Education, Finance, Investment Advice

What to Know about
Real Estate Sponsor Promotes

smartland-what-to-know-about-real-estate-sponsor-promotes.mp3 Here, we look at how real estate sponsor promotes are used to incentivize real estate developers and keep the investors’ interests aligned... Listen to this article

Introduction

Despite the misconception that all real estate sponsors are “deep-pocketed” with abundant access to capital, the reality is that most only have a fraction of their own equity invested into any one real estate endeavor. Generally, most multifamily real estate deals are financed using some combination of debt and equity, with the lion’s share of the equity invested by third-party passive investors.

Those third-party investors, known as limited partners (LPs), will expect to be repaid their initial capital investment as well as a certain preferred return. However, at some point, the sponsor will look to earn a disproportionately higher share of the returns if they are able to manage a deal so that it exceeds initial return projections. This larger slice of the pie is referred to as the “sponsor promote”.

In this article, we look at how sponsor promotes are used to incentivize real estate developers and keep the equity investors’ interests aligned.

How Real Estate Sponsors Make Money

There are two primary ways a real estate sponsor (a/k/a the “developer” or “general partner”) can make money on an apartment investment.

The first is through a series of fees, including but not limited to an acquisition fee, project management fee, capital events fee, disposition fee, and more. These fees are usually calculated as a percentage of specific costs (e.g., an acquisition fee totaling 1% of the property’s purchase price).

One of the ways where sponsors
earn money is through profit-sharing with
their limited partner (LP) investors.

The second way sponsors earn money is through profit sharing with their limited partner (LP) investors.

The specifics around how, when, and how much profit the sponsor will earn is a critical part of the real estate equity waterfall. The real estate equity waterfall is a fancy way of describing which parties are repaid, in what amounts, when, and under what conditions.

Here is a very simple example.

Let’s say the limited partners have invested 90% of the equity needed to acquire and renovate a multifamily property. The sponsor has invested the remaining 10%. The equity waterfall might stipulate that the LPs will collect 90% of the cash flow distributions up to a certain threshold—say, an 8% internal rate of return (IRR). The sponsor will collect the remaining 10%. What happens beyond that level of return will depend on whether the deal includes what’s known as a “sponsor promote”.

What is a “Sponsor Promote” in Apartment Investing?

One of the ways to keep the GP and LPs’ interests aligned is to structure the real estate waterfall in a way that incentivizes the sponsor to meet (or better yet, exceed) initial return projections or hurdle rates. One way to do so is by using sponsor promotes.

The sponsor promote, which is the same as “carried interest” in non-real estate private equity investments, is used to reward the GP with a disproportionately larger share of cash flow distribution after meeting certain return hurdles.

For example, let’s say that an apartment syndicator is planning to acquire a building for $3 million. They are planning to finance the deal at 65% loan-to-value. The syndicator only has $50,000 of their own equity to put into the deal, meaning they need to raise another $950,000 from private equity investors to have the $1 million in equity necessary to close.

Purchase Price$3,000,000
Assumed Debt$2,000,000
GP Equity$50,000
LP Equity$950,000

The waterfall is structured so that cash flow distributions are split proportionally to the degree of the investors’ equity investment up to an 8% IRR. In this case, that means the GP will earn only 5% of the profits and the LP investors will earn 95% of the profits until they hit the 8% IRR benchmark.

At this point, the sponsor layers in some sort of promoted interest. The promoted interest is to compensate the sponsor for doing all of the work associated with the deal. If the deal exceeds the 8% IRR that was originally projected, the sponsor wants to be rewarded for their work in achieving this milestone.

Therefore, the sponsor says that they’ll take a 30% promote for any cash flows above and beyond the 8% IRR that was originally projected.

This is not the same as taking 30% of the total profits above the 8% IRR. Instead, this means that the sponsor will collect 30% of the LPs’ profits over the 8% IRR (i.e., 30% of 95%).

GP Receives 30% of LP Profits over 8% IRR

Sponsor Promote = 30% x 95% = 28.5% of total profits above 8% IRR

Sponsor’s Total Profits above 8% IRR = 28.5% + 5.0% = 33.5%

Now, why would an investor agree to the GP taking a greater share of their profits above that threshold? The answer is simple: most investors will be happy that the deal is generating the 8% IRR as originally intended. If a sponsor is able to exceed those return projections, the LPs will still be earning a bulk of the excess profits—but now, they are returning more money to the sponsor to compensate them for earning more money for everyone involved.

Fast-forward five years. Using the example from above, let’s say that the deal has actually achieved a 16% IRR – double what was originally projected. Everyone is really happy with the results. There is more than $1 million excess profits upon sale of the property.

Where does that profit go and how is it split?

