Main Fees Associated with CRE Investment
In this article we discuss the main fees associated with the investment in commercial real estate.
Fees reduce investment returns significantly in both short- and long-term investments. It might look like paying an annual 2% management fee is not a big deal but do not forget how it accumulates over time, negatively impacting the overall return on investment. The effect of an annual fee is erosion of initial investment capital. To make a rational investment decision you have to be cautious about applicable fees and make sure you understand how those are impacting your prospective returns.
During the investment process you will usually encounter all or most of the following types of fees depending on the deal structure:
Deal structures with the sponsor vary widely across the space and mostly depend on the timing on the market, historical performance of a prospective sponsor, type of deal, previous relationship history with a sponsor and so on.
For example, if you consider a deal syndication with a company new to the market, their fee structure will probably be relatively moderate, maybe even solely based on performance. As a sponsor is new to the market they want to gain some performance history so they are regularly willing to work for lower fees. If the sponsor has a long history, solid performance over years and good connections in the market, they are free to charge more as there is a higher demand for their services. A good operator is not as easy to find as one might think.
There’s no market standard for sponsor fees and those depend on negotiations. Typically, fees include:
*An acquisition fee paid to the sponsor for putting the deal together. Usually an acquisition fee is maintained at 0.5-2% of total purchase price. The average fee is 1%. The fee is paid up front to the sponsor.
* Asset management fee for managing the deal. The fee is usually calculated into the initial equity raised during deal initiation or gross deal revenue. While calculated annually, the fee is most often paid out quarterly. The usual size of the asset management fee to the sponsor is 1 -2% annually.
* Profit split above a preferred return (promote) as compensation for deal performance. A profit split depends on the agreed waterfall structure and can be whatever both investor and sponsor decide is fair. Oftentimes the sponsor is not paid any profit split until an investor realizes the annual preferred return level based on IRR or equity multiple. A typical preferred return is 7- 10%, although sometimes the preferred return is split pro rata and can be either compounding or non-compounding. For example, if a sponsor puts 5% of the equity into a deal, the sponsor’s profit share is 5% up to the point when the preferred return is achieved. The preferred return level is referred to as Tier I in a waterfall structure. During the deal structuring there might be as many tiers created as both parties wish but typically 3-tier levels are agreed in the structure. After the second tier the profit split to the sponsor goes disproportionately.
For example, when the IRR of between 10% and 14% is achieved, a sponsor receives 20% of the profit even though their initial investment was only 5%. And furthermore, when the IRR of above 14% is achieved, the profit split to a sponsor is 40%. In some cases, the investor would not pay the sponsor any split of the profit before the deal is sold and then only a percentage of the sales price goes to the sponsor, but in that case the sponsor would not usually have put any money into the deal.
Transaction costs of sale are usually high but depend mostly on how liquid the market is during the disposition of an asset. The seller would usually cover the cost of an agent; therefore broker fees would usually only be included in sale costs.
For example, if the market is illiquid and it takes much effort for the agent to find a buyer, thus spending much money on advertising of a property, the sale fees would go up to 7% of the sales price of which 2% for example would go as a flat fee to the agent. If the market is hot and the demand for a property is high, the disposition fee might only reach 3 -4% while 2% would still go to the agent.
The main fees you the investor will incur on sale are as follows:
* Agent’s Commissions or Finder’s Fee: There are two basic ways of covering costs for the agency which makes a sale possible: through finder’s fee or sales commission. Sales commission is a fixed agreed percentage of a sale price to an agent for making a sale possible. The agent fee can be as low as 1% and as high as 5% depending on the agent and the deal. The finder’s fee is a fee paid to the person who makes the deal possible. Oftentimes you hire a sales agent while they pay a finder’s fee to whoever finds a buyer. Agents usually earn 3% to 7% on a deal but finders fees are usually much lower of only 1% of a deal’s value.
* Legal Fees: Most lawyers would charge less during the sale of an asset than during its purchase. The lawyer will discharge the title for the property, take care of the mortgage closing, and verify that all tenant payments were collected. Standard exit legal fees are up to $1,500 and usually represent a flat payment.
* Mortgage Prepayment Fees: During the sale process you have to account for the prepayment fee to the bank for paying off your mortgage before the maturity date unless you have owned the property for at least 30 years (considering this is a term of the loan).Generally, the earlier into the mortgage it is paid in full, the higher the costs of mortgage discharge. The mortgage repayment fees should be budgeted somewhere between 1 – 2% of the outstanding mortgage amount.
Property Management Fees
Property management fees are paid to a property manager for the day-to-day management of the property. Their tasks include taking care of the leasing, billing, advertising and keeping the property in its best shape. These fees usually range from about 2 – 9% of the collected rental income (effective rental revenue), with 5% most often charged. Some companies would prefer to charge a fixed monthly fee.
The important thing to note about a property management fee is that it is deducted from the rental revenue as an operating expense and therefore impacts the NOI of a property. And by decreasing the NOI on a property the PM fee directly impacts the value of the building. Let’s see how much difference in 100 bps could make to the value of a property.
Let’s assume the property you are looking at generates a stable rental revenue of $500,000 a year. Projected vacancy loss is 1% moving forward and credit loss is additional 2%. The cost of utilities is $100,000 a year. And you have a choice of two property managers of whom the first charges 5% of effective rental revenue and the other is charging 6%. To estimate the impact of this difference to the value of a property let’s first estimate an NOI.
NOI = Effective Rental Revenue – Utilities – PM Fee
Effective Rental Revenue = Rental Revenue – Vacancy Loss – Credit Loss
Effective Rental Revenue = $500,000 – $500,000 x 1% – $500,000 x 2% = $485,000
NOI with 5% PM fee: $485,000 – $100,000 – $485,000 x 5% = $360,750
NOI with 6% PM fee: $485,000 – $100,000 – $485,000 x 6% = $355,900
The difference in NOI is $360,750 – $355,900 = $4,850
Let’s assume the cap rate on the building is 6%. Then the value difference that the 1% difference in PM would create is $4,850 / 6% = $80, 833.
As discussed above, proposed sponsor fees have a significant impact on the returns expected from the deal. Make sure that firstly, the sponsor is clear on the fees and secondly, the fee structure is fairly set in relation to the market and the sponsor is motivated enough to manage the deal to the best of their abilities.