Before an individual investor commits their own capital to a private equity commercial real estate deal, one of the most important things for them to understand is the deal’s fee structure. The fees charged by a deal sponsor can impact investment returns and must be understood in order to compare multiple commercial real estate investment opportunities.
In this article, we are going to describe the typical fees charged by a private equity sponsor. We will define what they are, how they are charged, their typical amounts, and why they are assessed. By the end, readers will have the information needed to compare the fee structure between two or more private equity deals.
Like other private equity real estate firms, First National Real Estate Partners does charge fees. But, we firmly believe that they should not be a profit center for the firm. Instead, they should be normal for the private equity industry, customary, and just enough to cover the costs of administering the investment. If you are an accredited investor and would like to learn more about our current investment opportunities, click here.
How Are Private Equity Commercial Real Estate Deals Structured?
In order to understand how/why deal fees are charged, it is first important to understand how a typical private market deal is structured. In a standard private equity commercial real estate transaction, there are two groups of investors, each of which have distinct roles and responsibilities.
The private equity firm usually acts as the “General Partner” or “GP” and their role is to serve as deal leaders/ investment advisers. In this role, they are responsible for finding suitable investment properties and performing due diligence on them, arranging financing, and managing the asset once the deal is closed. In most cases, they will invest some amount of their own money as equity in the real estate deal.
The other group of investors is the “limited partners” or “LPs” who are individually accredited investors who provide equity capital. Their role is otherwise passive.
Because it can take a tremendous amount of upfront time, resources, and effort to find, finance, and manage a deal, private equity firms charge fees to recoup some of the upfront cost. For real estate investors, it is important to understand what these fees are, how they are assessed, and how much they cost.
Private Equity Fees
How Are Fees Charged?
Before discussing specific fees, it is first important to discuss how they are charged. Generally, there are three options:
- Total Deal Size: when the fee is charged on total deal size, this means they are charged based on the purchase price for the property. For example, if a commercial real estate investment had a total deal size of $10MM and a fee of 1%, the dollar amount of the fee is ($10MM * 1%) $100,000.
- Invested Capital: If a fee is charged on the amount of invested capital, it is assessed against the total amount of equity invested in the deal – usually around 30% of the purchase price. So, for example if the purchase price was $10MM, the total invested equity could be $3MM. If there was a 1% fee on invested equity, it would be $30,000.
- Committed Capital: In certain deal structures, investors will “commit” a certain amount of capital, even if it is not collected by the sponsor at the time it is committed. If a single real estate investor committed to $1MM of the $3MM needed and the fee was 1%, the cost would be $10,000.
Every private equity firm does this a little but differently so the first step towards understanding the fee structure is to understand how fees are assessed. The second step is to understand what the fee is charged for.
Below, we want to highlight four types of fees that are common in private equity real estate deals. It should be noted that it is normal for them to vary by deal and asset class.
Transaction Fees
Transaction fees are those that are charged based on certain triggers in the lifecycle of the transaction. There are two that are common:
- Acquisition Fees: To recoup the initial costs of finding real estate deals, arranging the financing, and setting up the ownership entity, private equity firms commonly charge an acquisition fee that can range from 1% – 2% of the total deal size.
- Disposition Fees: It also takes a lot of work to prepare a property for sale, list it, market it, and eventually sell it. For this, a typical broker charges 3% – 6% of the total sales price. Sometimes a private equity firm may even add another .25% – .75% on top of the broker’s commission in the form of a disposition fee.
Management Fees
Management fees are charged to investors for the work of managing both the property and the asset. While these may sound like similar activities, they are in fact distinctly different.
Property management fees are charged by a third party to manage the day to day operations of the property. This includes things like collecting rent, basic maintenance, finding and vetting new tenants, and maintaining the landscaping. For this work, the third party property manager can charge 3% – 10% of gross income. This cost is passed through the GP and ends up as a line item on the operating statement.
Asset management fees are charged for activities like: tracking the property’s performance relative to its budget and monitoring market trends to ensure rents are competitive. This work is usually performed by the private equity firm (the GP) and they may charge 1% – 2% of the committed capital or invested equity for it.
Incentive / Performance Fees
This category is where the fee structure can get a bit tricky, but it is also where the general partner(s) can make the bulk of their income. Incentive or performance fees are fees that are charged based on certain deal milestones or return benchmarks. They are designed to incentivize the GP for performance and typically follow a “distribution waterfall” pattern. While this term can seem intimidating, it really just means that the GP gets a larger share of the cash flow produced by the property when they meet certain rate of return milestones. To explain how this works, an example is helpful.
Suppose that a private equity firm finds a $10MM property in New York. To finance its purchase, they get a $7MM loan and raise $3MM in equity. Of the $3MM, the private equity firm invests 10% of their own money ($300,000) and the limited partners provide the remaining 90% ($2,700,000).
At the beginning of the real estate investment period, any cash produced by the property is usually split according to the percentage that each group put in, 10% for the GP and 90% for the LP. But, if the property’s return reaches a certain threshold, say 10% annually (the “hurdle rate” – usually measured as IRR), that split may change. It could change to 20% for the GP and 80% for the LP. This extra 10% for the GP is the incentive or performance fee for producing strong returns.
For this fee, it is especially important to understand how it is structured, when it is paid, how much it is going to cost, and how it can impact returns because this is the one that can vary the most by deal.
Private Equity Fund Structure vs. Deal Structure in CRE
When working with a private equity firm, there are two common structures – funds and deals.
In a fund structure, a private equity firm raises capital for a broad purpose of real estate investment. At the time fund investors make an allocation of capital, they likely don’t know which properties it will be used to purchase.
In a deal structure, capital is raised for a very specific deal so real estate investors know exactly which property they are investing in.
This distinction is important because fees can be charged at the deal level or at the fund level, depending on the structure of the investment. For example, a fund manager could charge an annual management fee for all of the assets in the fund. On the flip side, a single deal manager would charge fees based on the single property being purchased.
Potential investors should be aware of whether their real estate investment is in a fund or a deal, and if the fees are charged at the fund level or the deal level.
Summary of Private Equity Real Estate Deal Fees
There are two groups of real estate investors in a typical private equity deal. The general partner (GP) is in charge of finding, analyzing, financing, and managing the property. The limited partners (LPs) provide equity capital, but their role is otherwise passive.
For their advisory services, real estate investment advice, and work as the investment manager, private equity firms – acting as the GP – charge fees. Generally, fees can be grouped into three categories: transaction fees, management fees, and incentive/performance fees.
Transaction fees are charged for certain deal milestones like acquisition or disposition.
Management fees are ongoing fees charged for overseeing the property and the asset.
Performance fees are charged based on the return the general partner delivers to the limited partners.
Potential private equity investors should pay close attention to the fee structure, particularly if they are charged at the deal level or the fund level. In addition, they should ensure that the fees charged are not a profit center.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
