortunately, usually, fees are in line. So then I go to the next step and look at the waterfall.
You say "waterfall." I say "profit split." (Or "promote." Or "carry"...)
All these words are used interchangeably, and they all mean the same thing. They describe the profit-sharing arrangement between the investor and sponsor in a deal. The reason it's sometimes called a "waterfall" is that the rules apply in a specific order and each one feeds into the next (like pools of water in a waterfall).
You'll find a waterfall in virtually every real estate/private equity/alternative investing deal out there. Unlike fees, there's also a huge variety. I've found that many still fall in line with averages, but unfortunately, quite a few don't.
Before talking about that, it's important to understand the different parts of the waterfall so you can interpret what you're seeing. Here's a quick rundown.
Sliding Down The Waterfall
As I mentioned above, the parts of the waterfall happen in a very specific order. Here's how it usually goes:
"Preferred return": This is the amount that the investor gets back first, before the sponsor is allowed to dip their hand into the profits via later tiers in the waterfall. The idea is that since the investor is putting in the money to make it possible, the investor is entitled to the first cut. Typically this is anywhere from 5 to 8%. I find most sponsors pretty much stick to the script here and generally there isn't much to find fault with. However, occasionally I will see a deal with no preferred return at all. It's rare and can be a sign of a deal that is targeting unsophisticated investors. When I see that, I reject the deal. (More on my thoughts about unsophisticated investor offerings is in the last section of this article).
"Return of capital" (optional): This is an optional tier that requires the sponsor to next return all the investor's capital before they have a chance to start dipping into the profits via later tiers. It would be great for investors if this was standard, but unfortunately it isn't. So there are many deals that do not have a return of capital. When they do, it's obviously a great plus.
"Sponsor catch up" (optional): Not every deal has this tier, either. It's very beneficial to the sponsor (at the investor's expense). The "catch up" allows the sponsor to collect their cut of the profit split (discussed next) on the previous two tiers (in effect nullifying them). This isn't quite as bad as having no preferred return and no return of capital tiers at all. The deal has to perform well enough to at least pay back the investor for the previous stages, before the sponsor can do this. But if the deal does perform, then after this tier is completed, the previous two tiers have essentially disappeared.
"Profit split": Here's where the investor and sponsor split the rest of the additional cash flow. As an example, the investor may get 80% and the sponsor may get 20% (which is called an "80/20 split"). This is where the sponsor generally makes the bulk of their compensation, and therefore is where I spend most of my time looking. I'll talk more about what's typical and not typical in the next section.
More profit splits (optional): The average deal has only one split, but some deals may have one or more additional splits. These extra tiers are almost always structured to allow the sponsor to take even more of the profit (at the investor's expense). As an example, the deal might say that once the return goes above 15%, the split will change to 60% investor/40% sponsor. In general, the least competitive deals I've seen often have the most profit split tiers.
So, profit-sharing involves a lot of fluidly moving parts. As you can imagine, that means there are many ways to set it up. Waterfalls come in every shape and color.
And that takes us back to the question: "How can I tell if a particular waterfall is fair or not?"
Thank you, Joe Average
The first thing I do is compare the waterfall to the average for the asset class and strategy.
What's average? I look at perhaps 100 deals a month, so it's pretty easy for me to instantly eyeball something and know where it falls. But if you're new, you'll have no idea. So here's some help on what I'm currently seeing in the market:
Value-added multifamily: Since this describes 85%+ of the deals out there today, I'll talk about this one first. The average here is a single profit-split tier that is between 75%-85% to the investor and 15%-25% to the sponsor.
Other mainstream asset classes (office, retail, hotel, self storage): Same as above.
Supply-constrained asset classes (mobile home parks): These are asset classes which are more difficult for sponsors to either source deals or manage them and they tend to have higher splits. Mobile home parks are both (there is no equivalent of the MLS for apartments to buy, and many sponsors have to develop the property management expertise in-house). So, currently, I'm seeing the investor typically getting 60-65% (with 35-40% going to the sponsor).
Core and core plus strategies: These generally have the same profit splits as value-added, but will have a lower preferred return (5-6% instead of 5-8%). This makes sense, because along with less execution risk they also tend to have a lower return, and the sponsor needs to be compensated fairly to keep the lights on.
So using the above, you can tell if something is out of line or not.
If it's within averages, I'm happy and move on to my next steps of due diligence. (See the Conservative Investors Guide to Picking Real Estate Investments).
But what if it isn't within the average?
Some people may choose to just walk the other way at that point. Personally, I look a little closer, and occasionally I end up making an exception. Here's how I do it...
"Uncompetitive" or "highway robbery"?
The first thing I look at is just how badly out of line the deal is.
If it isn't horribly out of whack (the split is within 5 percentage points of the bottom of the average), then I look to see what I feel about the sponsor and the deal. If I love both, then I will often overlook the profit-split's flaw.
As an example, maybe it is a value-added multifamily that is a 70% (investor)/30% (sponsor) split. That's very uncompetitive with other options. However, perhaps the sponsor has multiple real estate cycle experience with no money lost (something that 99% of the other offerings don't have). And I personally feel we're late in the cycle, so as a conservative investor I prefer to avoid green sponsors. (I don't want them learning expensive lessons with my money in the next downturn). So if I loved the sponsor and the deal, I would pay the uncompetitive split. To me it would be worth it.
On the other hand, if I'm only so-so about them, then I toss the deal and move on to something worth spending more time on.
One important side effect of an uncompetitive split, is that it can drastically skew the risk/reward nature of an investment. And this can change the way a sponsor behaves. In his interview on sponsor alignment, Paul Kaseberg talked about this dynamic.
Kaseberg said that the "dirty secret" of the real estate investing industry is that the profit split financially incentivizes sponsors to push the risk envelope more aggressively. And the more generous the split to the sponsor, the more it is in their best interest to take risks.
As a conservative investor, this is the opposite of what I want my sponsor doing. So this is another reason I look at these deals much more carefully. On the other hand, an aggressive investor wants the sponsor to push the risk envelope as much as possible (to have the best shot of hitting the high projected returns). So an aggressive investor may be perfectly fine with an uncompetitive split (and even prefer it).
"Reach for the sky!"
Sometimes the split is severely out of whack (worse than 5 percentage points off the bottom of average). Some investors use words to describe them like "exploitive" or "highway robbery". With so many other options out there, it's hard for me to imagine liking any sponsor or deal so much. When I see this it's an immediate red flag for me, and I walk away.
What I've also found is that a deal structured like this is often a sign of a sponsor who's targeting unsophisticated investors. And in my experience, such sponsors aren't going to offer a deal worth my time. In addition to usually being much more expensive, many of the sponsors take more risks than I'm personally comfortable with (including but not limited to higher leverage, lower skin in the game, overly-optimistic pro-formas). These techniques enable them to market the high projected returns that unsophisticated investors generally love and more experienced investors look at suspiciously. As soon as I feel a sponsor is targeting unsophisticated investors, I take that to be a red flag and move on.