Episode 28: Sponsor Compensation Explained – Fees, Promotes, & Alignment

Welcome to Building Passive Income, the podcast for professionals, entrepreneurs and investors who want to build wealth, diversify beyond Wall street, and create true financial freedom through passive commercial real estate investing. I'm Wayne Courageous III, founding and managing principal of Crei Partners, a leading commercial real estate company, I created CreiCollen, an AI powered resource to serve as your investor education guide. Built on the insights and experience we've developed at Crei Partners, CreiCollen is here to educate you through passive invest tax strategy topics to help your journey in passive investing. Just a quick disclaimer. This podcast and CRA Colin is for educational purposes only and is not legal tax or investment advice. Always consult with your attorney, CPA and financial advisor before making any investment decisions. I've spent nearly two decades helping investors understand the power of commercial real estate from multifamily to storage to retail. Each episode is under 15 minutes, simple to follow and and packed with insights to help you grow your income and protect your capital without becoming a landlord. If you're ready to learn quickly and invest smarter, you're in the right place. Welcome to Building Passive Income. Let's build wealth together. Here's creicollen.

Fees, Promotes and Alignment Here's a question that makes a lot of new investors. Is the sponsor making too much money on this deal? It's an important question. As a passive investor, you're trusting the sponsor with your capital and you want to make sure their compensation is fair, transparent and aligned with your success. But here's the Sponsor compensation is often misunderstood. Investors see a list of fees in the PPM and assume the sponsor is double dipping or taking advantage of. The reality is more nuanced. Sponsors earn compensation for the work they do, the risk they take, and the value they create. But not all compensation structures are created equal. Some are fair and investor aligned. Others are heavily weighted toward the sponsor with fees stacked on top of fees and promotes that kick in too early. I'm Crei Collin and this is Building Passive Income, where we give you the strategies to build real wealth through passive real estate investing. Today we're breaking down sponsor compensation. You'll learn what fees are standard, what fees should raise questions, how promotes work, and how to evaluate whether a sponsor's compensation is aligned with your interests. Let's dive in. The five main Componsor compensation Sponsor compensation typically comes from five sources. Let's break down each one. Acquisition fee this is a one time fee charged at closing, typically 1 to 3% of the purchase price. The acquisition fee compensates the sponsor for sourcing the deal underwriting it, securing financing, raising capital, and closing the transaction. On a $10 million purchase, a 2% acquisition fee is $200,000. This fee is paid at closing out of the equity raised from investors or from the loan proceeds, depending on the deal structure. Asset Management Fee this is an ongoing fee charged during the hold period, typically 1 to 2% of gross collected revenues or net operating income. The asset management fee compensates the sponsor for overseeing the property, managing the property management company, monitoring financial performance, handling investor relations, and making strategic decisions. For example, if a property generates $1 million in annual revenue and the asset management fee is 1.5%, the sponsor receives $15,000 per year. This fee is typically paid monthly or quarterly out of the property's operating cash flow. Refinance Fee if the property is refinanced during the hold period, the sponsor may charge a refinance fee, typically 1% of the new loan amount. This fee compensates the sponsor for the work involved in securing the refinancing, including lender negotiations, underwriting, and closing. On an $8 million refinance, a 1% fee is $80,000. Disposition fee when the property is sold, the sponsor charges a disposition fee, typically 1% to 2% of the sale price. This fee compensates the sponsor for managing the sale process, including marketing, negotiations, due diligence and closing. On a $15 million sale, a 1.5% disposition fee is $225,000. Promote carried interest the promote is the sponsor's share of profits above certain return thresholds, typically after the LP receives their preferred return and return of capital. This is where the bulk of the sponsor's upside comes from in a successful deal. For example, in a 7030 deal, the sponsor receives 30% of profits after the LP has been paid their preferred return and capital. Your Action Step when reviewing a ppm, find the section on fees and compensation. Make a list of every fee the sponsor is charging and when they're paid. What fees are standard versus what should raise questions. Not all fees are created equal. Some are industry standard and reasonable. Others should prompt you to ask questions. Here's a standard and reasonable fees acquisition 1% to 3% asset management fee 1% to 2% of revenues disposition 1% to 2% of sale price refinance 1% of new loan amount 20% to 30% after LP preferred return and return of capital fees that should prompt questions. Acquisition fee above 3% this is on the high end. Ask the sponsor why it's higher than typical. Asset management fee above 2% this is also on the High end Ask whether the sponsor is providing exceptional value that justifies the higher fee. Multiple overlapping Fees if