Despite the misconception that all real estate sponsors are “deep-pocketed” with ample access to capital. The reality is that most only have a fraction of their own equity invested into any one real estate endeavor. Typically, people finance most multifamily real estate transactions with a mix of debt and equity. This is with the lion’s share of the equity that is invested by third-party passive investors.
Those third-party investors, or better known as limited partners (LPs). 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. This is if they are able to manage a deal so that it exceeds initial return projections. People refer to this bigger piece of the pie as the “sponsor promote.”
This article examines how real estate sponsors utilize real estate promoter incentives to encourage developers. As well as how to 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. This is including but not limited to an acquisition fee, project management fee, capital events fee, disposition fee, and more. Usually, people calculate these fees as a percentage of specific expenses. For example, 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 describes in detail how, when and under what conditions the parties involved receive their repayments in specific amounts.
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%. Beyond that level of return, the outcome depends on whether the deal involved 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, also known as “carried interest” in non-real estate private equity investment
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.
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. Then the sponsor will seek a reward for their efforts in reaching 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. However, 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. So-
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 commonly 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. However, after factoring in the value of the sponsor promote, the LP investors’ IRR may land marginally lower at 14%.
Remember, that a 14% IRR is still much higher than what the LP investors had 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?
People can structure real estate waterfalls in may ways. Some may not include a promote at all. For those that do, the sponsor promote can range significantly 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 increase 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?
Investors frequently inquire whether a promote will apply if they experience higher than expected cash-on-cash returns. The answer is no, there is no connection between promotes and cash-on-cash returns.
It’s crucial to know that promoters usually base their calculations on IRR exceedances, not off cash-on-cash returns. For example, if the preferred return is 8% and the 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 design it so that after the LPs reach their agreed returns, the GP receives a larger share 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.
People can also use promotes with real estate funds, where both the sponsor and the real estate fund manager receive a promote based on certain IRR exceedances. This is better 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 enough 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, people generally apply a Cross-promote.
While a sponsor may earn a promote when a particular deal surpasses its original benchmarks, a cross-promote may occur when a fund manager achieves or exceeds specific IRR benchmarks across the entire portfolio. Cross-promotes assume that not every deal in a portfolio will meet or exceed initial return expectations. However, fund sponsors do deserve a reward when the whole fund exceeds 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.
Keep in mind, not every fund structure uses cross-promotes. 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.
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 often just wants to be incentivized for exceeding the return projections. This creates a win-win scenario for all parties involved, and often, 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.