Real estate is an illiquid asset class and, therefore, when someone invests in a real estate deal, they will often have their capital tied up for at least a few years. This type of commitment requires significant trust. An investor will want to have faith that the sponsor is working diligently to execute the business plan as intended.
Of course, building trust can take time. Having full faith in a sponsor may only come after a project is complete—after an investor earns their returns and sees that the sponsor performed accordingly (or better yet, beyond expectations).
Short of completing a deal together, another way to foster trust is by ensuring the sponsor’s and investors’ interest are aligned. When one does well, so does the other – and vice versa. This usually requires the sponsor to co-invest in the deal (to ensure they have “skin in the game”) and will influence how profits are distributed to whom and when.
How to Determine Alignment of Interests
There are two factors, specifically, that investors should look at when trying to determine whether the sponsor’s interests are aligned with their own.
Sponsor Investment in Deal
First, investors should always consider whether a sponsor is co-investing their own equity in a deal. By co-investing, this indicates that the sponsor is a true believer in the deal and likewise, has “skin in the game”. How much equity a sponsor invests may vary. Well-heeled sponsors may have the ability to invest proportionally more than a sponsor with a weaker balance sheet. There is no set amount (percentage or otherwise) that is indicative of a sponsor’s commitment. Instead, the sponsor should invest at least enough that, if something were to go wrong, the sponsor would feel the pain and would be motivated to course-correct to preserve its own equity in addition to that of investors.
Investors will want to understand how a sponsor is being paid. Some sponsors will simply collect fees. This is not inherently problematic if the fees are collected incrementally throughout the deal, with the most significant fees paid based on performance and closer to the deal’s closeout. But not all deals are structured that way. Some sponsors will frontload their fees, something that should be a red flag for investors. Those who only collect fees, especially those who collect fees early on, are not incentivized to carefully manage the project through to completion. Real estate is illiquid, and deals can often take three, seven or even ten years to close out. You want to be sure a sponsor is fully invested throughout the duration of a project. If they have already earned the bulk of their fees, they will be less motivated to perform. Instead, they will simply continue collecting their fees, regardless of how well a project performs and regardless of the rate of return generated for investors.
A better way to ensure alignment of interests is using a payment structure in which the sponsor only collects fees periodically and based on performance, such as achieving certain milestones. For example, a sponsor may collect a modest one percent acquisition fee after a deal closes (i.e., all due diligence is now complete), a small monthly property and/or asset management fee (usually around five percent), and then a bonus fee upon certain construction and/or leasing milestones. An investor will want to compare the sponsor’s fees with those being charged by the sponsors of other projects to ensure the proposed fees are commensurate with market standards.
An “Ideal” Alignment of Interests
In an “ideal” situation, a sponsor would limit the fees they collect and instead, would rely on earning a substantial return based upon the success of the project. This may include a property management and asset management fee, as some income is needed to pay for the team providing day-to-day property management and project oversight (e.g., overseeing the partnership, making decisions about financing, etc.). But the balance of a sponsor’s profits would be earned only after investors have received their preferred return.
This return on a sponsor’s equity is often referred to as a “promote.”
Here is a simple example. Let’s say investors in a value-add, cash flowing multifamily deal are promised a seven percent preferred return. This return is cumulative. If cash flow distributions equate to six percent one year, the investors would be paid eight percent the following year before the sponsor collects any return on its equity investment. In year three, the property generates another eight percent return. In this case, a sponsor earning a 30 percent promote would get 30 percent of that additional one percent profit (one point above the seven percent owed to investors). The balance is split among investors.
Upon refinance or sale, investors would get their capital back plus any unpaid preferred return. The sponsor would then collect its 30 percent promote on any profit above and beyond the preferred return.
A structure like this ensures that a sponsor is motivated to execute above and beyond expectations. The more profit the project generates, the more a sponsor could potentially earn – but only after investors have been repaid their preferred return.
Real Estate Equity Waterfalls Can Vary Drastically
Real estate equity “waterfalls” are a way to describe how profits are accumulated and then flow down to various investors and the sponsor. In the example above, the investors earn a preferred return before the sponsor can earn their promote. It is important to understand that the structure of real estate waterfalls can vary drastically from deal to deal. Some are much more nuanced than others.
For example, a sponsor may earn a higher promote after reaching certain hurdle rates. A sponsor may earn a 30% promote until investors have received a 18% IRR after which point the sponsor may earn a 40% promote on excess cash flow.
The ability to earn an oversized share of the profits is one of the many ways to incentivize a sponsor and further ensure alignment of interests.
Alignment of interests doesn’t ensure a sponsor will diligently pursue execution of their business plan through completion but investment and profit structures that foster this alignment protect investors by giving the sponsor a meaningful incentive to stay engaged throughout the hold period. Investors should always read through offering materials carefully to understand how each deal is structured. Then, investors should ask questions to be sure they are comfortable with the structure that the sponsor is proposing. Ultimately, an investor will need to use their best judgement to determine whether a sponsor is sufficiently vested in a deal. Those who are incentivized to perform are more likely to do just that.
At Jacobson, we believe alignment of interests is the foundation of any successful sponsor/investor partnership. Contact us today to learn more about how we structure our deals to be mutually-beneficial for all of those involved.