A Warning to Passive Investors: Why Your Sponsor's Incentives Might Be Misaligned with Your Own
How common fee structures in real estate syndications can undermine long-term investor returns.
As a passive investor in real estate syndications, you rely on the General Partner (GP) or sponsor to act in your best interest. However, a closer look at common incentive structures reveals that they don’t always create the long-term alignment they promise. As Charlie Munger famously said, “Show me the incentive structure and I will show you the outcome.” In real estate, certain fee-heavy structures can incentivize short-term thinking and poor decisions that may leave investors with subpar returns.
Let’s break down some of the most common incentive structures and how they can affect a deal’s outcome.
The Problem with Sponsor Fees
I do not think that sponsor fees on their own are a bad thing, and I’ve participated in many syndications as a limited partner where there are modest fees in place. However, many sponsors have a very “fee-minded” approach and performance for investors can suffer because of this.
Acquisition fees are a big one here; this is a fee paid to the sponsor when the property is purchased and is typically 1-5% of the purchase price. Nothing is done to earn this fee beyond simply closing on the property. For instance, if I’m a sponsor purchasing a $10,000,000 property with limited partners, and I am charging a 3% acquisition fee, I will be paid $300,000 when the settlement occurs.
Closing on a $10MM property is certainly no small feat, and presumably several million dollars of both debt and equity must be raised for something like this. That is not easy to do. However, it is our belief that a sponsor should not be rewarded based on their ability to raise money, but on their ability to deliver returns to investors. In this business, you aren’t paid for your efforts, you’re paid for being right and executing well.
If I have a multiple six-figure payout (or even seven-figure payout) coming my way for simply buying a property, that can cloud my judgment and potentially lead me into doing a questionable deal that I otherwise would not have done if this “carrot” were not dangled in front of me. I don’t think it is difficult to see how acquisition fees CAN incent sponsors to make purchases. If I’m the sponsor in the example I gave above, I have 300,000 reasons to convince myself that this is a deal worth doing when it may not be. The human mind is very good at rationalizing the nonrational and justifying the unjustifiable. I’ve seen this firsthand on several occasions.
There are some other common fees such as asset management fees, although the main point of concern for me is the acquisition fee as this is usually the largest fee and is also received by the sponsor at the beginning of the venture prior to anyone else receiving anything, economically speaking.
I’d prefer to get rich with investors, and not from investors as many others are focused on doing.
The Pitfalls of Preferred Returns
A preferred return is a fixed rate of return, based on the investor’s capital contribution, that is to be paid first prior to a sponsor split, which typically follows. For instance, If I invest $100,000 in a syndicated deal that offers an 8% preferred return (pref), followed by a 70/30 split, I am entitled to $8,000 per annum prior to the profit split between investors and the sponsor. Essentially, my equity is in 1st lien position over the sponsor’s.
In theory, prefs are great and seemingly place the investor’s interests above the sponsor’s. The investors must be paid their pref prior to the sponsor being paid a penny, and this sounds like a good thing, in theory.
In practice, however, I have seen that prefs can cause the interests of investors and sponsors to diverge.
Pref payments generally accrue even if they are not actually paid, and this is where the problem can arise from. If I am a sponsor and purchase a property today, but that property has an extensive rehab planned to optimize and capture the most value, the pref will continue accruing for the investors regardless of the property’s performance.
If this is a large project undertaken by the sponsor, it may take a year or longer before the property is stabilized and operating at an optimal level. From the day of purchase and beyond the pref has been accruing for investors. This accrued pref payment to the investors can take a long time to catch up once the property is cash-flowing, and sponsors are not paid a single penny until this occurs.
Therefore, this can create an incentive for the sponsor to want to sell the property when they might not have, had this pref payment not been in place. If acquisition fees incentivize purchases, preferred returns incentivize sales.
A partner and I purchased a property over a year ago with investors, and there is a preferred return attached to this one. We ended up purchasing another property through this venture that went on the market about 2 months after the original purchase as having this property as part of the venture would be a great benefit to the overall value in the long-term.
