Investing in private equity real estate deals is more accessible than ever, thanks to the recent rise in reputable crowdfunding platforms that have opened the door to single-property commercial real estate investing to the investing community.
In any investment, it's important to know the costs, and that's especially true when it comes to alternative investments like private equity real estate deals. The main way that a deal's sponsor (the general partner in the project who does the actual work) gets paid is known as sponsor promote. Here's what sponsor promote is, how it works, and why it's worth paying.
Sponsor promote is a real estate term that refers to the share of investor profit paid to the sponsor for a profitable real estate private equity investment.
In most other forms of private equity investing, this is referred to as "carry" or "carried interest."
In a private equity real estate investment, such as those offered through popular crowdfunding platforms, investors are entitled to receive a certain return before the sponsor is entitled to take a disproportionate cut of the profits.
This is known as a preferred return and is also commonly referred to as the return hurdle or IRR hurdle, which stands for internal rate of return. For example, if a particular deal has a preferred return of 8%, this means that the first 8% in annualized investment returns pass through to the deal's equity investors.
Beyond the preferred return, profits begin to get distributed to both the investors and the deal's sponsors. And the portion that goes to the sponsor is known as sponsor promote.
Consider this simplified example. Let's say that a deal provides for an 8% preferred return, and any profits beyond that threshold are distributed 75% to investors and 25% to the sponsor. If the deal achieved a 12% annualized return, the sponsor promote would only kick in on the portion of the return in excess of 8%.
In practice, most private equity real estate deals have a multitiered sponsor promote structure, also known as the distribution waterfall. As an example, you might see a structure that looks like this:
- 100% of returns go to investors (or members) until each investor has received an 8% internal rate of return, or IRR.
- 75% of returns in excess of 8% go to investors, with the other 25% going to the deal sponsor, until a 16% IRR has been achieved.
- 65% of returns in excess of 16% IRR go to investors, with the remaining 35% of profits distributed to the deal sponsor.
The idea behind a tiered structure like this is that it incentivizes the sponsor to make the investment as profitable as possible. In short, the more investors get paid, the better the sponsor's return gets.
The sponsor promote structures can vary dramatically. Generally speaking, sponsors with a more impressive track record of success can get away with a more sponsor-friendly promote structure than inexperienced sponsors can, and rightfully so. And as a general rule, the riskier a deal is, the larger the "preferred return" tier will be in order to attract more investment capital. For example, you might see a preferred return in the 5%-8% range for a deal that involves a stable commercial property with minimal execution risk, while it's not uncommon to see preferred returns in the double digits for more opportunistic (read: risky) projects.
Now, you might be thinking that in a profitable real estate deal, sponsor promote can translate to a lot of money. And you'd be right. It's not uncommon for sponsors of private equity real estate investments to make millions on a successful deal, even without investing a ton of their own capital.
The short answer is that sponsor promote is designed to both compensate the sponsor for their work and expertise and also to incentivize them to make the investment as successful for investors as it can possibly be.
One thing I advise investors to keep in mind is that if you have the money, commercial real estate development is easy to get into. But it's hard to do in a profitable manner. And that's why there's so much potential for sponsors to profit; it's very difficult to take a commercial real estate project and generate a double-digit rate of return for investors.
Not only does the sponsor have to find the project, make sure the numbers work, and negotiate the purchase price, but there are lots of other jobs they do. They obtain financing, deal with tenant leases, oversee capital projects, and much more that inexperienced investors simply wouldn't know how to do -- at least not in an efficient and profitable manner.
Meanwhile, the investors of a private equity real estate deal, also known as the deal's "members," literally do nothing. They write a check and let the sponsor do the actual work required to turn an idea into a profitable real estate investment. And that's why they deserve a disproportionate share of the deal's profits. Even if it turns out to be millions of dollars in a relatively short period of time.
This is how most joint venture business arrangements work where there are both active and passive investors. For example, if you and a friend decide to buy a restaurant, and your friend works at the restaurant as a full-time job while you remain a silent partner, don't they deserve more compensation than you? The same idea applies here.
Note that there are three main ways sponsors typically get paid in real estate investments:
Sponsor promote – A portion of investors' profits the sponsor receives as compensation for a profitable real estate investment, which typically kicks in above a certain minimum return threshold or IRR hurdle. This is the compensation method we've discussed in detail throughout this article.
Profit split – In virtually all private equity real estate investments, the sponsor contributes a portion of the deal's necessary capital. For example, if a real estate deal requires $25 million in equity capital to fund the project, the sponsor might make an equity contribution of $5 million themselves and raise the other $20 million from investors. Just like any other investor, the sponsor would be entitled to their proportional share of profits from the investment, including cash flow (if any) and profits from a successful exit.
Acquisition fee – Sponsors often get a modest one-time fee upon the start of a private equity real estate investment. For example, if a sponsor raises money from investors to purchase a hotel, they may receive a 1% fee when the purchase of the real estate asset closes. The acquisition fee is typically based on the purchase price of the subject property (as opposed to the total project budget), and acquisition fees in the 1%-2% range are common.
The Millionacres bottom line
Of the three ways sponsors get paid, sponsor promote is where they (hopefully) will make the bulk of their money. Think of it this way: As long as the structure is reasonable, a large sponsor promote paid to the deal's sponsor is a win-win situation, as it means that you, the investor, made an outstanding return on a completely passive investment.