As you enter a deal, it is vital to know the standard fees that are customary to charge to get compensation. As mentioned in the previous episode, it is essential to hire a syndication attorney to assist with the legal matters of real estate investments. Amy Wan, Founder and CEO of Bootstrap Legal, breaks down the fees every realtor and investor should be aware of prior to making and closing deals. A well-known legal expert, Amy reveals the charges sponsors usually advance personally, the three most common ways to structure your investor distributions, and the real estate waterfall method. On the side, she gives away the things you have to take note of before taking money from investors.
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Understanding Real Estate Fees And Investor Distribution with Amy Wan
Our guest on this episode is Amy Wan. Thanks for being on the show, Amy.
Thanks for having me back.
Amy is the Founder and CEO of Bootstrap Legal. She’s graciously taking the time to explain many important topics to us on the legal side of this business that is so important. Amy, what are we going to talk about?
We’re talking about fees that you can charge and how you structure your distributions.
Get us started with the fees and things we should consider when we’re doing this syndication.
A lot of times when syndicators are putting together their offering, they don’t get paid up front from distributions. That’s earned through the lifetime of the actual project. They will charge certain fees. There are a lot of different fees that you can charge. Sometimes I have clients who make up a new fee. I’ve had people make up like construction fee because they’re managing the construction themselves or something like that. There are a number of standard fees that are customary to charge so that you can get compensation as you’re entering into the deal.
I’m going to go through a couple of those. The first one, by far the most common, is the organization and due diligence fee. A lot of people sometimes also call this the acquisition fee. It’s the same thing. It’s a fee that is charged once on the purchase of each property. It usually ranges somewhere between 1% to 3% of the purchase price of the property and the sponsor usually earns this fee at the close of escrow on the acquisition of the property. The justification for this fee is that it compensates the sponsor for their efforts in conducting due diligence on the property and making the investment opportunity available to investors.
This is probably the most common upfront fee I see across all different deals. The second one is the asset management fee. The asset management fee compensates the sponsor for his or her efforts in oversight, management of the company and property during the course of the investment. Typically, the sponsors will charge somewhere between 1% to 2% of the gross revenue collected from the property that’s earned monthly and this is a recurring fee. It’s usually done annually. The third one is a fee that may or may not be charged by the sponsor themselves. It’s a property management fee.
It’s a recurring monthly fee that’s paid to a third party property manager that will provide all the property management services. Sometimes syndicators also end up being the property manager. In that case, it would be paid to them or their affiliate. This fee is collected during property operations and capital improvements. The amount is whatever the market with local rates for such services is. If you’re using a third party, it’s whatever they’re charging you. If their sponsor is managing the property themselves or through a very close affiliate, then it will be whatever rate is standard in that particular geographic location.
The next one is a fee that you can get whenever you are working with loans. It’s called a debt placement fee. I want to make sure that we distinguish this from a loan brokering fee. A loan brokering fee is when you are going out and helping get the loan, but you are licensed as a loan broker and a lot of people are not. We call it a debt placement fee because the debt placement fee, which is sometimes called like a finance consulting fee or something like that. It compensates the sponsor for his or her efforts in doing all the work to go out, find and obtain the original financing for the property.
I know you had mentioned, depending on the sponsor’s track record, they may be able to get a lot better financing because of their experience and track record. I felt like that hasn’t come easy. You’re reimbursing them for that experience and the time taken to make the financing happen.
Oftentimes I find that syndicators are always networking for investors, but they’re also always networking for loan providers, different ones. Sometimes this provider can give them the best rate, but the project won’t qualify for their underwriting so they go to this person. They’re always bouncing between bunches of different lenders. That is definitely a lot of time and networking on the part of the sponsor. The debt placement fee, it’s also a one-time fee. It’s usually 1% of the original purchase price of the property or it can be for the loan amount. The fee is earned upon the lender granting initial financing of the property. I’m talking about a lot of fees here. You probably don’t want to charge every single one of them because they as your investors would never make any money. People tend to pick and choose. They usually always have the first one I mentioned, the acquisition due to diligence fee. The first three are the most popular and then all the ones I’m talking about, they’re less popular, but they do exist.
