In this article, we’re covering an in-depth review of real estate private equity deal structures and fees. You should walk away from reading with a thorough understanding of answers to the following two questions:
How are private real estate investment deals structured?
Private real estate investment deals are structured in different ways. There’s the Single LLC structure, where the sponsor contributes equity as a class A member along with all other LPs. The next structure is similar, but the sponsor contributes as a class B member, keeping his equity separate from the other LPs. There’s the JV LLC model where sponsors and LPs invest in different entities, and the Delaware Statutory Trust, which is rising to prominence as a structure to take advantage of 1031 Exchanges.
What are the common fee structures adopted by sponsors of private real estate deals?
Common fee structures used by real estate deal sponsors include the acquisition fee, management fee, asset management fee, and disposition fee.
Deal structuring is the organizational hierarchy in which a deal is acquired, funded, managed, and eventually, held. Most importantly, it determines how profits are divided and how cash flows are allocated. A defined deal structure and outline of fees are the foundation of any successful real estate private equity deal.
When deciding what structure is best, sponsors must address the four following questions: Who will contribute to the capital stack? What preferred returns are expected? How will distributions be allocated? And, what level of control will be sought? Once the GP, perhaps with some input from the LPs, has addressed these questions, the appropriate deal structure and accompanying deal fees reveal themselves. For the purpose of this article, it is vital to understand the relationships between sponsor and investor, GP and LP, as well as Class A and Class B members. Based on the designated structure, the roles, responsibilities, and expectations of each member or entity may be affected.
Types of Deal Structures
Single Purpose Entity / Single LLC
Often chosen for its simplicity, the SPE-model is the easiest to comprehend. The defining feature of an SPE is the fact that the entirety of the equity is contained under a single entity in a structure similar to the one below:
Within the SPE structure, the sponsor, if choosing to co-invest, would contribute as a Class A member, side-by-side with all the other limited partners (LPs), with all cash flows to be treated equally on a pro-rata basis.
Class B members, typically the sponsor, seek a promote waterfall distribution per the LLC Member Agreement, based on the asset’s performance. This SPE structure is often pursued based on the clear distinction of cash flows between Class A equity distributions and Class B promote. Additionally, as outlined within the Member Agreement, the GP frequently retains a greater level of control over major hold/sell decisions, either through full discretion or subject to a member vote.
Sponsor contribution as class B member
The explicit distinction within this structure lies in how the sponsors’ co-investment contribution is categorized. As opposed to an SPE where the Class A equity contribution is inclusive of the GPs co-investment, the GP and LPs equity is separately siloed within this structure. The LPs, making up the majority of equity requirements (typically between 80% and 90%), retain their Class A Membership. Alternatively, the GPs contribution, as well as promote, is under a single umbrella under the Class B Membership. The cash flow waterfall reflects this delineation accordingly, as illustrated below:
Based on this tweak to the equity structure, cash flows can become more complex. Preferred returns cannot be realized until equity is returned. Because of this, comparing the returns between the GP and LPs is not always apples-to-apples due to the fact the GP promote is baked in, residing in the same entity as their original equity co-investment contribution.
The JV LLC
The JV LLC, short for joint venture LLC, is structured similarly to a sponsor contribution as a class B member. The treatment of cash flow is the same, but this time the sponsor’s contribution is placed in a separate entity from the rest of the investors. The difference in this structure is that there are now three entities, with the JV LLC having title to the property. There are no longer class A and class B members. The structure would look like this:
The JV LLC structure treats cash flows most similarly to those found within the Sponsor Class B Contribution-model; however, it differs in how the participating legal entities and deal control are defined. Within the JV-model, Class A and B Membership is replaced by two distinct LLC’s, each possessed by the GP and LPs under the JV LLC in the organizational hierarchy, as depicted below:
This structure is preferred as separate legal entities are designated, limiting the comingling of funds. Organizing as a JV LLC also allows for deal control to be more effectively assigned and may be favored when hold/sell decisions are to be retained by the LP. Deal control dynamics are outlined in the JV Agreement, as opposed to the Membership Agreements found within the first two structures. A manager is assigned, and powers designated therewithin. Vitally, the GP maintains day-to-day operational control over the asset in this model.
