An Introduction to Private Real Estate Investment Fees
Before choosing with whom to invest with, investors should be extremely familiar with the fees they charge. Real estate investing requires a dedicated team of people to be successful and fees help pay for that team.
Someone must find the property, negotiate the price, create marketing materials and legal documents, raise equity, manage the day-to-day operations at the property, formulate and execute the business plan, report to investors, provide K-1’s, sell the asset and distribute the proceeds. A great team does not come cheap, and fees help managers attract and retain high-quality employees.
Unlike the public markets, real estate is not a business where you want to base a decision on fees alone. There is a big difference between price and value and low fee real estate deals can end up being very expensive. The quality of a business plan and the asset manager who runs it make the most impact on the success of a real estate investment. Fees are a function of the complexity of a business plan and should be correlated to the value the manager is able to create.
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Fees should be outlined clearly in a private placement memorandum or in their marketing materials. Besides just reading the materials, investors should ask about every possible fee because sometimes they can be buried.
There are two main types of fees in real estate investment management: transaction fees and performance-based fees.
Real Estate Transaction Fees
Transaction fees are guaranteed. The manager gets paid these fees regardless of how the deal performs. Below are the most common transactional fees:
Acquisition Fee: This fee is most common amongst managers syndicating individual deals. The acquisition fee is usually between 1% and 2% of the total deal size and is generally on a sliding scale. The bigger the deal, the lower the fee. This is a market rate fee and is justified because the manager probably looked at 50 deals to find this one. The manager already paid all of the dead deal and personnel costs out of their own pocket.
Acquisition fees are paid on the total deal size, as opposed to equity invested. This is a significant difference because a 1% acquisition fee on a $30 million property comes out to $300,000. Most properties are typically leveraged using two-thirds debt, so the required equity may only be $10 million, meaning that $300,000 fee equates to a 3% cost of equity invested.
Committed Capital Fee: This fee is typically charged by called capital real estate funds and ranges from 1% and 2% on committed equity. The manager receives this fee even if the capital is not invested. If a committed capital fee is charged, an acquisition fee should not also be collected, as this is what the industry calls “double-dipping.” Unfortunately, many managers try to get away with double-dipping when serving individual investors, so be careful.
Investment Management Fee: This fee is charged by both fund managers and managers sponsoring individual deals and is sometimes referred to as the Asset Management Fee. For real estate funds, this fee replaces the committed capital fee once the capital is invested so that investors are not being charged on the same capital twice. The commitment fee is reduced proportionally as money becomes invested. This fee ranges between 1% and 2% of invested equity and is used to pay for investment management services. This fee should be a function of invested equity and not total deal size.
Set Up and Organizational Fee: Both real estate funds and managers of individual deals incur set-up costs. These are typically passed through to the investment entity and paid by all investors. One-time upfront costs include legal, marketing, technology, investor relations, and other costs associated with capital raising and forming the investment company. This fee is typically between .5% and 2% of total equity.
For individual deals, these are generally not a line item easily identified in the marketing materials and are often costs that are lumped into the property’s acquisition cost. Investors should be aware of this line item and ask the manager to explain the terms in specific detail to know exactly what this fee is being used for.
Administrative Fee: These fees cover tax reporting, audits, fund administration and third-party software. They typically range between .10% and .20% per year on invested equity.
Debt Placement Fee: This is a fee that is often paid to an outside broker, which is standard industry practice for lining up debt. The typical fee is between .25% and .75% of total debt, depending on deal size. A good broker can save a project a lot more than the cost of this fee. However, some managers try to layer on their own internal fee on top of a debt placement fee to the tune of between .25% and .75%. This is very impactful to equity, as the amount of debt used in a typical transaction is two times larger than the amount of equity.
Refinancing Fee: This is similar to a debt placement fee and some managers charge between .25% and 1% for this service.
Wholesale Marketing Fee: This fee is typically paid to the broker-dealer by non-traded REITs for product distribution and equates to roughly 3% on equity.
Advisor/Syndication Fee: Some real estate companies such as private REIT’s use broker-dealers to distribute their products through an advisory network. These advisors are typically paid an upfront, one-time fee of between 4% and 7%. Some sponsors will charge a smaller upfront fee but add acquisition or transaction charges. Often these commissions are hidden in the fine print that itemizes capital spending.
Joint Venture Fees: By themselves, joint ventures don’t add another layer of fees, but the investor is then paying two managers instead of one. If the investment manager is simply providing access, then those fees should be much lower than a manager who adds value to the joint venture by executing the business plan.
Selling Fees: It’s always good practice to take a project to market to generate the highest value. Typically, brokers are paid between 1% and 3% of sales price, depending on project size. Some managers charge their own internal fee between .25% and .75% on top of that.
While this may seem like a lot of fees, a good manager will limit what fees they charge and how much. Transaction fees are meant to keep the lights on but not be a profit center for the company. While we don’t believe fees should guide a decision, they can tell you something about the manager. A manager trying to extract every last penny out of the deal through guaranteed transaction fees is a clear sign that they don’t have the investor’s interests in mind.
Private Real Estate Performance-Based Fees
Performance fees are variable, based on the success of the real estate investment. They are common in nearly every private equity investment — even beyond real estate — and are used to align the interests of the manager with those of the investor. The typical performance/incentive fee entitles the manager to between 20% and 30% of profits.
An investment waterfall is a method used in a real estate investment to split the cash profits among the manager and the investor to follow an uneven distribution. In most waterfalls, the manager receives a disproportionate amount of the total profits relative to their investment. For example, a manager may only put in 5% of the investment capital but be entitled to 20% of the profits.
Performance fees are usually subject to what is called a preferred return hurdle, which is the rate of return tier (usually as defined by a certain IRR or equity multiple) that must be met before the manager begins to participate in the profits. These tiers are what define the various profit splits. The preferred return typically ranges from between 7% and 10% annually and can be viewed as an interest rate on investor capital, but it’s not guaranteed.
There are two common types of waterfall structures used in both real estate funds and individual deals — European and American. In a European waterfall, 100% of all investment cash flow is paid to investors in proportion to the amount of capital invested until the investors receive their preferred return, plus 100% of invested capital. Once these distributions have been paid out, then the manager’s portion of the profits increase. This is the most common waterfall used in real estate fund structures.
In the American waterfall, the manager is entitled to receive a performance fee prior to investors receiving 100% of their capital back, but usually after receiving their preferred return. To protect investors, there is usually a caveat in the documents that states the manager is only entitled to take this fee so long as the manager reasonably expects the fund or deal to generate a return in excess of the preferred return. It’s not uncommon for income products that have longer hold periods to be structured with this type of waterfall or deals withhold periods that are longer than 10 years.
When vetting private real estate investment opportunities, look for a fee structure that is largely performance-based, so the manager wins when the investor wins. There is a difference between fees that are used to create investment value and exorbitant fees that simply make the managers of private equity real estate funds wealthy at the expense of their partners. But in the end, fees should guide — not drive — an investor’s decision about whom to invest with. What matters most is the return on investment after all fees are considered and if that is an appropriate return for the level of risk.