Fair Trade: Let’s Talk About GP Compensation…
I opened up an email the other day from one of our readers:
Hi,
I would like to first thank you for being so transparent in your blog post discussions. I look forward to your posts every week and I find them extremely helpful.
Since your writing pieces are so informative on investments, I have a question for you: if I were a potential investor in one of your deals, I am just curious, how does CF Capital receive compensation for managing a real estate investment?
I think any investor would like to know how you all get paid for what you are doing. Any details related to this would be much appreciated.
Thanks
I love these emails.
We are grateful that our readers are so engaged in our blog posts. This kind of email brings a smile to our faces, as it is our goal to be as transparent and informative as possible to our audience.
With that said, who are we to deny our readers the answers they are looking for? So our blog post today, inspired by a member of our loyal audience, is about how we, the General Partner (or “GP”), are compensated. We know this is not the most exciting topic, but we have tried our best to make it as “interesting” as possible!
The Fee Structure
Our two previous posts (syndications and accredited investors) reviewed terminology relevant to investors looking for the same answers related to compensation.
The general partner (“GP”) is also referred to as the sponsor in an investment partnership. In the case of CF Capital, we are the GP/sponsor in our investment offerings. Sometimes there are co-sponsors (i.e. multiple investment managers) in a real estate deal, but for simplicity, we will discuss scenarios with one sponsor.
Typically, there are two types of fees that compensate a GP: an asset management fee and incentive fee.
Asset Management Fee - This is the amount the GP charges for overseeing the management of the real estate investment and implementing the business plan. In our case, the asset management fee amount is a percentage of the collected income at the property. This is separate from the property management fee that is allocated to the on-the-ground property managers are paid for doing their jobs. .
Incentive Fee (i.e. Carried Interest or “Carry”) - This is also known as “carried interest” and is the GP’s portion of the LP/GP split. An LP is a limited partner, which is an investor. Any time you see LP in this discussion, think “investor.”
If the split between the LP (i.e. limited partners or investors) and GP is 70/30, this entitles investors to 70% of the investment profits and the GP to 30% of the profits. It is called an incentive fee because a GP is incentivized to generate large profits so that they are able to receive a large sum for being successful in an investment.
In order to align interests with LPs, the incentive fee is put into place and it is where the GP makes most of its money. Think of the incentive fee as a “we only win if you win” mechanism.
Pref
Taking investor alignment one step further and to reduce principal-agent conflicts, a GP may set the terms so that the incentive fee can only be earned once an annualized return is earned by LPs. This rate of return hurdle in the real estate investment industry is most commonly called the preferred rate of return or preferred return (“pref”).
Typically, the pref is set to a reasonable percentage (e.g. 7%), and it is equal to the amount of return an LP must meet on top of their initial investment in order for the GP to start earning their share of the incentive fee.
Furthermore, the pref terms could also be accompanied by a mechanism called, catch-up. A real estate investment manager, like CF Capital, would include this mechanism to arrange the way profits are shared between the GP and LP once the pref is attained.
A frequent incentive fee structure might be stated as “30% incentive fee over a 7% pref with a 50% catchup” or an “LP/GP split of 70/30 over a 7% pref with a 50% catch-up.” This means that the partnership has to earn at least 7% return before the GP earns their share of the profit split. Anything above a 7% return, the sponsor gets half the profit (i.e. the catch-up is 50%) until the ratio of profit split is 30% to sponsor.
Thereafter, the profits are split 70% to the investors and 30% to the sponsor. Although the catch-up can be negotiable (usually from 50% to 100%), this is just one example of a compensation structure for private real estate GP.
For those of you who are interested in seeing an example of how the math works, let’s walk through the fee structure involving a 70/30 LP/GP split over a 7% with no catch-up and an annual asset management of 2% and a hold period of five years -- excluding any impacts from taxation. (For those uninterested in the “numbers,” feel free to skip to the Main Takeaways below):
Management Fee
The GP initially invests $980,000 of the $1,000,000 capital from LPs.
The $20,000 difference is attributed to the 2% management fee and goes to the GP.
An amount of $20,000 is then drawn each year for the remaining four years -- a total of $100,000 of management fees over five years.
Preferred Return and the Incentive Fee from Cash Flow Profits
Rental cash flow profits over the five years equal $200,000, which are periodically distributed according to the incentive fee arrangement.
The pref of 7% entitles the LPs to $70,000.
Once the LPs earn this amount, this preferred return ($) is taken away from the $200,000, leaving $130,000 to be split 70/30 between the LPs and GP.
The LPs earn $91,000 on top of their already earned $70,000 for a total of $161,000 (i.e. the LPs capital has now grown from $1,000,000 to $1,161,000 at this point).
The GP earns $39,000 from the rental cash flow profits
Incentive Fee from Sale Profits
Once the property is sold at the end of the five year hold period, profits equal $300,000.
Since the LPs have already earned their pref, the split of the sale profits remains at 70/30.
This split gives LPs $210,000 in profits -- a grand total of $371,000 in profits, and their capital has grown from $1,000,000 to $1,371,000 over a five-year holding period.
The GP is entitled to $90,000 of the profits -- a total of $129,000 earned in incentive fees for the five-year investment.
Total GP Fees (Management + Incentive)
Total fees paid to the GP over the five-year holding period are $229,000.
Keep in mind that the $100,000 in management fees are basically a breakeven cost to remain operational during the life of the real estate investment.
Quantifying Returns to the LP and GP
The LPs earned $371,000 in profits from their initial investment of $1,000,000.
The total percentage of profits that go to LPs equal 74.2%, an amount higher than the 70% LP portion of the LP/GP split because of the preferred rate of return.
LPs earn a total return of 37.1% over the five-year holding period.
The GP takes $100,000 in management fees and $129,000 in incentive fees for a total of $229,000.
Using the cash flow profits plus the final sale as a base value or measurement point (i.e. $1,500,000), we can essentially say that over five years, the investment has paid the GP ~15.3% in total fees (management plus incentive).
There are also more complex compensation structures that “tiers” incentive fees once a pref level is met.
For instance, a real estate deal might be stated as “20 over 7, 30 over 11 and 50 over 20” . In this way, the GP starts sharing 20% of profits once the LP earns a 7% return, switching to 30% of profits once the LPs have earned a 11% return. Once the LPs have earned a 20% return, 50% of profits go to the GP.
There may be no catch-up in this structure, but between the 7% and 11% pref GP incentive fee starts to drag on return, and the gross return (i.e. the return without any fees) needs to be higher than 12% before the next tier of incentive fee kicks in.
Although this does not apply to the type of fee structure used in CF Capital’s offerings and may be more common in opportunistic strategies, we believe it is worth mentioning.
The Main Takeaways
There is a management fee charged annually to the GP for managing the real estate investment. This is stated in percentage terms and is based on the total initial capital from LPs.
There is an incentive fee (or carried interest) amount that the GP can earn. This equals the percentage of profits that the GP is entitled to. Often this is expressed in terms of a LP/GP split. An example of this is 70/30, which means LPs earn 70% of the investment profits and the GP earns 30% of the profits
The preferred rate of return (“pref”) is the amount that LPs must earn in profits from their initial investment before the GP starts to earn their share of the profits (or the LP/GP split).
Sometimes there is a catch-up mechanism that allows the GP to take some or all of the profits after the pref to the LPs is attained. Once the GP catches up to a percentage of the LP/GP split, the normal LP/GP split continues.
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