While in the long run this decision should greatly boost returns for everyone, it delayed the distributions from starting for investors and the pref has continued accruing. It has been well over a year and myself and the partner have not received a single penny from this venture’s operations, nor will we anytime soon. However, the value created in the form of forced appreciation (we’ve drastically increased the property’s income, and therefore the value of the property) gives us a nice payday to look forward to. All we have to do is sell the property and we will be able to pay the accrued pref payment to investors, and then receive a handsome reward once we get into the profit split.
It might be in everyone’s best interest to sell the property, but we might also be better off holding onto it to let it continue generating cash for years to come, and hopefully have it increase in value as well. A pref payment can certainly get in the way of making the right decision here.
The Unfairness of IRR Hurdles
Of these 3 topics I’m discussing, this one has the least impact in terms of the incentive structure; however we still think it puts the investor and sponsor on unequal footing by effectively “capping” the limited partners’ upside.
An IRR hurdle(s), as it is commonly called, are tiers that designate different investor-sponsor splits based on the realized returns of a given syndicated deal. As the returns increase, the sponsor’s share increases as a percentage. This is meant to incent the sponsor to deliver great returns as their split will be greater as a result.
For instance, if I am doing a waterfall structure with IRR hurdles, I might offer a 70/30 split up to a 15% IRR, a 60/40 split for 15-20% and then a 50/50 split for anything north of 20% IRR. This is analogous to the US’s tax system that is progressive based on the amount of income earned. The more income earned; the more money is owed to the IRS as a percentage. In the case of waterfall structures, the higher the returns; the more money is owed to the sponsor.
My belief is that a waterfall with IRR hurdles acts less like a carrot and more like an insurance policy for the sponsor in the event that the deal wildly exceeds expectations (what a terrible problem that would be!). I don’t feel comfortable doing this and would prefer to have everyone be on equal footing without fees, hurdles or prefs.
Both the sponsor and the limited partners are taking on risk and should share equally in both the potential upside as they do in the potential downside.
My first investment as a limited partner was in 2019 when I was far less knowledgeable about syndication structures. This was an 84-unit apartment building in the Phoenix area that I invested $25,000 into. The property was purchased for $7,400,000 and had a $370,000 (5%) acquisition fee. It also had a 2% asset management fee based on the net income (top line rents), and a 1% capital transaction fee (based on refi proceeds). To top this all off, it also had a hurdle where anything up to a 20% AAR (average annualized return – non-compounding and easier to hit than IRR) was split 70/30 favoring investors, and anything above 20% was split 50/50.
“Feeing” a deal to death like this one is simply not a winning formula in the long-term. This group mentioned consistently struggles to raise money for new ventures and must rely on less sophisticated and less experienced investors to fund their deals. If they focused less on fees and enriching themselves at the expense of their investors, this likely would not be the case.
I consider myself extremely lucky to end up doing well on this one, and in my opinion the only reason I did was because they sold in 2021 at the top of the market. These exorbitant fees that reward the sponsor handsomely without them delivering any value to investors are a symptom, but not the root illness.
The root illness is short-term thinking, and this manifests itself in the form of high fees, hurdles, and other elements that put the investors and sponsor on unequal footing. I’d prefer to avoid that and enter into more of a long-term win-win partnership where we make money when investors make money.
A Winning Formula for Long-Term Alignment: Simplicity
The goal of any successful venture should be to get rich with your investors, not from them. By avoiding these misaligned structures, a partnership can focus on making the best long-term decisions for the asset, which is the only true way to maximize returns for everyone involved.
My view is that less is more when it comes to creating these deal structures. Not having a preferred return like almost every other syndication may seem counterintuitive, but I believe a simple split between the GP and LPs is going to allow the best outcome to happen for everyone.
Important: This information is for general purposes only and is not financial advice. Always seek professional guidance for investment decisions.