Not surprisingly, the most important factor in investment performance of real estate partnerships is property appreciation. But, the fees charged the partnership by the sponsor run a close second. Some observations from studying both private and public real estate partnerships, the latter where such data is more readily available:
• Low fees, or investor charges, can allow the passive, or limited partner as much as a 50% larger return on investment than high fees, assuming identical property appreciation.
• An overall high level of fees can neutralize significant differences in property appreciation, say the difference between 7% and 10% appreciation per annum.
• A high-fee partnership would have to raise rents up to 50% faster than a low-fee partnership to make up for bad offering terms.
• Adverse offering terms can also neutralize favorable property acquisition prices. For example, the sponsor of a "bad" deal must acquire property 20% below the price paid by a "good" deal to provide the same return to the limited partners.
• The faster property appreciates, the more disadvantageous are high fees.
• Picking real estate programs with low fees maximizes your chance of achieving the best overall economic result.
Here are some rough guidelines you can use.
Differences in front-end fees among publicly registered programs (again, this data is more readily available than data from private transactions) impact the limited partner's rate of return more than twice as much as any other component in deal structure. Variations in operational fees are of second highest importance.
Differences in liquidation fees are the third most important factor; however, as leverage increases, liquidation fees become more important relative to operational fees.
When investing in a real estate program with relatively high liquidation fees or relatively low leverage, it’s important to look closely at the program's provisions for "cumulative preferred return" to the limited or passive partner. ("Cumulative preferred return" refers to the limited partners' receipt of initial investment, plus a minimum annual return on investment before the general partner receives compensation.)
It goes without saying that a high cumulative preferred return increases the investor's share of partnership earnings considerably.
OTHER FEE CONSIDERATIONS
Fees in private placements are not the most important factor in judging a transaction's value. The price the partnership pays for the property is the single most important element in analyzing any real estate private placement transaction. As we show with The EQUALIZER™ (see THE MATH), you calculate the property price by adding the discounted value of all the equity capital (including interest) contributed by the passive partners to ALL the debt to which the property is subject at the conclusion of the pay-in period. That's the adjusted purchase price in dollars.
Compare this price to other comparable properties according to the standard measures of real estate value: gross rent multiplier; price per square foot; capitalization rate (net operating income divided by adjusted purchase price—The EQUALIZER™); and the sale price of similar properties in the same location.
PROPERTY PRICE & FEES
If the real estate is fairly priced, the importance of fees declines. But, one difficulty with this truism is the inability of most investors and financial intermediaries to determine whether a property price is "fair," or "on the market." Even other real estate professionals would have difficulty second-guessing the acquisition price of a property, because the price alone does not tell the whole story. For instance, a property with low rents and leases expiring in the near term could command a high price in relation to current income.
Fees paid to a syndicator are not all "add-ons." If you bought a property outright, you might well order and pay for an appraisal, you also might have an accountant construct an income statement for the property, hire a lawyer to close the purchase transaction, pay a real estate commission, and conceivably incur cost in refinancing the property. In addition, you might have to travel, investigate the property and negotiate the acquisition. In all cases, you are out both dollars and time.
In a private real estate partnership investment, the syndicator performs these services or sees they are performed. Reimbursement is certainly reasonable. In effect, the syndicator enables "passive" investment. The syndicator does the work for investors and provides economies of scale.
As with hiring any financial intermediary or investment advisor, the prime ingredients investors are paying for are experience and good judgment. The syndicator researches real estate markets and properties, analyzes individual transactions, and probably reviews hundreds of acquisitions before selecting one for purchase. The syndicator must negotiate with the seller of the property and put proper financing in place. Investors also pay for judgment concerning leasing, operating and finally disposing of the property.
The syndicator can be a risk manager by negotiating guarantees from the seller or by stepping in himself. As a result, investors can be partially insulated from the cost of renting up the property on time or operating the property at a cash loss.
Acquisition fees should reflect the true nature of the property buying process. Look at two examples: one syndicator acquires built, tenanted properties as high bidder through a real estate broker; another contacts a property owner, negotiates to buy from him directly and perhaps identifies an uncommon opportunity. The second syndicator provides added value and may be entitled to higher fees.