The first three are definitely the ones I hear of the most. I was going to ask you about the debt placement fee. You said it’s earned upon when the financing is granted initially. What about a refinance at three years?
We’re talking about a lot of different loan fees. The next one is a loan guarantee fee. Sometimes you are not able to find a loan that is nonrecourse. They want someone to provide a personal guarantee. Sometimes the sponsor does not have the personal financial ability to be able to personally guarantee that or they don’t want to. The sponsor will go out and find someone else to come in on the deal with them and provide that personal guarantee. The loan guarantee fee is paid to the person who provides the personal guarantee for the purchase money loan, to the extent required by the lender. It’s also a one-time fee. It ranges between 1% to 3% of the loan amount. I would say in the vast majority of cases, it’s probably 2% to 2.5% and it’s earned when the loan is made.The better returns you give, the more people are going to invest. Click To Tweet
The next one is the refinance fee. On the tail end of investment, the sponsor may earn a refinance fee as compensation to the sponsor for their efforts in going about and getting refinancing for the property. This is a one-time fee. It’s usually between 0.5% to 1% of the new loan amount and it’s earned on the origination date of the new loan. If you’re not refinancing, there’s another fee. It’s called a disposition fee. That is also a onetime fee that compensates the sponsor for their efforts in marketing the property or the properties for sale. It’s usually 1% to 3% of the sale price of the property. It is earned upon the sale of the property.
For those of you out there who are syndicating a property that is in the same state where you have a real estate broker or salesperson’s license, some of them also want to take a commission off the acquisition. The initial purchase or the sale of the property that they’re also planning to syndicate and that’s perfectly fine. You can charge the market rate for it. The most important thing though, is you have to disclose this to your investors. It should be in your legal documents. Obviously, don’t charge a crazy amount. It should be whatever is commensurate with the local market.
The next one is expense reimbursements. It’s not so much a fee as it is making sure that the sponsor is reimbursed for everything out of their pocket that has to do with the deal. When a sponsor is doing a real estate syndication, there’s a number of expenses that have to come out of their pocket personally before they ever get very far down the road. That’s probably entity formation, attorney fees, due diligence costs, travel costs to go see the property to make sure it’s kosher and that they definitely want to do the deal. These are all fees that the sponsor will probably have to advance personally. When they do go out and decided to go forward with the deal and syndicate the project, they can get their out of pocket expenses reimbursed upon the start of the company and throughout the lifetime of the project.
This is not every single fee in the world out there. I’m talking about the most popular one. The last one I want to mention is to the extent that there are deferred fees or the manager has advanced funds for any reason, whether it’s for these incidental expenses or because maybe the project is going sideways. You have construction cost overruns and they can’t find a loan or something like that. There is interest that the manager can charge on deferred fees and manager advances. The market rate for this is typically 10%. Sometimes investors especially for beginning syndicators, they’ll push back against this or if there are not a lot of trusts, they’ll say, “What if you defer every fee and you’re charging me 10% on this stuff that’s terrible?”
Sometimes I’ll have investors and syndicators ask me to push this fee down to either 0% interest or even 3% or something like that, but the market on most deals is about 10%. The only thing I’ll say about this is when a project gets into that certain situation where it’s looking like they have to do some capital cost or something like that, your legal documents should talk about what’s the order of people you should be looking at for money from. Typically it’s like, “Go get a loan, maybe ask an investor for a side loan or maybe the manager advances if they can.” If that’s truly not something that can happen, then we go to capital cost. Capital costs are on every deal. It does happen sometimes. Those are all the fees I wanted to talk about.
Some of them, I don’t hear about as much. I know they’re out there. I feel if you put all these fees in your deal, the investors are going to go somewhere else.
You’re not going to put every single fee, you’re only going to put a couple.
You have to pick and choose. I’m sure even those operators that are doing many deals get in a groove of this is how we charge like a couple of specific phases or the first three that we talked about and the rest is part of the business.
