Of four manager incentive structures I've read, I trust exactly one

Question

I've read management agreements on five apartment deals in the last two years as a passive investor, and the base fee is almost never the interesting part. Everybody's at 2.5% to 4% of collected revenue and it's negotiable at the margin. The incentive fee is where the behavior gets set, and I've seen four different answers.

One. Percentage of NOI above budget, usually 10% to 20% of the excess. Aligns the manager to the number that drives value. Also means the manager has a strong interest in a soft budget, and if they get a vote on the budget you've handed them the scoreboard. I've seen a budget with 2% expense growth in a year insurance renewals were coming in far above that, which made the bonus close to automatic.

Two. Bonus on renewal rate and turn days. Cheap to measure, hard to game, and it points at retention, which is where the money is when rent growth is flat. But a manager can hit a renewal target by handing out flat renewals to everyone, and you'll never see the revenue you left behind because it doesn't appear on any line.

Three. Shared savings on controllable expenses, manager keeps 25% of the reduction. Directly rewards the operational efficiency everyone says is the value lever now. Also rewards deferring maintenance, and deferred maintenance is invisible for about 18 months.

Four. No incentive at all, negotiate the base down 25 to 50 basis points instead. Simple, no gaming, and the argument against is that you've made a manager indifferent between a good year and an average one.

I keep landing somewhere different depending on which property I'm looking at. Curious where the room comes out.

jordan_ellis2 · Answer

Somebody finally put the gaming case next to each structure, which is what I'd been waiting to see. Option one's problem seems fixable though. If the budget is set by the owner and the manager's input is advisory, does the soft-budget risk mostly go away, or does the manager just push the softness into the assumptions instead of the total?

samantha_ruiz · Answer

@pike they push it into the assumptions. Every time. Vacancy factor, bad debt allowance, turn count. I've done this on a 44-unit with a third-party manager and the negotiation over the budget took longer than the negotiation over the contract, because the manager knew exactly which four assumptions their bonus lived in.

What I ended up doing was a hybrid nobody's listed. Base fee plus a bonus on NOI above the prior year's actual, not above budget. Prior-year actual is a fact, nobody argues about it, and it can't be softened. The downside is you punish the manager in a year when a tax reassessment or an insurance renewal blows up, so I carved out taxes and insurance from the calculation. Everything else counts.

laurenkim53 · Answer

At my scale none of these exist. I pay 8% and there's no incentive fee because the whole management fee on a 24-unit at $790 rents is about $1,500 a month and nobody's structuring a bonus on that. Is there a unit count below which this entire conversation is theoretical?

omar_haddad · Answer

Option three is the one I'd refuse outright, and I say that as someone who does the renovation work that gets deferred. Shared savings on controllable expenses pays a manager to not call me. I've walked into properties 20 months into a savings-bonus arrangement and found roof penetrations that were $400 fixes turned into $22,000 of decking and interior drywall on two units. The bonus paid out on schedule every quarter of those 20 months.

If someone insists on it, the only version I'd sign has open work order aging as a gate. Bonus doesn't pay if the count of work orders older than 14 days is above whatever number you agree, and the reading is taken by somebody who isn't the manager.

renee_dubois · Answer

@hollow yes and no. I'm at 22 units and I don't pay an incentive fee either. What I did steal from the big-deal structures is the measurement. I track renewal rate, turn days, and open work order age myself every month and I go through them with my manager. No money attached. The conversation still changes behavior, because she knows I'm looking at the same four numbers every single month and she'd rather not explain a bad one twice.

The structure is for when you can't watch. At 22 units I can watch.

chriswalton8 · Answer

The thing I'm still stuck on after reading all of this is who verifies the number. @harrow wants work order aging read by someone independent, @keystone carved out taxes and insurance, and both of those depend on an owner who can actually audit the manager's own system. On the deals I've looked at as an LP, the property software is the manager's software and the reporting comes from them. If the manager both produces the data and gets paid on it, the structure choice matters less than whether there's a real audit right in the agreement. Which, from what I've read, there usually isn't.

Of four manager incentive structures I've read, I trust exactly one

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