How to Identify Sponsor Compensation in a Real Estate Investment

When allocating profits from a real estate investment, two parties are typically involved; those who bring the money necessary to pursue the project, and those who bring the experience and resources necessary to make it all happen. Terminology varies by project. Those who bring the money are sometimes referred to as investors or limited partners (LPs). The individual/team/company overseeing the project is commonly referred to as the sponsor or general partner (GP).

There are endless ways to allocate profits from a real estate project. Whatever the structure, the critical first step is to gain a clear understanding of how profits are to be allocated.

In a typical business, profits accrue to the benefit of the equity owners. For example, say you own 10% of the equity in a company that generates $1,000 in profits. $100 of the profits accrue to your benefit. In real estate investing, there is an added wrinkle. This is because the sponsor shares in the profits but does not invest the cash required to do the deal (although most sponsors do participate at some level). Keeping with the example above, if you are a 10% owner in a real estate project that generates $1,000 in profits, you don't necessarily receive $100 as a 10% equity holder. The amount by which your share of the profits as an investor is less than what you would have received using your % ownership represents the sponsor compensation.

The purpose of the sponsor compensation is to compensate the sponsor for their time, efforts, and, most importantly, their expertise in vetting, assembling and overseeing the project. After all, without the sponsor, there's no deal for the investors to participate in.

It's important to distinguish between fees charged at the project level and profit-sharing. Most projects include a component of compensation at the project level, typically in the form of a developer or management fees. These fees are charged before any profits are paid to investors. As an investor in a real estate project you should be aware of both forms of compensation.

As an investor, your preference should be for sponsor compensation to be in the form of profit-sharing over project level fees. By allowing the sponsor to share in the profits of the project as if they were and equity owner, the interests of the two parties are better aligned.

Quick example. Let's assume a project requires $1,000,000 in cash equity from investors. The project will take 3 years and generate $500,000 in net profit. The structure of the deal is as follows: investors receive a 10% preferred return* and 50% of any excess profit above the preferred return.

*Preferred return means 100% of profit accrues to the benefit of investors before the sponsor shares in profits.

$500,000 - Net Profit
$300,000 - Preferred Return (10% for 3 years)
$200,000 - Excess Profit
*50%
$100,000 - Additional Return to Investors

The total return to investors is $400,000 ($300,000 preferred return and $100,000 excess split). The sponsor compensation is $100,000 (excluding any project-level fees).

This is one of many ways to allocate profits from a project. Regardless of the structure, the critical thing to understand as an investor is the mechanism by which the sponsor shares in profits, and if it is reasonable based on the risk/reward of the project.

If a potential project has big upside (profits) and high risk, investors might prefer a higher preferred return and lower excess split. Alternatively, if a project is relatively low risk/upside, investors might prefer a lower preferred return and higher excess split.

There's a common saying in investing:

I went into business with a friend. I brought the money and he brought the experience. Now he has the money and I have the experience.

As an investor, a little upfront effort to understand how potential profits will be allocated can help you avoid this fate.