Active vs Passive Investing

Active vs Passive Investing: A Multifamily Syndication Perspective

A common beginner topic of discussion in the real estate investing world is the active versus passive investing. Active investing essentially means to work for the returns you are achieving. Conversely, passive investing requires due diligence (work) upfront to make the investment decision, but once the decision is made, the investment is largely hands-off. When people first get educated about the benefits of real estate ownership/investing. Many get excited and jump in head first but quickly realize that part-time active real estate investing is neither prudent nor realistic. For example, individuals with highly-compensated specialized skills such as doctors, lawyers, and software engineers likely shouldn’t drop everything and start flipping houses in their neighborhood. On the other hand, many people are turned off by the idea of handing their money over to someone else to manage and collect fees from.

The active versus passive discussion creates a fork in the road for people and requires soul searching in order to become set on a certain path. Many blogs will imbue its readers to leave their boring day jobs to go out and amass a huge portfolio of real estate, while others will convince you that managing your own investments is so much trouble that you should just simply invest with the author. My goal today is neither. Instead, I’d like to take a more analytical approach (as you know, I prefer). 

First, I’d like to quash the notion that general partners in private equity real estate are overly compensated. To the contrary, LPs, for the most part, have become much savvier in the last 20 years and are thus able to negotiate much better deals for themselves, especially at the institutional level. Nevertheless, passive investors making small investments ($50,000 to $500,000) must be vigilant as many sponsors are charging both above-market and hidden fees in the realm of retail syndications. Today, I will use market fees for a retail syndication model to accurately quantify and compare GP versus LP compensation. 

Here is the typical fee structure often found in a value-add multifamily syndication:

• 2% acquisition fee
• 2% asset management fee
• 8% preferred return
• 30% carried interest or “promote”

Additionally, many sponsors charge the deal a 1% loan guarantee fee, a 1% disposition fee, 5% construction management fee, put their travel costs onto the property, put corporate software costs onto the property, include return hurdles which increase the carried interest as the returns increase, pay the preferred return via pre-raised investor principal in order earn carry, which is insidiously dilutive to returns, and more. 

Now that we have established our example fee structure, we will now overlay these fees on top of a pretty good property level return for a class C value-add investment financed with 10-year debt:

• The project level returns are 23.3% over a five-year hold (pretty great!)
• The LP IRR is 17.6% (investors have come to expect this but this is a great return for a passive investment)

• LP Equity Multiple – 2.03x
• LP Annualized Return – 20.5%

• Basically, the GPs are cutting into the LPs return by 5.7%. This means that if an investor were to buy the asset his or herself and implement the business plan, they could earn the project level return of 23.3% all for themselves or do nothing and earn 17.6%. 

This could be one way to evaluate whether the general partners are earning a reasonable compensation and whether or not it is worth it for an investor to do the deal themselves (if they could) to capture those additional returns. However, another way to look at this equation yields a potentially more interesting result. 

Instead, if we take this same deal with the same returns and general partnership structure and calculate the net present value of the fee-based compensation (acquisition fee and asset management fee) using a 20% discount rate and calculate the net present value of the performance-based compensation (carried interest – 30% of the cash flow above 8% to the investors as well as 30% of the sale profits), it would look something like this. 

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Next, we discount the performance-based compensation to the general partnership by 25% because there is a fair amount of uncertainty of earning the promote. Then we add the two compensations together (NPV of fee-based compensation plus NPV of performance-based compensation discounted by 25%). For our example, this equals $546,620.50. Lastly, we divide this sum by the amount of equity required for the project to arrive at 16.5% - our weighted NPV compensation number as a percentage of equity raised. This percentage means that a sponsor who raises $1MM to perform a value-add multifamily investment essentially makes 16.5% on that raised capital. Meanwhile, that same capital is projected to passively earn 17.6% IRR. A 17.6% IRR means an investor is making a 17.6% compounded return annually (over a five-year example timeline that is well over 5 times the compensation as a 16.5% NPV). Yes, the sponsor gets to leverage OPM to a significant degree, but he still has to do all of the work. And it truly is a lot of work. So much so, that these deals/companies require employees such as acquisition analysts, asset managers, project managers, and more. Additionally, the general partnership is usually split amongst multiple partners and joint venture groups. In the end, the main general partner and/or key principal might only receive 20% of the GP compensation after splitting the profits with partners and paying overhead. This means the person doing all of the work to facilitate the investors’ 17.6% IRR might only make 3.3% on raised equity on an uncertainty discounted net present value. This is obviously not very much! To compare, equity brokers typically get paid 3% on the equity they provide for a deal and they get paid upfront and never have to think about the deal again. Equity brokers certainly provide a lot of value to a sponsor and a deal since they are typically arranging a JV equity partner to bring 90% of the required equity. Debt brokers, on the other hand, have a much easier time arranging debt financing since it is simply a much easier product to find and procure in the open market. However, debt brokers still can make 1% of the loan proceeds at closing and never have to think about the deal again. On a deal that is 75% leveraged, a 1% debt broker fee actually equals the same as a 3% equity broker fee! This is a very sobering reality considering the fact that equity brokers are providing much greater value.

Example – $10MM deal @ 75% leverage:

• $7.5MM of debt @ 1% broker fee = $75,000
• $2.5MM of equity @ 3% broker fee = $75,000

Comparing the fees paid out to intermediaries involved in multifamily transactions to sponsor fees strongly argues the fact that sponsors really are not being overcompensated, even in the more expensive, retail syndication structure (2% acquisition fee, 2% asset management fee, 8% pref, 30% promote). I think this discussion and line of reasoning should help to educate passive investors about the realities of sponsored deal structure as well as compel him or her to look a level deeper at all of the costs involved in a proposed investment, beyond just the syndication structure. For example, we had an investor tell us that 50/50 promote after the 18% IRR hurdle is “rich”. This is market! An investor should be thrilled if we are delivering over an 18% IRR (depending on the risk of the deal). What they should really be asking is how much is the deal paying debt and equity intermediaries as well as the myriad other fees which are often used to facilitate an investment. 

Certainly, this article is not your typical active versus passive discussion but I believe it shines a unique light of clarity on the private equity compensation model. Terrific returns can be achieved for limited partners through well-sourced and negotiated passive investments. This is why one of our capital allocation strategies is to partner with other deal sponsors and let them do the heavy lifting of finding, analyzing, acquiring, financing, and managing the investment for a small piece of the profits. I believe this article’s analysis went a long way to show how general partner fees are a reasonable cost of partnering on and accessing private equity investments.