the sponsor is charging an acquisition fee, a financing fee, a loan guarantee fee, and a development fee all on the same deal, ask whether those fees could be consolidated fees paid to related parties. If the sponsor owns the property management company, the construction company, or the brokerage and those entities are also charging fees, ask whether those fees are at or below market rates. Fees that are Red Flags Loan Guarantee Fee Some sponsors charge a separate fee for providing a loan guarantee. This is unusual because the loan guarantee is part of the sponsor's role as gp. If this fee exists, ask why Promote that kicks in before LP Preferred Return if the sponsor starts taking promote before you've received your preferred return, that's a misalignment. Undefined or discretionary fees if the PPM includes vague language like other fees as determined by the gp, that's a red flag. All fees should be clearly defined. Your Action Step Compare the fees in the deal you're evaluating to the standard ranges above. If anything is above the range, ask the sponsor to explain why. Section 3 Understanding the promote and Alignment the promote is the most important component of sponsor compensation because it directly ties the sponsor's earnings to the deal's performance. Here's why. The Promote Structure the promote should be performance based. The sponsor should only earn their promote if you the LP receive your preferred return first. If the deal underperforms and doesn't generate returns above the preferred return, the sponsor's promote should be zero. The promote should be back end loaded. The bulk of the sponsor's compensation should come from the promote at the sale, not from front end fees. This ensures the sponsor is focused on maximizing long term value, not just collecting fees and moving on to the next deal. The promote should have hurdles Some deals have tiered promote structures based on performance hurdles. For example up to 15% IRR 8020 split LP GP 15% to 20% IRR above 20% IRR, this structure rewards the sponsor for exceptional performance while protecting the LP's downside. Deal level versus investor level numbers let's walk through a clear example using both deal level and investor level numbers. Deal level total LP equity raised 3,000,000 GP CO invests $150,000 total $3,150,000 preferred 8% cumulative to LP promote 7030 after LP pref and return of capital at sale Net proceeds after debt payoff $5,000,000 waterfall distribution deal level tier 1 accrued LP preferred return over 5 years $1,200,000 simplified assumes unpaid pref accrued tier 2 return of LP capital $3,000,000 remaining $800,000 tier 34 combined for simplicity split 7030 LP $560,000 GP receives $240,000 total LP return deal level $3,000,000 capital plus $1,200,000 pref $560,000 profit share equals $4,760,000 on $3,000,000 invested equals 1.59 times equity multiple investor invested $100,000 your share of LP equity $100,000 divided by $3,000,000 equals 3.33% your distributions preferred return 3.33% of $1,200,000 equals $40,000 return of capital $100,000 profit 3.33% of $560,000 equals $18,648 total return to you $158,648 on $100,000 equals 1.59 times sponsor compensation deal level acquisition 2% of $10,000,000 purchase $200,000 asset management 1.5% of $1,000,000 revenue per year times 5 years $75,000 disposition fee 1.5% of $15,000,000 sale $225,000 $240,000 total sponsor $740,000 as a percentage of total profit to LPs $1,760,000 42% Is this reasonable? That depends on the value the sponsor created. If they took a $10 million property and sold it for $15 million through strong execution, most investors would say yes. YOUR ACTION STEP when reviewing a deal, ask the sponsor to walk you through the promote structure. Confirm that the LP gets their preferred return and capital back before the promote kicks in. Section 4 the role of GP Co investment in Alignment One of the strongest signals of sponsor alignment is GP Co Investment when the sponsor invests their own capital into the deal alongside the LPs. Here's why GP Co investment matters. Skin in the GAME when the sponsor has their own money at risk, they're more likely to make conservative decisions, avoid unnecessary risks and prioritize long term value creation, shared risk and reward. The sponsor participates in the same waterfall as the LPs. If the deal underperforms, the sponsor loses money too. A sponsor who co invests is signaling confidence in the deal. They believe in the business plan enough to put their own capital on the line. Typical GP Co Investment amounts Most Sponsors co invest 5% to 10% of the total equity raise. On a $3 million equity raise, a 5% GP co investment is $150,000. Some sponsors co invest more, 10% to 20%, which is an even stronger signal of alignment. What if the sponsor doesn't co invest? If the sponsor isn't co investing, ask why. Possible reasons include they're raising multiple deals simultaneously and don't have the liquidity to co invest in all of them, they're early in their career and don't have significant personal capital yet they believe their value comes from execution, not capital, and they're earning their returns through fees and promote. None of these reasons are automatically disqualifying, but lack of co investment should prompt deeper due diligence on the sponsor's track record, experience and alignment mechanisms. Your Action Step when evaluating a deal ask Is the sponsor co investing? If yes, how much? If no, why not Red Flags in Sponsor Compensation Here are some red flags to watch for when evaluating sponsor fees. Stacked on Fees if the sponsor is charging fees at the high end