When examining the different fee structures in real estate deals not only is it important to look at the fees charged against the investment portfolio, but also at the fees charged by the sponsor against the project because this effects the potential of any upside returns in excess of the preferred returns.
Fees charged by the sponsor to the project may include:
- A yearly management fee
- A yearly asset management fee
- A construction fee
- An asset disposition fee
Russell Research has an in-depth analysis of these fees in a downloadable pdf report called Management Fee, Carried Interest, and other Economic Terms of Real Estate Funds.
Exit Participation by Sponsor
On top of the fees charged by the sponsor to the ongoing project, there is usually a provision for exit participation in profits that are in excess of the preferred returns for investors. Let’s examine the effect on these fees and participations, which may take various forms including:
- 80/20 split after preferred return - 80% to investors, 20% to sponsor
- 70/30 split after preferred return - 70% to investors, 30% to sponsor
- 50/50 split after preferred return - 50% to investors, 50% to sponsor
- 80/20 split after preferred return to 15% IRR then 50/50 split thereafter - 80% to investors, 20% to sponsor until the investment has returned 15% IRR then 50% to investors, 50% to sponsor
- Catch up Style - Preferred return to investor, then equivalent preferred return to sponsor, then 60/40 split - Investor get preferred return (10%), the sponsor get an equal amount of return (10%), any remaining profits are divided 60% to investors and 40% to sponsor
For an investment of $100,000 with a preferred annual return of 10% and a 50% extra profit on exit after year five, here is how the calculations work out when comparing these investment programs:
| Initial Investment | $100,000.00 | Yr1 | Yr2 | Yr3 | Yr4 | Yr5 | EXIT | TOTALS | Gross Profit | |
| Return | 10% per year | $10,000.00 | $10,000.00 | $10,000.00 | $10,000.00 | $10,000.00 | $50,000.00 | $100,000.00 | ||
| Project Fees | ||||||||||
| no fees | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $100,000.00 | |||
| 1% annual fee | $1,000.00 | $1,000.00 | $1,000.00 | $1,000.00 | $1,000.00 | $5,000.00 | $95,000.00 | |||
| 2% annual fee | $2,000.00 | $2,000.00 | $2,000.00 | $2,000.00 | $2,000.00 | $10,000.00 | $90,000.00 | |||
| Deal Structure | no fees | 1% annual | 2% annual | |||||||
| 80/20 | Gross Profits | $90,000.00 | $85,000.00 | $80,000.00 | ||||||
| Total IRR | 90.0% | 85.0% | 80.0% | |||||||
| Annualized | 18.0% | 17.0% | 16.0% | |||||||
| 70/30 | Gross Profits | $85,000.00 | $80,000.00 | $75,000.00 | ||||||
| Total IRR | 85.0% | 80.0% | 75.0% | |||||||
| Annualized | 17.0% | 16.0% | 15.0% | |||||||
| 50/50 | Gross Profits | $75,000.00 | $70,000.00 | $65,000.00 | ||||||
| Total IRR | 75.0% | 70.0% | 65.0% | |||||||
| Annualized | 15.0% | 14.0% | 13.0% | |||||||
| 80/20 to 15% IRR | Gross Profits | $72,500.00 | $70,000.00 | $67,500.00 | ||||||
| then 50/50 | Total IRR | 72.5% | 70.0% | 67.5% | ||||||
| Annualized | 14.5% | 14.0% | 13.5% | |||||||
| Catch Up Style | Gross Profits | $50,000.00 | $50,000.00 | $50,000.00 | ||||||
| no extra returns | Total IRR | 50.0% | 50.0% | 50.0% | ||||||
| Annualized | 10.0% | 10.0% | 10.0% |
As illustrated by these comparisons, the returns are strongly affected by the change in any fees charged to the project and IRR limits. With the “catch up style,” any extra returns go to the sponsor in the case of where there is a 50% return on exit because this is equal to the investor’s preferred return of 10% per year. Investors would be wise to carefully consider the ongoing fees charged to the project and the sponsor participation.
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