3 Questions to Consider When Bringing in Capital Partners
“After you develop a winning investment formula, stick with it.”
Developing your winning investment formula is only half the battle. The other half of the battle involves developing winning capital partnerships. The business of taking on partners is one of the most common ways that new and small investors can invest into larger investment opportunities.
3 Questions to Ask When Looking at Bringing in Capital Partners:
Question 1: Who puts up the money?
Question 2: What are the fees?
Question 3: How are the cash flow and the proceeds from a sale being distributed?
There can be countless variations of answering the above stated questions. I will try to lay out the most typical scenarios that I have used and seen been utilized by other sponsors when bringing on capital partners.
Money is most critical fuel for getting a real estate deal initiated and completed. Capital investors like to see the sponsor have some monetary stake in the investment so I have typically initiated funding wherein the capital investors puts in 90 to 95 percent of the investment cash and the sponsor puts in the remaining 5 to 10 percent. This structure may be difficult for a new sponsor with limited risk capital so you can get capital partners to invest a 100 percent of the cash if the sponsor gives them a high preferential rate (keep reading to understand this term in greater depth).
Fees can be a point of contention with capital investors as they want you to make your money from the deal rather than their cash. As a sponsor you have to balance the capital partner wants versus the fact you may have spent a lot of time sourcing , underwriting and structuring the deal so you need to be adequately compensated for that time and effort and potential on-going work at the asset.
TYPES OF FEES
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|Acquisition Fee||The sponsor typically can get a 1 to 2 percent of the deal purchase price. The reason for this fee is the time and effort spent sourcing, negotiating and underwriting the deal.|
|Administration Fee||The fees for this category typically range from 1 to 3 percent of the total investment size. The reason for this fee is to help compensate for the costs associated with setting up the syndicate i.e. lawyer fees, accountant fees and custodian fees.|
|Management Fee||For assets that need off-site management, a management fee of 3 to 7 percent off the collected gross income would be paid monthly from the investment cashflow.|
|Disposition Fee||To help effectuate and manage the disposition of the asset; the sponsor can charge between 2 to 5 percent of the property purchase price.|
|Investment Management Fee||For deal composed of multiple assets or a large number of capital investors, I have seen offerings where sponsors have taken 1% of the value of the investment on a per annum basis.|
The table above is meant to be a reference guide as the actual fees that you can charge for an investment will be balanced by multiple factors ranging from sponsor experience, investment risk, and the proportion of investment returns paid out to capital partners.
Craving up Returns
The real estate investments will typically produce two streams of returns: cash flow and resale profits. Prior to diving into craving up the returns; it is important to understand the concept of preferential returns aka PREF.
What is a PREF?
A PREF is basically a minimum rate of return (e.g., 8–12%), which must be achieved before the sponsor can receive any carried interest payments. The PREF is typically paid out of cash flow and distributed quarterly. If the cash flow from the property is insufficient to cover the PREF payment, then the PREF would accrue a simple interest and paid out from future cash flow or from the asset resale proceeds.
What is carried interest payments?
A share of the profits (cash flow and resale proceeds) paid to the sponsor as a performance incentive. The share of profits is a function of the sponsor’s track record and how high the PREF return is to the capital partners. The share from the cash flow and the resale proceeds do not have to be same and can be sliced and diced in multiple ways.
The best rule of thumbs that I have seen for real estate investment offering is as follows:
For PREF’s below 9%, the profit would usually be split 50-50 to the sponsor and capital partner respectively.
For PREF’s 10 percent or above, the profit would usually be split 55-45 to the sponsor and capital partner respectively.
The setting up the terms of an investment offering and the associated splits are a balancing act driven by the deal, the sponsor reputation and the capital partner’s needs & wants. I hope the readers are able to use this article as a reference when they are setting up their future investment offerings. Remember every deal is different so the economics will vary.