Also, the more functions the general/lead partner performs, the more compensation he or she may be entitled to. Some syndicators take no risk, acting as a "middle man" between a real estate broker and a securities dealer who finds investors. Others actually acquire the property as principal, renegotiate leases, change property managers, and refinance prior to syndication.
The timing of when the syndicator earns a profit from fees is important. If a profit is based only on the transaction occurring, or is paid in the early years, that can be worrisome.
Investors probably haven't gotten all that they bargained for at that point, but the syndicator is making a profit. On the other hand, if the syndicator is receiving compensation early, but only as reimbursement for costs and services, no harm is done.
You should look at "front-end fees" (fees paid during the pay-in period) as a percent of the total value of the real estate, not the equity capital contributions; otherwise, the degree of mortgage leverage may well distort the calculation if you don't.
If fees are compensation for actual costs, front-end fees should decline relative to total real estate value as property size increases. The expense, cost and time involved in putting a transaction together are fairly similar regardless of the size of the transaction.
You should prefer "back-end" compensation, fees which are paid to the syndicator when the property is sold. This way the syndicator keeps his eye on the ball. The syndicator's incentive is parallel to the investor's economic interest. Ideally, back-end fees should be paid only after investors have received their original investment back, plus a reasonable return.
In analyzing compensation, all fees to the syndicator at the back end of a transaction should be quantified in dollars and lumped together regardless of their label. On the basis of a hypothetical sale, you should determine the split of the total dollars between the limited, or passive, partner and the syndicator.
For a transaction with appreciation potential, the back-end split calculated this way should be in the range of 75%/25% or 80%/20% in the investor's favor. Transactions with limited appreciation potential should be closer to 90%/10%.
Be aware that in situations where "markups" are involved, they generally come in two forms. In one, the syndicator acquires the property and transfers it to the partnership at a higher price. Any cash resulting from a markup of this type should be added to the calculation of front-end fees. In another form, the markup is represented by debt, which is paid off from sale and refinancing proceeds. Here, the extra amount of the loan to be paid off should be added to back-end fees.
Comparing fees for different types of transactions may lead to erroneous conclusions. In transactions such as net leases and subsidized housing, where significant residual value is not anticipated, most of the syndicator's fees will be at the front end. The only source of payment is capital contributions. Back-end fees should be low. On the other hand, where residual values can be significant, you should prefer lower front-end fees and be willing to pay higher back-end fees based on performance.
Fees should also vary based on the type of syndicator you're dealing with. A professional, ongoing syndication company may review hundreds of transactions for each one selected. Overhead costs are significant. Personnel often include mortgage financing experts, in-house legal and accounting staff, engineering talent, market and financial analysis experts, etc. You'll benefit from the "value added," but you also have to consider the costs.
Some partnership investments are put together by "hobby" syndicators. These are often investors, who are just getting started with syndication, and whose main business may not yet be real estate syndication. Fees should be lower, because the syndicator is not absorbing the cost of the substantial ongoing overhead, nor are they committing to provide investors the same kind of service.
PROPERTY MANAGEMENT FEES
Be sure you look at management fees paid to the syndicator. Investors could be overpaying. Apartment projects require significant hands-on management. Conversely, many commercial rental properties subject to a net lease are almost entirely run by the tenant. Larger properties generally don't entail a linear expansion in the cost of management. Direct management should cost more than supervisory management.
Often in private placements, an asset management fee is charged. The function of asset management is extremely important. Be sure the service is performed. Asset management is preparing budgets, monitoring results, deciding on lease terms, refinancing and selling property, and considering the financial condition of the partnership and distributing cash flow.
A private placement is somewhat like a horse race.
Investors are invited to place their bets, but the greater the odds of victory, the more it will cost you to participate. The higher the profile of the race and the favorite horse, the greater number of investors that will want to attend; therefore, the higher the cost of the bet an investor will need to pay so they can have a chance of getting in on the victory.
The best deals, that combine sound economics and experienced sponsors, will command the highest bets. You should try to avoid events (and horses) that don't live up to their advance billing. Use common sense. Basic business instinct and judgment are almost always the best predictors of success. Talk to other people, who have been to previous races and bet on the same horses. Would they do it again?