What is Fee Drag in an Apartment Syndication? Understanding the Hidden Costs

Fee drag is an arcane but important term in the investment world, and all investors should understand why fee drag is important. Fee drag in an apartment syndication relates to the fact that transaction costs related to a real estate investment will almost always reduce investor returns on a one for one basis, all else being equal. All investments involve fees, but some investments involve excessive fees, and excessive fees in a real estate syndication will almost always erode investor returns excessively. Here is a great example from Kiplingers in an article about the dangers of unlisted real estate trusts:

“When an investor puts $10 into an unlisted REIT, he or she is often getting only about $9 of real estate investments. Commissions and other upfront costs can immediately consume roughly 10% of the investment. The investments can also carry ongoing management fees and expenses.

Michael Black, a broker in Scottsdale, Ariz., says he generally gets a 6% or 7% commission when selling clients non-traded REITs. He acknowledges that the real estate investments must deliver “quite a return” to overcome the fee hurdles.”

Translation: If you invested $100,000 into the unlisted REIT described above, your $100,000 investment would immediately be reduced to $90,000 on day one. This is an immediate $10,000 loss. How are you going to earn that $10,000 back and why put your hard earned money at such a disadvantage? 

This is a very simple example of fee drag, but fee drag comes in lots of different flavors that are not as easy to detect. Accordingly, it is incredibly important for investors to acknowledge and understand this risk, and the different ways in which fee drag can infiltrate your investment. So let’s take a deep dive on this topic!

Definition of Fee Drag

Fee drag is a term used to describe the effect of fees on the overall return of investors. It refers to the fees charged by the general partner (GP) or the sponsor of an investment, which can reduce the net profit for limited partners (LPs).

In an apartment syndication, the GP is responsible for sourcing, acquiring, financing, managing, and selling the property. The LPs provide the capital and receive a share of the profits based on their investment. The GP charges fees for their services, which can include acquisition fees, asset management fees, disposition fees, and performance-based fees known as the promote.

Causes of Fee Drag

Transaction Fees, On Going Fees & the Sponsor Promote

When the property is purchased, fee drag occurs almost immediately because the acquisition fee is a transaction fee. The acquisition fee paid to the GP is paid from the funds received from the LPs, but these funds are not invested in the asset. Instead, they are paid to the GP. For example, if the GP charges a 1% acquisition fee on a $10 million property, the acquisition fee would be $100,000. This reduces the amount of capital being invested by $100,000, because that $100,000 is going to the sponsor, not into the asset. As a result, the overall return for the LPs would be reduced by $100,000, all else being equal.

Excessive Transaction Fees

A one percent acquisition fee on a larger property is relatively common. But what should you do if the acquisition fee is higher than 1%, maybe something like 2 or 3%? This should catch your attention, and you should then be on alert for other factors that, if present, could put you at an even bigger disadvantage.  An acquisition fee of 2-3% is generally considered “above-market” (and it could be an incentive for the sponsor to overpay for the property), so if that above-market 2-3% fee is just one of numerous other fees being charged by the sponsor, and those fees are also above-market, this should be a red flag. 

Additional fees could be things like a fee for debt placement, a fee for refinancing, a fee for the Guarantor, a fee for disposition, and a fee for asset management. Fees for debt placement, refinancing and dispositions are not commonly charged by most sponsors, so if you see these fees and they are combined with an above-market acquisition fee, we would suggest doing business with a different sponsor. Sponsors who engage in these practices are usually running a fee-driven business, not a return-driven business, meaning these sponsors make their money from charging fees to their LPs, not from generating attractive returns for their LPs.

On-Going Fees

The most common example of an on-going fee is an asset management fee, but the ways in which this fee is assessed can be significantly different. Some sponsors charge an asset management fee based on a percentage of gross revenue, usually somewhere near 2% of gross revenue, depending on the size of the asset. Other sponsors also charge a 2% asset management fee, but they charge their fee based on the total equity invested in the asset. 2% of total equity is usually a much higher number than a 2% fee based on gross revenue.

The asset management fee is the most common on-going fee, but some sponsors also charge on going administrative fees, construction management fees, and on-going fees for things like investment management software fees. Obviously, transactional fees and ongoing fees will add up, so a good sponsor/manager will limit the number of fees they charge, and they will restrict the amount of each fee they charge. This helps align the GPs interest with the interests of their LPs. We will address alignment of interests in more detail below, because alignment of interests is also very important to identify and understand.

The Sponsor Promote

There are other causes of fee drag, like expensive legal fees and property managers allocating purely corporate expenses to the property, but the main cause of fee drag in an apartment syndication is overly generous and even unfair sponsor compensation. On the other hand, scrupulous sponsors understand that charging excessive fees will result in a lackluster track record for investor returns (fee drag, after all!), and that excessive fees will ultimately hurt them as a result.

The same is true for the sponsor promote. Scrupulous sponsors will do their best to strike the right balance with the promote, such that the waterfall structure provides the right long term incentives for the sponsor, but also prioritizes LP returns. The waterfall governs how profits are split between the LPs and the sponsor, and the sponsor share of the profits is known as the promote. If you’re not familiar with a waterfall, we have a separate post on how waterfalls work in a syndication here. 

The key in the waterfall structure is that the LPs receive a majority of the profits, and they receive their returns plus 100% return of capital before the sponsor shares in any profit at all. A simple, fair waterfall usually includes a Preferred Return that is paid to the LPs, and then a 70/30 split of profits (in favor of the LPs) once the LPs have received their Preferred Return and 100% return of capital. Obviously, if the split were 70/30 in favor of the GP, the LPs would struggle to earn an adequate return.

For LPs, Proper Alignment of Interests is Everything

Sponsors who have made an effort align their interests with their LPs are sponsors who do not want to benefit at the expense of their investors. These sponsors do not charge numerous, excessive fees and they will structure a fair promote. A fair promote leads to GPs earning profits only if the investment is successful, not through charging excessive upfront fees that can ultimately make the GP indifferent to the overall success of the investment. This can also lead to better decision making, such as the sponsor heavily negotiating the purchase price, rather than paying full price because the full price will earn the sponsor a higher acquisition fee.

It’s critically important to have the ability to recognize a deal structure that is properly aligned with you as an LP, and one that is not. In addition to the absence of certain fees (such as disposition fees and refinancing fees) and a fair promote, many sponsors will also invest significantly alongside their LPs. This is called the sponsor co-invest, and a significant co-invest means that the sponsor will not only lose profit if the investment is unsuccessful, but they will also lose capital, just like their LPs. We have published a guide to alignment of interests and shared goals here, and we have written more on how we align our interests with our partners here.

What Can You Do About Fee Drag?

Shop around before you invest. Just like shopping around for the best price on any other product or service, you should consider how much you are paying for investing services. Different sponsors have different philosophies on fees, promotes and co-investment amounts, and you should invest with those sponsors who’ve made thoughtful and deliberate efforts to align their long term interests with yours.