Investors who are interested in placing their capital in private real estate deals are often initially enamored with the concept of participating in an exclusive investment opportunity that offers superior risk-adjusted returns. While it’s true that these investments can generate compelling outcomes, there are very real costs associated with taking part in them. However, these costs are not always obvious without intentional consideration.
In an age where the cost of investing in public markets has been dramatically reduced through technology and increased transparency, private markets are lagging behind. Whereas investors could have historically expected to pay at least 1% per year to invest in a stock fund, passive index funds have been driven down in cost to the tune of less than 0.10% per year. Fidelity has gone so far as to offer a suite of “zero funds” that are fee-free. Yes, you read that right -- investors can invest with a world-class company today and pay no fee to participate. However, participation in most private funds today still generally requires a bare minimum charge of 1% per year, and more frequently, management fees in private funds range from 1.5% - 2%. Additionally, private investments have no shortage of ancillary fees that are charged to investors -- and far too often, investors do not have a clear understanding of what fees they are paying.
Birgo Capital deeply believes investors should be adequately informed regarding all elements of their investment holdings and the costs associated with them. (We’ve published many educational resources to help investors make informed decisions). We also believe that it is perfectly reasonable to charge handsome fees for stellar performance. Investment firms have employees, and there are costs associated with operating an investment business; we keenly understand this and take no issue with it. The key is education and transparency -- investors should never be surprised about the fees that they are paying to participate in a particular investment. This article will attempt to improve industry knowledge and understanding by providing an overview of the various fees that exist within private real estate investments.
What is an Asset Management Fee?
This is generally a recurring fee that is a fixed percentage of revenues earned by a fund or project. This fee goes to cover the cost of the ongoing work of portfolio management within a particular investment. Asset management fees generally range from 0.5% to 3% of total revenues. It’s important to note that this is different from a property management fee; property management fees are charged by the company that actually collects rent, handles maintenance calls, etc. This is also generally a percentage of rents collected. However, asset management fees are charged not for collecting rent, but for providing strategic direction and oversight on behalf of ownership.
What is the Committed Capital Fee?
Committed capital fees are generally annual recurring costs that are charged as a percentage of capital that is committed to an investment. These fees generally range from 0.5% to 2% of committed capital, and they cover the cost of general overhead for the investment company. It’s important to note that committed capital fees can be excessive and can result in the enrichment of investment managers regardless of fund performance. A $100 million fund with a 2% annual fee will generate $2 million in annual revenues for the manager, the vast majority of which is profit for the partners if the firm has only a few employees.
What does an Administrative Fee mean?
The administrative fee is a one-time fee that is charged for onboarding the investor into a new investment. This goes to cover the cost of putting the offering together, sourcing initial capital, legal costs, and other general administrative work that is involved in the investment formation process. Administrative fees are charged up front as a percentage of committed capital, and they typically range from 0.25% to 1%.
What is the Guaranty Fee?
When sponsors personally guarantee the debt associated with a real estate investment, they sometimes charge a fixed percentage rate to the investment entity to compensate for the personal risk they are taking on behalf of the partnership or LLC. Sponsors who personally guarantee loans subject their homes and personal assets to seizure by lenders in the event that the investment defaults on the loan; as such, they often require an incentive in order to accept this risk. Guaranty fees are charged annually as a percentage of the outstanding principal balance of the loan, and they range from 0.1% to 0.5% of the principal balance. This can be thought of as effectively increasing the interest rate on the loan. If a partnership can borrow at 3.5% without a guarantee, or 3% with a guarantee and pay a 0.25% guaranty fee, the partnership is better served to borrow with a guarantee and pay the guaranty fee.
How does a Financing Fee work?
Financing fees are charged to compensate for the work associated with arranging loans for real estate investments. Obtaining a mortgage for an investment property can be very time consuming, and the level of quality of financing terms can have significant bearing on the success or failure of an investment. Financing fees are one-time fees that are charged as a fixed percentage of the loan amount, and they can be charged for both acquisition loans and refinancings. Financing fees generally range from 0.25% to 2% of the loan amount.
What are Acquisition Fees?
When a fund closes on the acquisition of a new property, the sponsor will often charge an acquisition fee. This fee is charged to cover the cost of the investment team’s time and expense in sourcing, diligencing, and closing on an asset. The process of finding and vetting a potential investment property is extremely time intensive if done correctly, and this fee is charged to compensate for those efforts. Acquisition fees are paid at closing as a percentage of the purchase price, and they generally range from 0.5% to 3%.
Can you explain the Disposition Fee?
At the time of a property sale, investment managers may charge a disposition fee to the investors. Similar to acquisition fees, disposition fees are levied to compensate for the time and effort associated with marketing and closing on a sale. This can also be very labor intensive, often requiring coordination among large teams and many third parties. Disposition fees are also paid at closing as a percentage of the purchase price, and their range tends to be comparable to that of acquisition fees.
What is an Incentive Fee?
If there is such a thing as a favorite fee, incentive fees would be just that for Birgo Capital. These are performance-based fees that are charged to investors as a percentage of profits generated for investors. Incentive fees align the investors and the manager as they place both parties on the same side of the table: earnings for both increase in direct proportion to the success of the manager’s efforts. Incentive fees are also called “carried interest” or the “promote,” and they are highly customizable based on a particular deal waterfall or fund structure. They tend to range from 10% to 50%, and are most often charged as a percentage of total return over a baseline rate of expected return, otherwise known as the “hurdle rate.” Incentive fees are either paid out over the life of an investment or upon final exit.
What are Affiliate Fees?
In instances where the sponsor controls other entities that service the business needs of the real estate investment, investors should be aware of fees they may be paying through sponsor affiliates. The most obvious and prevalent instance of this is for property management services, but it can take the form of title companies, construction companies, consultancies, vending machine operators, laundry service companies, architects, engineers, or any number of other service types that take place within real estate operations. The amount and recurrence of these fees will vary with the nature of the underlying service performed, but astute investors should be sure to understand to what extent affiliates will play a role in the execution of an investment.
As you can see, there are a wide variety of ways in which real estate investment managers are compensated for the work they do. None of these are inappropriate in their own right, and each serves a purpose for legitimate work that is performed. What is most important is that they care clearly disclosed and not duplicative. Birgo Capital’s philosophy is that managers should be able to cover costs and make a very modest profit from non-performance-based fees, but that fees that generate significant wealth should be incentive-based. As such, Birgo charges only financing fees, acquisition fees, and incentive fees, in addition to property management and operational charges that are borne by our funds as a result of our vertically-integrated strategy. We believe this structure is transparent, sustainable, and appropriately aligned with our investors. Regardless of what investment strategy or manager you are considering, those who wish to participate in real estate syndications must learn to evaluate the fees and costs that are going to be incurred within a particular investment.