Where the more novel fees come into place are when you’re dealing with something, a project that has some complexity to it. I mentioned construction fee and that was because that client was managing the construction themselves because they had that previous experience. They didn’t have to hire anyone to manage all the contractors, subcontractors and the construction crew. They were doing it themselves. They were doing it for cheaper than the market. They charged a fee for that. Another one I saw was someone charging a licensing fee because it was one of those deals where in order for the project to be successful, they had to go get certain licensing from the local government. It was a very complex license to get. They had a lot of experience doing it. Instead of going out hiring a third party, bringing a partner into a deal that was as good at getting that particular license, they went to do it themselves. They compensated themselves for it.
I want us to have time for the distributions, waterfalls and those things.
There are 100,000 ways you can structure investor distributions. We’re going to talk about the three most common ones. The most common is what we call pro rata. Pro rata is a fancy Latin word that means proportional. Under a pro rata distribution model, the distributions are given to investors proportionately according to their membership interests and it comes back to how much did they invest? I would say on average, the median distribution for investors in terms of the split is somewhere between 70/30, so 70% to investors pro rata, 30% to the sponsor. It’s usually about a 10% standard deviation. You can go anywhere 60/40 to 80/20.
The next one is the preferred return followed by a split. Some people call it pref. It’s where the distributable cash is first distributed to certain members, usually the investors until they achieve a certain rate of return on the initial investment. It’s before any other group, for example, a sponsor receives any money. Investors receive money first up to a certain rate of return. After that, it is followed by whatever that split is if it’s 70/30 or whatever. The pref incentivizes investors since it subordinates the sponsor’s profit participation or their promote.
When you are using preferred return, you should be careful to specify whether it’s a cumulative preferred return and whether it’s compounded or not. The next one that is very common, we have to be very careful in terms of how we word it, is the preferred return included in the split. The one I talked about is preferred return first, then everything after that is split. Here, the preferred return is included in the split. The investor members first received their preferred return. All the money that’s left, it goes to everyone pro rata, but whatever you already received in terms of your preferred return is included in that 70/30. The idea is investors get a little bit less than the previous scenario.
I’d like to go back and clarify a couple of things. I was going to go back to the pro rata and the preferred return also. They both have a split. The pro rata distribution model, it’s per membership interest. I want you to explain it. They both have a split but it’s not the preferred return if it’s the pro rata distribution.The more money you raise, the more you should be deploying that capital. Click To Tweet
There is a number of ways to structure these things. Pro rata means whatever the distributable cash is, if it’s $100 and you had one investor of the amount that you received. You have one investor who invested 50%, one invested 30% and one invested 20%. Let’s say it’s a scenario where the sponsor, the manager gets 20% and investors get 70%. There is no prefs here at all. Pro rata means according to their membership interest. I said 80/20, of the $100, $20 will go to the sponsor and the remaining $80 will go to the investors based on how much they invested. For the guy who invested 50%, they’re going to get $40, 30% of the $80 will go to the other guy and 20% of the $80 will go to the last person.
I was confused about the pro rata distribution model. I got it now. Is that the most commonly used, the preferred return?
The preferred return followed by a split is probably the most common followed by pro rata and then the third one I talked about. These are the three most common. After that, you can get as fancy as you want. On a previous show, I mentioned I know people who do triple waterfalls. It makes accounting a pain sometimes. Personally, it’s like a marketing tool for them. The way their triple waterfall works is we have an 8% preferred return and thereafter, it’s a 70/30 split until everyone gets to a 15% preferred return. Once investors receive a 15% rate of return, then it becomes a 60/40 split until you receive a 25% rate of return. Thereafter, it’s a 50/50 split. It’s good for them because they as a sponsor are incentivized to go and maximize the distributions because then they earn more. At the same time, it’s also half a marketing thing to the investors would be like, “These guys are so confident that they’ll get us over a 25% rate of return.” That’s great.
You could offer more money to investors initially. I could see that being a way to draw investors also that you’re going to make this type of return until we reach this level. I could see that bringing in more investors possibly.
