Eleven quarters of pref, then it turned out to be a fee deal

Closed out last month at 1.03x on $55k over four years and I've spent a while working out where the money went, because the property did fine.

Deal was a portfolio of small rural multifamily, five properties, 138 units total, low price points in markets I actually know. That's why I liked it. 7 percent pref, paid current, eleven of sixteen quarters. NOI grew about 19 percent over the hold. They sold at a slightly better cap than they bought at. On paper this is a decent deal.

So where did it go. Acquisition fee 2 percent on purchase price. Asset management fee 2 percent of gross revenue, not of equity, which on a rural portfolio with a lot of gross revenue relative to value is a very different number than I assumed. Construction management fee 5 percent on all capex, and they spent heavily on capex. Disposition fee 1 percent. Plus a $9,000 annual administrative charge across the fund for accounting and reporting.

I added it all up and the sponsor took roughly $780k of fees across the hold on a deal where total LP profit distributions were about $1.1m. The promote was small because the returns were mediocre, and it didn't matter, because the fee load did the work the promote was supposed to do.

Every one of those fees was disclosed. I read them. What I did not do was total them and express them as a percentage of projected LP profit, which would have shown me that a base-case outcome left me at roughly break even after inflation.

What I'd do differently: build the fee stack into my own model as a line item before I subscribe, and specifically model asset management fees against the base they're actually charged on. Percent of gross revenue and percent of invested equity are not comparable numbers and I treated them as if they were.

3 replies

1carlos_nunezActive

The 5 percent construction management fee on a heavy capex plan is the one that would have made me walk. It creates a reason to spend, and on rural multifamily where the units are cheap and the capex is proportionally large relative to value, that reason gets expensive fast. Did they ever justify the capex against rent achievement? Because 19 percent NOI growth over four years on 138 units with heavy spend is not obviously good. That could be inflation and market rent plus a lot of money you paid them 5 percent to spend.

0wendy_park48CapitalPRO7

Asset management fee on gross revenue is the clause I flag first now, and it's in more documents than people think. On a stabilized deal with a 55 percent expense ratio, 2 percent of gross revenue runs to something close to 4.5 percent of NOI every year, and it grows as you push rents. So the sponsor gets paid more for revenue growth whether or not it drops to the bottom line. The version I prefer to see is a fee on invested equity, because it stops growing, or a fee on collected revenue with a cap.

hollow, the other question is whether the administrative charge was actually pass-through cost or a margin. $9,000 a year across a five property fund for accounting and reporting is not obviously unreasonable. If it was billed as an allocation of actual third party cost, fine. If it was a flat charge to an affiliate, that's a sixth fee wearing a different hat. Did the docs name who received it?

One thing I'd defend you on. The disclosure was there and you read it, and the failure was arithmetic rather than diligence. Reading fees as a list is nearly useless. The number that matters is total sponsor compensation as a fraction of total projected profit, and almost nobody publishes that because it's ugly at base case in most deals.

-1derekj19SB1B

Sitting on the service side of this and it's striking how much of what you paid for was work that gets done by third parties anyway. Construction management on rural multifamily is usually a regional GC and a superintendent, both billing separately, with the sponsor's 5 percent stacked on top for oversight. I'd have wanted to know who was actually walking those five properties and how often, because if the answer is a quarterly drive-by then 5 percent of capex is a lot for a drive-by.

Eleven quarters of pref, then it turned out to be a fee deal

3 replies