Fees & Class Structures
What to Expect:
Fee structures and their importance in passive investments.
Acquisition, development, asset management, and capital transaction fees in real estate.
Class structures in investment opportunities and the importance of preferred returns and alignment of incentives between investors and operators.
Capital transaction events: critical moments in investment opportunities where returns are split between general partners and limited partners, and investors should prioritize alignment of incentives to protect their interests.
Hey friends! Today I want to talk to you about a few things that you need to know if you're getting involved in any fund or syndication, or any type of passive investment. There are class structures, fee structures, and capital transaction events and waterfalls. You need to know what all of these terms are and what is typical for any type of investment. Now, every investment is its own entity, and you should look at it for its merits within the documents that they give you, as well as looking at the operator. But it's really important to know that these fees exist. And if they aren't very clearly and transparently portrayed, you need to make sure that you're asking for where these fees are, how much they are, and what they cover.
Fee structures
Fees are very important for any operator putting a deal together. That's kind of how they stay in business. That's also how they make sure that they will continue to exist to serve you and to serve the business plan. So making sure that they are taking fair fees is very important because that is how you're going to make sure that they are underwriting the deal to make sure that they have covered all three steps. One, to make sure the asset itself does well. Two, to make sure the investors get their money back and three, most importantly, that they stay in business so that they can serve their investors.
Acquisition fees
So one type of fee that operators usually take is an acquisition fee. An acquisition fee is a one time flat fee paid to the manager or the operator of the purchase price, usually two to three percent. Sometimes more, sometimes less, it just depends on the deal. But in that range.
Development fees
Another type of fee is a development fee. It is also a one time flat fee paid to the manager or operator of the development costs and can be anywhere between six to ten percent. It does not include the general contractor fee. That will be within the actual construction costs itself. This is just the fees that are going to the operator, so a one time flat fee paid to the manager or operator of the development costs. For example, if it's going to cost $500,000 to renovate a building, it's going to be eight percent of that. And if that building costs one million to purchase, three percent of that goes to the acquisition fee.
Asset management fees
An asset management fee is a percentage of gross revenues paid to the manager or operator on a monthly basis. So this is a recurring fee every month, usually about two percent is a good estimate of where you are. This is not a property management fee, which is usually built into the business plan. But the two percent asset management fee ensures that all the business plans are running well and that the property managers are managed properly and that the asset itself is always serving the best possible tenants so you can get the most money from the space that you have.
Capital transaction fee
Finally, a capital transaction fee is a percentage of the sales price of each property upon disposition, and if applicable of the new loan amount on the refinance of each property. I know that's a mouthful, but basically a capital transaction fee is around two percent, usually give or take a percent or two. But it occurs at the disposition of the property meaning it occurs at the sale or the refinance of the property, and that's when that fee is charged. That is all the effort it takes to either put it on the market and sell it or to get all the paperwork ready for the bank and put all the information needed as well as any loan holders or note holders information to the property for the refinance.
Class structure
Now there can be more fees and there can be less fees. These are just the basic ones you should be seeing in every fund or syndication, so bear that in mind. The next thing you need to know about is a class structure. Basically, a class structure is how different investors can come into an investment opportunity. Usually, it's divided by how much money you're bringing in. So say if someone is bringing in 25,000, 50,000, 100,000 or one million, they will have different preferred returns based on the volume they're contributing, and/or other perks rather than just preferred returns. It just depends on how it is set up. This is something that they will tell you ahead of time, and you will be able to decide where you want to come into an investment based on the structure that exists. Within the class structure, you will get a percentage of returns- usually it's like 70 percent goes to the investors and 30 percent to the operator or the general partner.
So for example, a class structure would look like: Class A1 Investors get an eight percent preferred return, and a 70-30 split until the capital transaction event. Whereas the class A2 investors who come in at a lower amount get a six percent preferred with a 70-30 split until the capital transaction event. So that's kind of how a class structure looks like. Feel free to message me if you want to know more about class structures and what they mean.
Capital transaction event
A capital transaction event is when a change occurs in how returns are split between the general partner and the limited partners. In other words, between the investor and the operator. Usually, until the investor gets at least 100% of their initial investment back, they should have returned skewed in their favor. If that's not the case, I would double check the investment opportunity very carefully. Before you get your entire initial investment back as a limited partner, as an investor, you should have some kind of way to make sure that the operator is aligned with your incentives. So you should be getting either a larger preferred return or if you're not getting a preferred, you should be getting a larger percentage like 70 percent instead of 50. Once you have a minimum of your investment back, usually investors and operators agree to a minimum investment back plus a certain amount. For example, 120 percent, once you have that back then a capital transaction event has occurred, meaning you've gotten your 100 percent plus back and then the percentage shares switch. Oftentimes that capital transaction event is the sale of the property or the event that pushes investors out. So for example, if you're in an investment that is expecting a 20 percent IRR within five to seven years, at that point, they sell the property and give the investors their money back. And that is a capital transaction event at which point you are no longer in the deal. But you have gotten your money back and your 20 percent IRR or internal rate of return or whatever you have expected based on your involvement in the deal.
Other times if the operator chooses to refinance it, most operators still will kick you out after you hit a certain percentage, say 120 or 150 percent cumulative cash on cash you're then out from the investment because you've gotten your money back plus a return over a certain time period as was initially expected when they proposed the project or the deal to you. But another option can be deals where after the capital transaction event, instead of seeking out the investor it switches to a 50-50 so there are no more preferred returns. And any distributions that are made 50 percent goes to the investors and 50 percent goes to the general partner. So that is what a capital transaction event is. It's usually when you're getting most of your money back and the events that are happening around it, and the changes in the structure of the deal that happen when this capital transaction event occurs.
So, to recap, know what fees are being charged by the dealmaker, know what the structure is and where you fall on it and know when the structure will change.