Evaluating Real Estate Investments –Sponsor Compensation

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According to ZipRecruiter, the average musician salary is $47,003 per year, compared to the national average salary of $74,378. Given that professional classical musicians, at least, nearly always have an undergraduate degree, many have a master’s, and some have a doctorate, that’s years of training to make a less than average salary.

Plus, most musicians don’t make their money from a single job. Many have a teaching job at a school, music school, or university that provides a base salary. However, most also have private students who pay them by the lesson. The lessons usually are weekly and provide a relatively stable supplemental income. Musicians also may have sporadic income from wedding gigs, teaching at a summer camp or special seminar, or serving as a judge at competitions. Musicians who are composers or recording artists may also receive royalties based upon how many copies of their music are sold.

ZipRecruiter doesn’t say whether its numbers include multiple sources of income or just the base salary from a job. But it’s nearly certain ZipRecruiter doesn’t factor in the out-of-pocket costs associated with being a professional musician.

Performing musicians need first to purchase a professional-level instrument. Professional-level wind instruments can cost from several thousand to tens of thousands of dollars. Professional string instruments start in the tens of thousands of dollars and can cost millions for an instrument from a famous maker. Once that investment is made, musicians must pay for maintenance, supplies, and insurance.

Most musicians must pay union dues, purchase concert attire and music, and pay for their own (and their instrument’s) transportation to and from gigs, which sometimes can be some distance. Some musicians have agents that take a cut of their pay or pay rent for studios where they teach. These business expenses reduce the musician’s effective income.

Real estate fund sponsors similarly receive compensation from multiple sources. Like musicians, some of that compensation may come in fairly regularly, and some is sporadic. And like musicians, real estate fund sponsors must make an upfront investment in their businesses, and they have numerous ongoing expenses that are necessary for them to conduct their businesses.

This article is one in a series on Evaluating Real Estate Investments. This article discusses sponsor compensation.

Types of Sponsor Compensation

Sponsor compensation usually falls into two categories – fees and carried interest. Fees are payments for a specific service the sponsor provides and may be one-time or ongoing. For instance, a sponsor may receive one-time fees for structuring and marketing the fund, locating investments, finding suitable mortgage financing, or finding a buyer for each property when it’s time to sell. In addition, sponsors may receive ongoing fees for supervising construction or renovations, overseeing property management, or serving as a guarantor for the fund’s obligations.

Sponsors also receive a carried interest in the real estate fund. To incentivize the sponsors to manage the investment well, they have the right to a percentage of the gain when the real estate is sold. Occasionally, the sponsor also receives a percentage of the operating income, provided the property performs well.

One distinction between fees and the carried interest is their priority in the waterfall to investors (for information on waterfalls, read my previous article, Waterfalls). Fees usually are paid before the waterfall, so the sponsor receives fees before the investors receive any money.

But carried interest is usually paid at the end of the waterfall, so the sponsor receives no payment for its carried interest unless the investment succeeds. That’s because the sponsor usually only gets their carried interest if the investors receive a specified return on their investment.

One-Time Sponsor Fees

One-time sponsor fees are tied to a specific transaction or event. Although not every deal has every type of one-time sponsor fee, the following are some of the standard one-time sponsor fees:

Fund Organization Fee

Sponsors devote significant time and exercise to structuring a real estate fund. First, they must underwrite the property and determine what classes of equity the forecasted revenues can support. Since real estate funds usually are not publicly-traded, sponsors also decide what securities law exemption to use when offering equity for sale. Finally, the sponsor must work with a real estate securities attorney to prepare offering documents and must establish a marketing plan for the offering.

Sponsors receive a fee for these services. The fee may be a flat fee or determined by another method and typically is paid at the beginning of the offering.

Acquisition Fee

Sponsors spend significant time identifying suitable real estate investments. Like drug research and development, the sponsor may spend significant time and money on prospective property acquisitions that don’t close. It takes a lot of work to negotiate a purchase agreement, conduct due diligence, create financial pro formas and business plans, identify and negotiate terms with a property manager, and position a new real estate investment for success.

The sponsor receives an acquisition fee to compensate it for these efforts. Typically, the acquisition fee is calculated as a percentage of the purchase price of real estate and is paid at closing on the real estate acquisition. A one- to two-percent fee is typical.

