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In the last article we left off with one question, “How Do Sponsors and Passive Investors Get Paid?”
Well, in this article, I’ll answer that question and maybe more.
The sponsor often receives an acquisition fee calculated as a percentage of the deal's overall cost (typically between 1-3 percent of the deal). The acquisition cost, for instance, would be $150,000 if the deal was bought for $5,000,000 and the syndicator charged a 3 percent fee.
Not bad for a pay day! I'll go into more detail about alternative ways sponsors are compensated in another article.
As limited partners, the investors' risk is constrained to the amount of money they put into the transaction. They typically take a passive role in the transaction, investing in it but leaving deal management to the sponsor.
Some of you might be complaining that the limited partner isn't being paid enough. I want to introduce to you a concept that has altered my understanding of this assertion.
I've always believed that the structure and fees favor the sponsor. Not anymore!
ROE
(Return on Effort)
I concur that the syndicator receives a handsome payment, but there is a great deal of value for an investor who lacks the time, knowledge, or resources to invest in their own business.
Once the deal is funded, the limited partner needs to put very little effort into it and can shift his attention elsewhere while still getting paid.
The preferred return, internal rate of return, and sponsor promote are three additional words that are crucial and that I would want to touch on.
Preferred Return
Prior to the sponsor starting to earn remuneration, the limited partner is entitled to a specified return under a preferred return. A return hurdle is another name for this desired return. For the past three years, preferred returns have often ranged between 6 and 10 percent.
This means that before profits are divided with the sponsor, the limited partner receives the entire preferred return. For instance, if the preferred return is 8% and the deal generated a 9 % return for the quarter, the limited partner would receive 8% of the 9 % profit.
The remaining profit would then be divided between the two parties in accordance with the terms of the agreement that was signed.
Sponsor Promote
Profits begin to be divided between the sponsors and the limited partners after the preferred return has been reached. The “sponsor promote” is the portion that is given to the sponsors.
The sponsor promote is determined by a number of variables, including the sponsor's experience, past performance, and market demand.
The profit distribution in our deals is set up as a 70/30 split, with 70% going to the limited partners and 30% going to the sponsor. For instance, if our "pref" rate was 8%, the limited partners would receive 8%, and the remaining 4% would be split 70/30 between the sponsors and the limited partners.
Many transactions include what is known as a waterfall structure, where the sponsor earns more money dependent on how well the asset performs. The returns to the sponsor rise as the IRR (we'll get to IRR) rises. Why make things more difficult, you might ask.
This is a great approach for the limited partners to reward the sponsor for meeting their obligations under the agreement. Both parties benefit from this! Although the sponsors also receive compensation, the limited partners do.
Internal Rate of Return (IRR)
IRR, or internal rate of return, is a simple formula that combines time and profit to calculate the predicted yearly rate of growth of an investment. The fact that it considers the temporal worth of money is crucial. IRR is a topic on which we could write an entire article but would only scrape the surface.
When deciding whether to invest in your deal or not, the vast majority of limited partners will have this question in mind. Internal Rates of Return in the low 20 percent were typical a few years ago, but as pricing has been more aggressive and cap rates have continued to compress (go down), most sponsors are now aiming for an IRR of 12 to 15 percent.
We'll dig deeper into the pros and cons of syndication in more detail in our next article. We'll also pay attention to your objectives as an investor and determine whether syndication is the best course of action for achieving those objectives.
The more "tools" (strategies) you have in your toolbox, the more probable it is that you will be able to close your next deal. When investing in multifamily, syndication is only one of many possible tactics.
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