Delaware Statutory Trust
A Delaware Statutory Trust, or DST, while not new, has come into prominence with both sponsors and investors alike as an alternative real estate investment vehicle. A DST is a separate legal entity that allows for co-investment with sponsors and other investors, either into a single asset or across a portfolio of properties. The structure places full control in the hands of the trustee – the sponsor – while the Trust itself is made up of individual investors, each with beneficial shares in real property, or more simply, a direct interest in real estate.
Operating similar to a Tenant’s in Common, or TIC, structure, a DST possesses several favorable characteristics allowing for greater individual investor autonomy, and has widely replaced TICs amongst common investors. Sponsors favor DSTs as a vehicle to gain access into the widely used 1031 exchange marketplace, thanks to a 2004 change to tax legislation, as well as an alternative strategy for recapitalization. Investors favor this structure as a passive alternative to self-managed real estate investment or a tax-friendly alternative to a ground-lease or a REIT investment.
Due to tax laws, many of the promote or waterfall distribution models seen within the other structures detailed above are not applicable here. Conversely, distributions derived from fractional interests are handled on a true pro-rata basis. While Disposition, Property, and Asset Management fees are collected by the Sponsor in similar fashion to the precluding structures. Often times Sponsors seek higher Acquisition Fees (6-9%), specifically when seeking a recap. We’ve written a full guide on this structure, click here: Delaware Statutory Trust.
Prior to choosing the appropriate deal structure, it is important for sponsors to address the four questions mentioned above: who will contribute to the capital stack? What preferred returns are expected? How will distributions be allocated? And, what level of control will be sought? Each deal is unique. Each LP has its own investment profile. It is important to match the structure to each deal and LP(s) accordingly, as each profile may lend more favorably to varying structures.
As a sponsor, it is in your interest to go above and beyond to clearly outline your chosen waterfall and promote structures with your LPs, not only within your marketing materials but directly. An explicit understanding on the front end fosters a more accurate sense of investor expectations, and in turn, increases the likelihood of satisfied and repeat LP relationships.
Private Real Estate Deal Sponsorship Fees
Fees are paid to GPs to compensate them for their time and commitment to making money for all the investors involved. These fees may or may not be directly tied to the performance of the asset. There are four fees we are covering: the acquisition fee, management fee, asset management fee, and disposition fee. Although there are many other potential fees that can be taken, these are the four most common fees you will see in a commercial real estate deal and the easiest to justify to investors.
Summary of Real Estate Deal Sponsorship Fees
The acquisition fee is the most prevalently used for real estate deal sponsors, commonly around 1.5% but can vary between 1% and 2%, depending on the size of the deal. Typically, the bigger the deal, the smaller the rate.
The manager puts in a lot of work to find and acquire the right deal. They conduct financial analysis and due diligence in the process of making important decisions about significant capital investments. This work justifies the acquisition fee.
This fee is paid based on the total deal size rather than total equity invested. Most properties are acquired by leveraging significantly more debt than equity. Therefore, a 1% acquisition fee can sometimes equate to 3% or 4% of the equity invested.
The management fee is taken from the yearly revenue the property generates and is considered an operating expense. It is paid to whomever is managing the property, whether that is you as the sponsor or a third party. Generally speaking, the acting manager’s market rate is between 3% and 6% of the effective gross income.
Asset Management Fee
The asset management fee is given to the deal sponsor and used to pay for investment management services and compensate for the oversight of the investment, not dissimilar from asset management fees taken by other non-real estate investment vehicles. The fee ranges between 1% and 2% of the total equity invested, and is collected on a yearly basis.
Different from the management fee, which is given to whoever is in charge of managing the day-to-day operations of the physical property, this fee is given for managing the assets as a whole. The fee is paid because the asset manager sponsors the whole deal, overseeing the group in charge of managing the property, communicating with investors, distributing regular performance reports to investors, and managing the deal’s finances, such as when distributions are made.
Disposition fees are the sell-on fee taken when an asset is sold at the end of the hold period. In some structures, it may be best to think of them as a slight tweak to the cash waterfall model, upon sale. The GP receives a 100% distribution, effectively functioning as the fee, at which point the remainder of the waterfall kicks in. Oftentimes the disposition fee is tied to the performance of the property. The fee is paid as a percentage of the property sale, typically equal to or less than the rate of the acquisition fee. In certain cases, if the property does not perform well, a GP may waive their right to a disposition fee.