Construction Management Fee

A real estate business plan frequently includes plans to renovate a property. For example, someone needs to manage the invoicing and lien releases, ensure work is done quickly, and process draw-downs on any construction loan. So, the sponsor receives a construction management fee when it provides this service. The construction management fee is usually based upon a percentage of the total construction budget. However, it’s sometimes only based on hard construction costs (costs associated with the actual, physical construction work).

Financing Fee

Sponsors also must obtain mortgage financing for each property. Since mortgage loans aren’t one-size-fits-all, the sponsor must evaluate what type of loan best fits each property. Lenders and loan programs have specific requirements. For example, they may accept only properties in certain asset classes or of a certain age.

The property’s business plan also affects mortgage loan options. Some programs finance capital expenditures to improve a value-add property, but others don’t. The anticipated hold period also comes into play when obtaining a mortgage loan. For instance, a bridge loan with a maximum three-year term would be suitable for a property the sponsor expects to sell in two years, but a 30-year mortgage with steep prepayment penalties would not.

Once the sponsor selects the lender and mortgage loan program, the sponsor must complete and submit a myriad of paperwork. In addition, the sponsor will shepherd the loan process until the closing. Obtaining financing requires significant sponsor time and expertise. The sponsor receives a fee, typically a percentage of the mortgage loan amount for these services.

Disposition Fee

It’s also time-consuming to prepare a property for sale. Guiding the property through the sale process requires selecting a buyer, sometimes from numerous bidders, and negotiating a sale agreement. The sponsor coordinates due diligence with the seller, arranges mortgage loan payoff or defeasance, and coordinates the closing. Sponsors receive a fee for this service, usually a percentage of the sale price. If the sponsor is a licensed real estate broker, the sponsor might receive a standard real estate commission, as well.

Ongoing Fees

Property Management Fee

Most commercial real estate requires professional management. Some sponsors rely upon unaffiliated third-party property management companies to manage their properties. But other sponsors have an affiliated property management company that manages the properties they sponsor.

The cost of property management should be roughly the same whether or not the property management company is affiliated with the sponsor. But when a sponsor affiliate performs that service, it might be considered a sponsor fee.

Asset Management Fee

Sponsors must coordinate the distribution of financial reports and tax information. Sponsors also must maintain the investor roster, keeping contact information up-to-date and arranging for lender notifications or consents required for investor transfers of ownership due to estate planning or death.

Many sponsors also provide investor portals, formal investor reports, and regular investor meetings. Plus, from time to time, the sponsor must facilitate a change in the property management company or other contracts. The sponsor receives an asset management fee (usually a percentage of revenues, income, or asset value) as compensation for these services.

Guaranty Fee

Sponsors nearly always sign non-recourse carveout guarantees and environmental indemnities. The sponsor accepts personal liability for the borrower’s violation specified loan document provisions, such as filing for bankruptcy, fraud, misappropriation of insurance proceeds, and failure to maintain the borrower as a separate, special-purpose entity. Sponsors also agree to indemnify the lender for violations of environmental laws. Sponsors sometimes receive a fee for providing this guaranty.

Other times, sponsors may guarantee that the borrower completes construction, maintains reserves, or makes loan payments. These guaranties impose significant risk on sponsors, and sponsors usually receive a fee for serving as guarantor. Where the sponsor’s guarantee is of a specific dollar amount, the guaranty fee usually is calculated as a percentage of the amount guaranteed.

Evaluating Sponsor Compensation

Not every musician has every possible source of income. One might be a public school teacher, judge some competitions, and teach private lessons. Another might be in an orchestra, teach private lessons, and receive royalties from their compositions. Similarly, sponsor compensation varies depending upon the sponsor’s role and the fund structure.

Sponsor compensation differs from musician’s compensation in one respect – in addition to compensating the sponsor for services, some sponsor compensation may also incentivize desired sponsor performance. For example, because both a disposition fee and the sponsor’s carried interest are tied to the property’s sale price, they incentivize the sponsor to sell it for its maximum value. Sometimes, the sponsor’s carried interest percentage increases as the sale price increases, which further incentivizes a high sale price

Therefore, investors and analysts should evaluate sponsor compensation to ensure that the sponsor is properly compensated for its services and that the compensation structure is aligned with the company’s business goals. After all, a sponsor that isn’t adequately compensated may not be willing or able to support the resources necessary to provide investors with top service.

 

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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