I mentioned that I had a beginning syndicator who offered a 16% preferred return. They did not get paid at all until investors got a 16% rate of return. After that, it was a preferred return included in a split. The sponsor would get paid. That sure made investors feel pretty good. I’ve seen everything across the spectrum. When it comes to distributions, half of it is what’s market, half of it is what are your investors willing to accept. I often say this is not something that should be decided on by your attorney. This is something that will be decided on by yourself and your investors. It’s not necessarily through negotiation because you don’t want to get into that habit. It’s what can you command from the market. Obviously, the better returns you give, the more people are going to invest. The lower returns you give, the harder it is to get capital in.
I appreciate you explaining at least those three different types of distributions and the waterfall. Anything else as far as dealing with the debt and equity, how we structure it that we should know about before we move on to taking the money from investors?
When you’re raising capital, you have to set a minimum amount that you’re raising and a maximum amount, most people do. You don’t want those two numbers to be too far apart from each other because if you’re saying, “I want to raise a minimum of $100 and a maximum of $3 million,” first of all, it doesn’t look good to your investors. Secondly, if you’ve raised the $100 and you only have one investor, all the distributions are going to go to that $100 investor. That’s not great for you either. There is a point at which it does not make sense for you to syndicate the deal because you’ll probably be losing money.
What I tell people is when you’re deciding on what your minimum-maximum is, the minimum is what is the least amount of money you need to make this deal work? When you’re setting the maximum amount that you’re raising, you want to set the amount at as the ideal amount you’d like to raise plus a little bit of cushion. At the same time, don’t make the cushion too big because the more money you raise, you should be deploying that capital. If you raise too much, it ends up lowering the ROI people get a couple of years later. People love bragging about their ROIs like, “I make my investors a 40% return on investment. Everyone should come to me.” Keep that in mind, raise what you need.
What else should I be asking you that I haven’t asked you?
Most of you are probably going to take money from investors through the traditional banking system so you get wires or whatever. To the extent you’re doing that through a bank, you’re fine, you’re good. If you are talking to one of the recently wealthy and they’re trying to give it to you in Bitcoin or crypto or something strange like that, you have to do an additional step that we call AML/KYC, Anti-Money Laundering Know Your Customer Compliance. The reason you don’t have to do it if you’re taking a wire is that your bank already does that for you. That’s built into the traditional banking system. If you’re doing something more interesting, you’re going to want to consult with your attorney on that.
We can take it but there are ways that we have to go about it that are different than normal.
You need to make sure that the source that you’re taking it from isn’t a money launderer or someone selling weapons or something like that, someone on one of these government watch lists.
Amy, is there anything else that we need to know?
I think we’re good.
Tell our audience how they can get in touch with you and learn more about Bootstrap Legal.
I want to make sure the audience know that they can go to our Facebook group and they can ask questions. All the shows are posted there. I encourage people if you think of a question that I didn’t have time to answer or didn’t get to, that you can go there and you can ask questions. I’ll try to post the future guests so you can even ask questions ahead of time and I’ll try to ask some of them during the show. Afterward, you can go in there and leave questions. I’ll try to get you answers or I’ll communicate with the guests. They can reach back out and let everybody know the answer to that question. Also, go to Lifebridge Capital and connect with me. We will talk to you soon.
About Amy Wan
Amy Wan is Founder & CEO of Bootstrap Legal, which uses artificial intelligence to help draft real estate syndication legal documents faster and cheaper. She has authored Lexis Nexus’ Private Equity practice guide. Previously, she was a Partner at a boutique securities law firm and General Counsel at a real estate crowdfunding platform. Amy is also the founder and co-organizer of Legal Hackers LA, which programs around the intersection of law and technology; was named one of ten women to watch in legal technology by the American Bar Association Journal in 2014 and one of 18 millennials changing legaltech by law.com in 2018; and was nominated as a Finalist for the Corporate Counsel of the Year Award 2015 by LA Business Journal.
Amy has also worked in international regulatory and trade policy at the U.S. Department of Commerce, and was a Presidential Management Fellow at the U.S. Department of State and U.S. Department of Transportation. She holds an LL.M. in Public International Law from the London School of Economics and Political Science, a JD from the University of Southern California Gould School of Law, and a BA in Biological Sciences from the University of Southern California.