Let’s assume there is $400,000 in profit up to the 8% IRR and $600,000 in profit over the 8% IRR. This is how that would typically be split:

$400,000 in profit up to 8% IRR:

  • 95% goes to LP investors = $380,000
  • 5% goes to the GP = $20,000

$600,000 in profit beyond 8% IRR:

  • 66.5% goes to LP investors = $399,000
  • 33.5% goes to GP = $201,000

When utilizing sponsor promotes, the deal’s IRR may ultimately look different than the IRR an investor actually earned. In this case, the apartment project may have generated a 16% IRR, but after factoring in the value of the sponsor promote, the LP investors’ IRR may land marginally lower at 14%. Remember, of course, that a 14% IRR is still significantly higher than what the LP investors originally anticipated earning (i.e., an 8% return on their investment). Meanwhile, the sponsor will have earned a 40% IRR based on their promoted interest. At the end of the day, everyone wins.

What is a Typical Sponsor Promote?

Real estate waterfalls can be structured in many ways. Some may not include a promote at all. For those that do, the sponsor promote can range dramatically based on certain benchmarks.

In the example above, there was one flat sponsor promote: 30% over an 8% IRR. However, more complicated real estate deals (particularly those that are higher value or have many investors) may utilize more complex promote structures.

For example, a sample waterfall structure might assume the following:

Preferred Return = 8% IRR
8% to 11% IRR = 20% Promote
11% to 15% IRR = 30% Promote
15% + IRR = 40% Promote

While these promote numbers may seem significant, it is important to remember that the purpose of the promote is to incentivize the sponsor to make decisions that maximize returns for the operating partnership as a whole, and to reward investment performance that meets or exceeds return expectations

How do Promotes relate to Cash-on-Cash Returns?

This is a commonly asked question. Specifically, investors often ask whether a promote will be applied if cash-on-cash returns are higher than expected. The answer is no, there is no correlation between promotes and cash-on-cash returns.

It is important to understand that promotes are generally calculated based on IRR exceedances – NOT cash-on-cash returns. For example, if the preferred return is 8% and a deal generates a cash-on-cash return of 10% in Year 1, no promoted interest will be applied. This is totally normal. The reason for this is that for an IRR to be positive, it first requires the return of investors’ capital. This is very difficult to achieve in the first few years of an asset’s hold period, despite how impressive the cash-on-cash returns may otherwise be.

What is a “Double Promote” in Real Estate Investing?

A “double promote” situation is one that apartment investors will want to look for and be sure to avoid, as it is a way of a sponsor “double-dipping” in the profits.

In short, most joint ventures are structured so that, after the LPs achieve their specified returns, the GP will receive a higher percentage of the remaining profits (i.e., the promote). This structure results in the GP earning a higher share of profits relative to the original amount of equity they invested in the deal. In turn, the LPs receive a lower return than if the GP was not collecting a promote.

A double-promote scenario occurs when a fund invests limited partner equity with a sponsor.

Promotes can also be used with real estate funds, in which case both the sponsor and the real estate fund manager take a promote based on certain IRR exceedances. This is known as a double-promote.

Essentially, a double-promote scenario occurs when a fund invests LP equity with a sponsor. Then, if that deal performs well and exceeds the hurdle rate, the sponsor takes a promote, thus lowering the net cash flow back to the fund. Assuming the cash flow going back to the fund is still sufficient to exceed IRR targets, the fund manager (who is often the same entity as the sponsor), may be eligible for a promote as well, which further lowers the LP investors’ total returns. In other words, both the deal sponsor and fund manager are taking promotes, and oftentimes, the deal sponsor and fund manager are one in the same which results in “double-dipping” into the LP investors’ profits.

What is a “Cross-Promote” in Commercial Real Estate?

Just as a real estate sponsor promote can be utilized to reward the GP overseeing a specific real estate deal, it can also be applied to multifamily real estate fund situations. With the latter, a cross-promote is generally applied.

Whereas a sponsor may collect a promote when a specific deal outperforms its initial benchmarks, a cross-promote can be used when a fund manager meets or exceeds specific IRR benchmarks portfolio-wide. Cross-promotes assume that not every deal in a portfolio will meet or exceed initial return expectations, but fund sponsors should be rewarded when the fund, in its entirety, outperforms IRR expectations.

In other words, the fund manager’s promote is “crossed-over” the pool of properties instead of being tied to any one specific property.

Note, however, that cross-promotes are not used with every fund structure. Some real estate funds will opt to utilize promotes associated with individual property performance. Others will utilize the cross-promote structure instead. It is up to the fund manager to determine how best to proceed.

A real estate sponsor promotes can be a
valuable way of keeping the general partner
and limited partner’s interests aligned.

Conclusion

As noted here, real estate sponsor promotes can be a valuable way of keeping the GP and LP interests aligned. In addition to charging modest fees for their work, the sponsor generally wants to be incentivized for exceeding return projections. This creates a win-win scenario for all parties involved, and generally, most LP investors are willing to forego some profit above a certain threshold if there is more total profit to share than originally anticipated.

Interested in learning more? Contact us today to learn more about Smartland’s approach to utilizing sponsor promotes.


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