Considering Private Real Estate Investments? Understand the Fees Before Investing

Quick takeaways

• Like most investments, private real estate investments typically charge fees.

• Common fee types are for acquisitions, dispositions, and asset management services.

• Understanding how fees work, including how they affect total returns, is an important part of evaluating any private real estate opportunity.

Real estate investments are actively and directly managed, and that management takes hands-on work. Fees compensate project sponsors and investment managers for actively managing investments on investors’ behalf, so that investors can take a passive role.

Some of the fees are one-time, while other fees may be recurring. By carefully reviewing a project’s private placement memorandum (PPM) and offering memorandums, investors can estimate a project sponsor or investment manager’s fee load and the potential impact on investment returns. Doing so also helps investors compare investment options.

Typical Fees in Private Real Estate Investing

Fees related to acquisitions, dispositions, asset management, and performance incentives are common in private real estate investments. Fees can apply to investments in single properties as well as diversified investment funds.

Here’s a brief explanation of some typical fees in private equity real estate.

Acquisition Fees

Real estate project sponsors and investment managers may receive compensation for sourcing and acquiring real estate assets for their funds or as individual property holdings. Acquisition fees may be based on a percentage of the gross purchase price of assets.

Acquisition fees help sponsors cover the cost of sourcing the opportunity, conducting due diligence, underwriting (financially modeling investments), and getting assets under contract before further evaluation, and fees realted to consultants and experts assisting in the acquisition process.

Disposition Fees

Likewise, investment sponsors typically receive compensation when they sell assets. Disposition fees may be based on a percentage of the gross sale price of the asset or collection of assets sold.

Disposition fees help cover the cost of marketing assets for sale, managing the sale process, and expenses associated with execution of the sale and transfer of assets, including legal and brokerage fees.

Asset Management Fees

Sponsors of privately held properties and diversified real estate investment funds typically charge an asset or equity management fee. This fee covers the cost of a sponsor’s oversight of investments, monitoring performance against projections, and managing the administrative operations of a fund or property on a day-to-day basis. Asset managers direct capital improvements, monitor financial performance against projections, and coordinate with third-party operators. Note that hands-on property management activities such as leasing, tenant relations, and day-to-day operations are typically covered by a separate property management fee, commonly charged as a percentage of effective gross revenue (EGR).

Financing Fees

Real estate project sponsors and managers of diversified investment funds often charge a fee for arranging debt on a project, whether it’s securing a mortgage loan, refinancing an existing loan, the retirement of a construction loan (in the case of new development) and the acquisition of a mortgage loan. Financing fees help compensate the project sponsor or fund manager for their time, as well as offset any brokerage or other fees paid to third parties to perform due diligence and secure the debt. Related, project sponsors and investment managers often pass on the cost of any government loan guarantee fees that they incur to insure mortgages.

Development Fees

For projects involving ground-up construction or substantial renovation, sponsors typically charge a development management fee to compensate them for overseeing design, permitting, construction, and project delivery. Development fees are commonly calculated as a percentage of total hard costs or total project costs.

Guarantee Fees

Construction and bridge loans often require a personal or corporate guarantee from the project sponsor. When a sponsor provides this guarantee, they may charge investors a fee for accepting that personal liability. Guarantee fees can also arise when a project uses government-backed loan programs that charge their own guarantee fees, which sponsors typically pass through to the investment.

Performance Incentives

In addition to fees, many investment sponsors receive performance incentives if investment returns exceed certain thresholds. In the case of private investments and funds, these fees are commonly referred to as “catch-up distributions” and “promote” or “carried interest.” While related, these terms describe distinct concepts. “Promote” or “carried interest” refers to the sponsor’s share of profits above a specified return threshold. A “catch-up” provision is a separate waterfall mechanism: after investors have received their preferred return, the catch-up allows the sponsor to receive a larger share of subsequent distributions until the sponsor has caught up to its target promoted interest percentage. When a catch-up provision is present, the sponsor can begin collecting its promote before all remaining distributions are split with investors.

Performance incentives are intended to do just that: incentivize project sponsors and investment managers not just to meet projections but exceed them – for their benefit and for investors.

The term “waterfall” is often used to describe how these performance incentives work. The waterfall analogy connotes the thresholds at which different payments are made to investors versus sponsors and in what amounts based on achievement of performance goals. These incentives are a form of profit-sharing.

Understanding Fees and Their Effects on Total Investment Returns

Another distinction that is relevant to investors: Sponsors and investment managers typically speak in terms of “gross” returns and “net” returns. Gross refers to the investment return before fees are deducted. Net refers to the investment return after fees have been deducted.

When evaluating any private real estate investment, taking the time to understand the full fee structure and its potential impact on net returns is an important part of the due diligence process. At Realberry, we're available to walk prospective investors through our fee schedule and illustrate how fees may affect projected returns with concrete examples. We believe transparency is the foundation of a strong investor relationship, and we welcome every question. As always, we also encourage investors to consult their financial, tax, or legal advisors when comparing investment options and review all subscription documents thoroughly prior to making a decision.