of the range on multiple fronts acquisition, asset management, refinance and disposition, it can indicate they're prioritizing fee income over performance based compensation. Promote before Preferred Return if the waterfall allows the sponsor to take promote before the LP receives their preferred return, that's a misalignment. Related party. Fees Without Disclosure if the sponsor owns the property management company, the construction company or the brokerage and those entities are charging fees, those relationships and fees should be clearly disclosed in the PPM if they're not disclosed or if the fees are above market rates, and that's a concern worth examining closely. Vague or undefined Fees if the PPM includes language like additional fees may be charged at the discretion of the gp, that's worth understanding more clearly. All fees should be clearly defined and disclosed up front. No GP co Investment While not automatically disqualifying, lack of GP co investment should prompt questions about alignment and confidence. Non Cumulative Preferred Return A non cumulative preferred return allows the sponsor to take promote even if you haven't received your full expected return over the life of the deal, this is less investor friendly. If you encounter any of these situations, ask the sponsor to explain. A great sponsor will be transparent and willing to address your concerns. An evasive response is a warning sign. How to Evaluate Total Sponsor Compensation Here's a framework for evaluating whether a sponsor's total compensation is Add up all fees and promote. Make a list of every fee the sponsor is acquisition, asset management, refinance, disposition, and promote. Calculate the total dollar amount based on the deal's projections. Calculate compensation as a percentage of profits. Divide the sponsor's total compensation by the total Profit generated for LPs first for example Total LP $1,760,000 Total sponsor $740,000 Sponsor compensation as a percentage of LP 42% Is that reasonable? It depends on the value the sponsor created. If they executed flawlessly and delivered strong returns, most investors would say yes. Compare to industry benchmarks Compare the sponsor's fees and promote to other deals you've reviewed or or to industry standards. If the sponsor's compensation is significantly higher, ask why Evaluate based on track record A sponsor with a strong track record of delivering on projections and creating value deserves to be compensated well. A first time sponsor with no track record should have more conservative compensation. Ask Is the compensation aligned? The key question isn't is the sponsor making a lot of money? It's is the sponsor only making a lot of money if I make a lot of money? If the answer is yes, if the bulk of the sponsor's compensation comes from performance based promote rather than front end fees, then the structure is likely aligned. Your Action step Use this framework to evaluate the sponsor compensation in every deal you review. If the total compensation seems high, ask the sponsor to justify it. Recap and Action Steps alright, let's recap. Sponsor compensation is a critical element of any syndication deal and understanding how sponsors get paid is key to evaluating alignment and fairness. Here's what you need to know. 1. Sponsor compensation typically comes from 5 acquisition fee, asset management fee, refinance fee, disposition fee and promote. 2. Fees within the typical ranges 1% to 3% acquisition, 1% to 2% asset management, 1% to 2% disposition are generally reasonable. Fees above those ranges should prompt questions. 3. The promote is the most important component because it ties the sponsor's compensation to performance. The LP should receive their preferred return and return of capital before the sponsor takes promote. 4. GP Co investment is a strong signal of alignment. If the sponsor isn't co investing, ask why. 5. Be mindful of situations where fees are stacked. Promotes kick in too early, related party fees aren't disclosed or fee structures lack clarity. These warrant closer scrutiny and questions. 6. Evaluate total sponsor compensation by adding up all fees in promote, calculating it as a percentage of LP profits and comparing it to industry benchmarks and the sponsor's track record. Here's your action step. Pull out the PPM from one of your current syndication investments. List every fee and the promote structure. Calculate the total sponsor compensation as a percentage of projected LP profits. Ask yourself is this reasonable? Is it aligned? If you're ready to build a diversified syndication portfolio with sponsors who prioritize transparency and investor alignment. Let's talk. Check the show notes for a link to schedule a call with us@creipartners.com next week on Building Passive Income. We're diving into capital calls and reserve funds. What happens when a deal needs more money? Until then, remember, financial freedom isn't a dream, it's a decision. And it starts with understanding, fees, promotes and alignment. I'm Crei Collin. Let's Build wealth together.

Thanks for tuning in to Building Passive Income. Today's episode helped shift your mindset or gave you a new tool to grow your wealth. Do us a favor and like, subscribe and share this podcast with someone you care about. Want to go deeper? Join our free Passive Investor coaching program@ passiveinvestorcoaching.com it's the perfect next step to start building wealth through commercial real estate the right way. Remember, financial freedom isn't a dream, it's a decision. And it starts with Building Passive Income. We'll see you in the next episode. Sam.