Evaluating Passive Real Estate Investments - Beware Hidden Fees
by Don Konipol
TICS (Tenants in Common), 1031 exchanges, REITS, Real Estate Mutual Funds, LLCs,
Limited Partnerships; the types and number of passive real estate investment
opportunities are exploding. And as proclaimed by their sponsors, these
investments can offer the benefits of diversification, professional management,
access to "A" type properties, and potential high returns as a passive investor.
But how does the investor determine which investments merit his attention, and
which should be eliminated outright?
The first item to evaluate is the issue of fees. The investor needs to determine
exactly how much of his investment is going into real estate and how much is
being eaten by fees. The larger the percentage of his investment actually
purchasing the asset, the greater the chance for a good return and the less the
chance of taking a loss. As an extreme example, if 20% of the investment is
eaten by various fees, and only 80% of the investment is actually invested in
property, the investor faces a 20% loss of capital as soon as he makes the
investment. Additionally, only 80% of his capital is working to earn income or
appreciation. This is a huge amount to make up just to get back to break even.
Front End Fees
These are the fees that are taken out of your investment before the money is
invested in any real estate or asset. These can include organizational fees,
sponsor fees, commissions to investment advisors, legal fees, accounting fees,
underwriting fees, reimbursements to sponsors or any other fees you can imagine.
These fees are transparent and usually listed in the prospectus or private
placement memorandum. If these fees are greater that 10% I would eliminate the
investment from consideration outright. I look for front end fees of less than
5% to make a deal worthy of consideration. Ideally I'd rather pay no front end
fees and have 100% of my money invested in the property. This is possible if the
sponsor sells directly, has no selling expense and is willing to take his profit
on the back end when the investment is sold or as the investment earns current
income. Although "no front end fee" arrangements are rare, some sponsors do
offer them. These deals will have the best chance of success.
Hidden Fees
These fees are not accounted for separately. They are often "hidden" as part of
the purchase price of the property or as part of an ongoing expense. A thorough
reading of the prospectus will usually uncover these fees. An example of a
hidden fee would be when the purchase of the property has already been completed
and the fund is repurchasing the property from the sponsor at a higher price
than the sponsor paid. The sponsor might also obtain a percentage of the
property ownership for himself while having the investors pay all acquisition
costs. If the fund is paying a commission to a real estate broker to represent
itself in the transaction, then this is also a fee which must be evaluated. In
summary, any money paid by the investors and not directly going to the original
seller to purchase the real estate or the asset is a fee or expense which must
be "earned back" by the investment before the investor can get to break even,
let alone profit on the investment.
Ongoing Fees
Ongoing fees are fees paid by the investors on a continuing basis usually from
the ongoing income produced by the asset. These fees can be structured a number
of different ways. The sponsor may receive a straight percentage of the current
income, a percentage after the investors receive a preferred return, or a fixed
fee to "manage" the operation. These fees should not be confused with property
management fees which are fees an investor would pay for property management
whether he had invested directly or through a passive investment entity. Of
course, if the sponsor is the property manager, and the property management fee
is greater than the fee charged in an arms length transaction, than the excess
must be accounted for in the evaluation. Other ongoing fees would include yearly
legal fees, accounting fees, directors payments, etc.
Back End Fees
Usually charged when the asset is sold or as a percentage of the "profit". Other
back end fees are real estate commissions paid to brokers to sell the property,
points paid to mortgage brokers to obtain a mortgage on the property, and
"dissolution" fees associated with the ending of the investment entity.
In any passive real estate investment, the sponsor must be provided an economic
incentive for the promotion, management and risk of handling the "deal".
However, it is important for passive investors to know what they will be paying
for these services. Many of these fees are difficult to quantify since they may
be charged as a percentage of some profit number realizable in the future.
Others may be stated as a percentage of ownership interest. To do a proper
evaluation the passive investor must look at all fees under all likely scenarios
and determine exactly how much extra in fees the investment is costing him. If
the investor does not have the knowledge to accurately make this determination,
professional analysis is available by CPAs, Real Estate Counselors, and
Financial Analysts.
Bio:
Don H Konipol has a BS in Economics and an MBA in Finance from the University of
Michigan and is a licensed Texas Real Estate Broker and Mortgage Broker. Mr.
Konipol is General Partner of the Managed Mortgage Investment Fund LP, a private
limited partnership that invests in short term, high yield private mortgage
notes. He can be reached at 832.577.8838 or by email at dkonipol@yahoo.com.