Investing in multifamily real estate syndications involves research. You need to look at several different aspects of a project before deciding whether it is a good opportunity for your self-directed IRA or Solo 401(k). In our first articles of this series, we discussed performing diligence on the sponsor and the project. In this article, we want to look at how sponsors are compensated for their efforts and how that can impact your return as an investor.
It is the role of the syndication lead to identify a suitable property and execute the project. How sponsor compensation is handled can tell you a good bit about the experience of the team, whether they are properly incentivized to work for your benefit, and what kind of return you can realistically expect.
Because each deal is unique, there no set framework of fees that can be used as a benchmark. What you should strive for is to understand the various fees that may apply. You can then use that knowledge to ascertain if the overall compensation going to the project sponsor is reasonable and in line with the amount of work a particular project requires.
Most syndications have three to four phases, depending on the deal type. You will want to know what costs will apply to each phase and how much of that cost is going to the sponsorship team for several reasons.
Firstly, once you have seen several deals of a particular type – especially if you have previously participated in some – you can get a feel for whether the projections are realistic.
Secondly, the way sponsor compensation applies at each stage helps you identify if the proper incentives are in place to ensure full engagement by the sponsor for the life of the project.
Common phases include:
- Construction or Rehab
- Exit at Sale
Some projects may not have all four of these phases or may have a very short duration construction or operations phase.
Putting deals together takes time, energy, and expense. A sponsor may look at several potential deals before identifying a suitable project and will have put a good bit of resources into finding the right deal. Compensation to the sponsor at this stage helps them cover those expenses and provides capital to keep their operation going. It may be several years down the road before they see any meaningful income from a deal.
Fees common at this stage might include:
Acquisition Fee 1-2% of the property cost is common, but this may be higher on smaller deals or if some of the other expected costs of this stage are being rolled into this one fee type.
Financing Fees A sponsor may have a separate fee for the work necessary to procure financing. This may be in the range of .5 – 1% of the acquisition cost.
Placement Fees Compensate an internal or external team used to raise investor capital. A 2-3% range is normal.
The above fees will typically be separate from certain transaction related costs such as realtor commissions, loan fees, legal fees, diligence costs, etc. If you are not seeing some of these items listed separately on a deal sheet, they may or may not be included in some of the sponsor fees depending on whether they are addressed in-house or by 3rd party providers. It makes sense to ask if you are unsure.
A higher acquisition fee makes sense if it includes 3rd party diligence or fundraising. If there is an abnormally large list of itemized acquisition related costs, then you might expect the acquisition fees going to the sponsor to be lower.
Construction / Rehab Fees
In new build or value add projects involving upgrades to the property, the sponsor may have responsibility for project management of the construction phase. The nature of the work required and the type of resources the leadership team has in-house will drive fees at this phase.
If little work is required, or if the sponsor is bringing in a professional contractor that is largely self-sufficient, there may not be any sponsor added fees.
If the sponsor is providing oversight and project management, there could be fees associated with this effort in the range of 3-5% of the construction costs.
In some smaller deals, the sponsor may have an in-house construction team and may just include the costs of construction with a set markup as a line item separate from sponsor fees.
In this area, you have to rely on the “does it make sense?” level of evaluation. Each deal and each team’s approach to the construction phase is unique.
Most syndicators charge some form of asset management fee for oversight of the property on an ongoing basis. This fee may cover accounting, investor reporting, and paying out investor returns – or those may be listed as separate expenses.
The compensation method may vary, and could be 1-2% of the asset value, 2-3% of rents collected, or something in that range.
This type of fee should cover the sponsor’s costs specifically related to project operation and keep them actively engaged. It should not be a big source of profit for the sponsor.
In most deals, the sponsor will offer a preferred return to investors in the 7-9% range during the rental operations phase. This represents the annualized return based on the amount invested and serves as the baseline beyond which profits are split between investors and the sponsor.
Sponsor Promote is the term often used to describe the percentage of profits to the partnership that are allocated to the sponsor.
The promote cut for a sponsor can range widely, but something in the 20-30% range is common. More experienced sponsors with a solid track record of success may command a higher promote.
In some deals, you might see a tiered promote, with the share going to the sponsor increasing if they hit certain performance goals such as a higher internal rate of return threshold.
Be sure to understand how much capital the sponsor has in the deal, and if they get paid purely with the promote or if they receive preferred return on their own capital as well as the promote. The latter scenario is rare but would call for a lower promote percentage.
In most new build or value add deals, the real money is made at the time of sale. Sometimes the same sponsor promote percentage that applies to operating income will apply. In other cases, there may be a separate allocation for profits on sale.
It is important to ensure the split is fair to both investors and the sponsor, but also that it properly incentivizes the sponsor to execute the project to a profitable conclusion. If the bulk of the sponsor’s compensation is loaded towards acquisition and operations, they may not have as much incentive to sell at the best time for investors. If the profit on sale is overbalanced relative to compensation the sponsor receives during the life of the project, they may rush a sale before the market is ripe.
The nature of the deal will also help you to evaluate the right balance of how and when the sponsor is compensated. On a longer hold of a stabilized property, you might expect more compensation to the sponsor during the acquisition and operations phases.
It is not uncommon for a sponsor to charge a disposition fee of around 1% for the work associated with selling the property.
The more you understand about how sponsor compensation in a real estate syndication works, the better prepared you will be to make a judgement on the worthiness of a specific deal. Each deal is unique and different sponsors take different approaches to how they structure compensation and profit splits. It takes looking at a lot of deals to develop a sense for what strikes the right balance for a particular type of project.
If you are new to this type of investing, seeking guidance from a seasoned mentor, CPA, or attorney is wise.
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If you want to learn more about Multifamily Real Estate Syndications and how they can be a great way to invest with your self-directed IRA or Solo 401(k), please download our free guide.