The High Cost of Low-Fee Real Estate
This article was originally published on Valuewalk.
Real estate investment opportunities are frequently marketed to investors by advertising their low-cost fee structure. Phrases such as, ‘fees paid by manager,’ ‘manager pays all deal related fees,’ or ‘no fees paid by investor’ sound great, but does the manager really pay all those fees? Unfortunately, it’s very common for private investment managers or platforms that partner with managers to utilize deceptive marketing practices regarding the fees they charge.
Private investment fees don’t have the same regulatory scrutiny as public investments, and there is no standardization behind how fees need to be shown. To be clear, private investment sponsors are still legally obligated to provide investors with material information about their offering, but it’s up to each sponsor to choose how to share the information. This lack of consistency causes investor confusion because each sponsor uses different marketing materials and tactics to show the same information. The irony is that sponsors who are forthright about their fees are often penalized by the investment community because they look high, relative to the sponsor who buries their fees three layers deep. This puts the onus on the investor to figure out if they are being enticed by deceptive marketing practices or receiving accurate information.
Here’s how these advertising tricks work in practice and why it matters:
Let’s say a deal is advertised with the language, ‘investors pay no upfront fees’. What this means is that the investor does not pay the fees directly, but there is a high likelihood they pay them indirectly. In this example, let’s further assume that the sponsor pays a broker 4% to raise money from potential investors. On a $10 million capital raise, the fee equates to $400,000. In almost all cases, the sponsor does not pay for this expense out of his own pocket. Instead, he adds the expense to the capitalization of the deal. In other words, a sponsor who raises $10 million to acquire a real estate asset may only need $9 million for the property acquisition itself. The other $1 million is raised to pay for legal, capital raising, acquisition, and due diligence costs. And, because investors typically make up 90% or more of the invested equity, they pay 90% or more of these fees.
This detailed fee information can be found in the Sources and Uses of Capital section of the marketing materials and the Private Placement Memorandum. By law, every sponsor has to tell investors the intended use of the proceeds, but they don’t have to make it easy to find or understand. Here is what the Sources and Uses section for a $30 million property acquisition might look like:
|Legal & Due Diligence||$165,000|
|Capital Raising Fee||$400,000|
The sponsor simply throws every fee into the cost of the deal, which means the investor bears their pro rata share of the expenses. Again, if the investor makes up 90% of the equity, they bear 90% of the expenses.
Here is what the Sources and Uses of Capital section of the marketing materials would look like in the event the sponsor paid the fee:
|Legal & Due Diligence||$165,000|
Why does this matter? In this case, the amount of equity required by the investor is reduced by $360,000 (or 90% of $400,000). The investor is buying the same deal but putting in 4% less. While this fee may or may not break a deal, one must question sponsors and middlemen who resort to tactics such as this. What else are they hiding and why should you trust the rest of the information?
That being said, it’s a standard practice in private real estate investing for sponsors to include every expense into the cost of a deal. What is not standard is using deceptive marketing tricks to make it appear as if this is not the case. Most sponsors simply don’t have $400,000 to pay a broker out of their own pocket, but that doesn’t mean you should pay for it. An efficient sponsor will keep costs at a minimum and not use brokers or charge exorbitant front-end fees. And, investors should not be swayed into one deal over another just because the fees appear to be lower. Many sponsors, unfortunately, don’t have a true value proposition, so they use low fee marketing tricks to attract capital. If you are being lured into an investment or onto a website because of the fee structure, think twice.
Fees are important to understand and consider when vetting opportunities but should not be the only consideration when choosing between one investment over another. What’s more important is how the fees align the goals of the sponsor with those of the investor. Look for a sponsor who invests significantly alongside investors, has a track record of winning, and gets paid the majority of their fees after they’ve performed.