Guide to Alignment of Interests in Real Estate Investing: Maximizing Returns with Shared Goals

May 15, 2023

Real estate investing can be a lucrative way to generate passive income and build wealth over time. However, before you invest, it’s important to understand the concept of alignment of interests in real estate investing to ensure that all parties involved are working towards the same goals. This brief guide will provide an overview of what alignment of interests means in the context of real estate investing and why it’s crucial to maximizing your returns.

Alignment of interests refers to the idea that all parties involved in a real estate investment should have the same goals. This includes investors, sponsors, and property managers, and the sponsors and managers should have incentives create shared goals between them and their LPs. When the interests of all parties in a real estate investment are aligned, there are fewer conflicts because everybody benefits from the same outcome.

In real estate investing, alignment of interests can be achieved through various means, such as the sponsor/GP investing significantly alongside the LPs, minimization or elimination of fees that could create conflicts of interest, and structuring a waterfall and sponsor promote that aligns the GP with the long term goals of the LP.

This guide will explore these methods and provide tips on how to spot situations where the interests of all parties may not be fully aligned. By understanding the importance of alignment of interests, investors can make more informed decisions about where and with whom they invest, and this will increase the likelihood of a successful investment.

Understanding Real Estate Investing

The Basics

Real estate investing involves the purchase, ownership, management, rental, and/or sale of real estate for profit. It is a popular investment strategy because it offers the potential for long-term appreciation, passive income, and tax benefits.

Real estate investors can choose to invest in various types of properties, including residential, commercial, industrial, self storage and raw land. They can also invest in real estate through different methods, such as direct ownership, real estate investment trusts (REITs), real estate mutual funds, and crowdfunding platforms. No matter which method you choose, alignment of interests between the investors and the investment managers is essential.

The Concept of Alignment of Interests

Definition and Importance

Alignment of interests refers to the idea that all parties involved in a real estate investment have the same goals and incentives. This means that everyone is working towards the same outcome and has a vested interest in the success of the partnership. In other words, the interests of the investors, the sponsors are as identical as possible, and potential conflicts of interest have been eliminated or minimized, not just on paper but in substance as well.

The importance of alignment of interests in real estate investing cannot be overstated. When everyone has the same goals, it will lead to better decision-making, improved communication, and a higher likelihood of success. In multifamily investing, where Piping Rock is focused, we are even aligned with the interests of our residents, because improving the value of each asset starts with providing residents with a better living experience, including a higher quality apartment and prompt maintenance.

How to Confirm Alignment of Interests

1. Examine the fee structure

Real estate investing is a complex strategy that is often expensive to execute because it requires a great deal of coordination and collaboration. This is partly how some real estate investment products attempt to justify the kaleidoscope of fees they charge. You should examine each fee carefully, and do it in the context of different investment offerings from different sponsors. If you do this, you will see that some sponsors take a difference approach to fees than others. Some of the fees you may see in a prospectus or Offering Memorandum include the following:

  • Acquisition Fees
  • Debt Placement Fees
  • Equity Placement Fees
  • Marketing Fees & Allowances
  • Asset Management Fees
  • Expense Allowances & Allocations
  • Construction Management Fee
  • Guarantee Fee
  • Disposition Fee

Just like buying a car or getting a home mortgage, some of the fees you’ll see in some syndications are garbage fees. If you have the power to negotiate, you can often eliminate or minimize some of these fees, but the reality for most LPs is simply to understand the need to shop around for a better deal on fees.

Try to understand if the fees seem reasonable compared to sponsor’s experience and the forecast returns. Ask yourself if the fees being charged truly align the sponsor with your long term goals, or is the majority of the sponsors profit coming from upfront fees that basically take them out of the deal from day one? A great example here would be a 3% acquisition fee on a $50 million purchase. A fee of this magnitude could incentivize a sponsor to close the purchase due to the $1.5 million fee, even though physical challenges were identified during due diligence.

2. Assess the Co-Invest

The second screen you should have for alignment of interests in the sponsor co-invest. Sponsors should be willing to “eat their own cooking” and they should demonstrate this by co-investing alongside their LPs. Some institutional joint venture partners require a 10% co-invest, which is a number we think is too arbitrary. A 10% co-invest from a larger sponsor may not be meaningful at all, while a 2% co-invest from a smaller sponsor could be all the money in the world. The key is to make sure your sponsor has skin in the game that is meaningful to them in the context of their balance sheet. Piping Rock will usually invest at least 10% of the equity in each property, but we have often invested much more.

If you see a transaction riddled with fees and almost no co-investment from the sponsor, it’s likely that the sponsor profit comes mainly from acquiring the property and raising the money, not from generating a successful long term investment outcome. A sponsor should be well compensated because they’re doing all the work, but you need to make sure they’re truly incentivized to perform well over the long term.

3. Understand the Waterfall & Promote Structure

The waterfall structure should de-risk the investment for the LPs by giving them a first priority claim on early cash flows that is legally senior to the GP. In addition, the sponsor profit (known as the promote) should not be an enormous sponsor windfall regardless of how the investment performs. On the other hand, 100% of the profits going to the LPs is also suboptimal, because this is a sign that the GP has already made its money and doesn’t care about any incidental profits later on.

All waterfalls should include a Preferred Return for LPs. This is part of the de-risking mechanism of the waterfall, and it helps align the sponsors interests with the LPs, because the sponsor needs to pay the full Preferred Return to investors before the sponsor can make any money. Preferred Returns often range from 6-10%, and the current “market” Preferred Return is 8%. After the Preferred Return has been met and all LP capital returned in full, any remaining profits are split between the LPs and the GPs.

One of the more common LP/GP splits is 70% of profits to the LPs, and the remaining 30% to the GP. This is referred to as a “70/30 split”. Sometimes, there are additional profit hurdles over which the split for the GP can increase from 70/30 to 60/40 and even 50/50.  You can read more about how waterfalls work and their importance here, but you should know that a properly structured waterfall is an important tool for aligning interests between sponsors and their LPs. 

Proper Alignment of Interests is Essential in Real Estate Investing

If you are investing in private market real estate, it is essential to confirm that each party involved benefits from the same outcome. If the majority of the sponsor’s income comes from up-front fees at closing, then the sponsor benefits more from selling the deal, not from making money for the LPs over the long term.

Most reputable sponsors and operators with a proven track record will work hard to align their interests with their LPs. However, not all sponsors are as focused on the success of their LPs as others, and we hope that this guide will help you distinguish between the two. You can read more about how Piping Rock aligns its interests with our investors here.