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Private Real Estate Investment Funds
Article #3 –
Manager Compensation
In this 6-part series, I explain
private real estate investment funds. You have a real estate
fund when you accept money from passive investors to do
transactions in real estate. A real estate fund is a hedge
fund and it is subject to most laws that apply to hedge
funds, including securities laws and ERISA. Real estate
funds usually are LLCs or limited partnerships, and they
have complex terms for investor rights, manager compensation
and more.
These are the 6 articles in the
series:
In this
Article #3, I talk about manager compensation. Things get
interesting when we talk about fees. As a general matter,
managers receive a combination of management fees +
profit-share + reimbursement of expenses.
Management Fees
For small
real estate funds, I frequently set management fees at some
annualized percentage of the fair market value of assets
under management. The fund usually pays fees monthly or
quarterly. Fees range from 1 to 3% of assets. The exact
percentage depends on the manager’s track record. Note that
a California registered investment advisor may not take a
management fee over 3%.
Profit-Share
A fund manager earns a
profit-share, aka performance fee or “carry,” based on the
performance of the fund. For real estate funds, the manager
can take the fee as a percentage of profits distributed to
investors. The profit-share kicks in when the fund actually
distributes money to the investors.
Sometimes the manager takes its
percentage after satisfying a hurdle rate in favor of the
investors. A hurdle rate is a minimum return that the
investors must receive before the manager can earn a profit
share. There are hard and soft hurdles:
Hard hurdle – The manager
gets its profit share on all distributions after returning
the investor’s capital contribution + an annual preferred
rate (e.g. 5%). A common formulation is for the fund to
distribute all money to the investors until they have
received 100% of their contributions plus a 5% preferred
return. After that, the investors and the managers divide
all excess profits based on some agreed split, for example,
investors 70 / managers 30.
Soft hurdle – The manager
gets its profit share on all distributions once the fund
achieves the hurdle rate. Assume a hurdle rate of an
8% return and a 70 / 30 split. If the fund's annual
return does not reach 8%, the manager gets no profit-share.
If the fund achieves an annual return of 8% or more then all
profits are split investors 70 / manager 30.
Soft hurdles are tricky – based
on this simplified example, for an annual return of 7.99%
the manager gets no profit share and the investors get all
profits, but for an annual return of 8.01% the profits are
split investors 70 / manager 30. Usually a fund will tinker
with a soft hurdle to avoid unfair outcomes.
Expenses
Sophisticated investors are wary of how the fund pays
expenses. The issue is the allocation of fund expenses
either: (i) to the fund (that is, to be paid by the
investors), or (ii) to the managers (that is, to be paid by
the managers out of their fees). This issue frequently
stays hidden, but it is very important.
What to do
about investors who want a special deal and preferential
rights over the other investors? Use a Side Letter – see
Article #4
next.
Get a Lawyer
Real
estate funds, like all hedge funds, are very complex. This
is not something to learn as you go. You need the help of
accounting, tax and legal counsel who are experienced in the
area.
Call me to schedule a legal consultation:
510-796-9144 | 