March 1, 2022
Real estate sponsor promote is usually shown as equity waterfall, one of the most daunting parts of a real estate syndication. When people are just starting out, it is difficult for them to grasp this concept fully from the first time, and the more they try to read stuff online, they get even more confused than in the beginning. This article will break down this concept step-by-step in a simplified, easy-to-understand manner.
Before we continue, we would like to note that you should separate sponsor promote from other fees that a GP might earn, including asset management fees, acquisition fees, and disposition fees.
To explain what equity waterfall is, we will use an example. Let’s say you are in the process of building your multifamily portfolio and decided to buy an apartment complex. You have $100,000 to invest, and you start looking for your first deal. After many months of searching, evaluating, and vetting deals, you finally found a deal that 100% matches your goals.
At the asking price of this deal, you believe that you can hit 15% of the Internal Rate of Return (IRR) over a five-year hold period. The challenge is that this deal is listed at $3.3M, meaning that even if you get 70% of the purchase price as loan proceeds, you still need to raise $900K to close on this deal. Even though you only have $100K to invest, you strongly believe in this deal’s potential and want to close it.
However, since you don’t have $900K, you need to look for one or more equity partners to fund your deal and start the equity raising process. Since you are raising capital from investors, you’ve created a real estate syndication. You start speaking to people among your friends and family who might have the funds to invest in your deal, and you found 18 investors ready to invest $50K each.
You tell your investors that you will do all the work, from closing to asset managing and operating the property. They agree to invest $50K each if you invest your $100K to have some skin in the game.
Now, we have $2.3M of debt and $1M of equity ($900K is raised from your limited partners, and $100K is yours). This equity breakdown is a typical structure in real estate syndication. The deal sponsor funds 1%-10% of the total equity and does all the work on the deal, and limited partners or passive investors fund 99%-90% of the equity and are not involved in the deal management process. Consequently, you end up controlling $3.3M of real estate with only $100K of your own capital.
There are many waterfall calculators and excel models that you could use. However, the easiest way is to have real estate investment software that will do automatic calculations for you, like Cash Flow Portal:
Next, you agree with your investors that, till you hit 8% IRR, you will split portions proportionally to the investment. So, because you invested $100K out of $1M, you will get 10% of all the cash flows, and your investors will get 90%. However, since you will be doing all the work (we call it sweat equity), you tell your investors that you need an additional reward for your efforts to achieve significant returns for them once your investment reaches 8% IRR. Consequently, for every $1 of profit over 8% IRR, you will take 25% of what his profits would otherwise be. This 25% is called sponsor promote.
This story shows how the equity waterfall is formed. You ask for 25% of passive investor profits over 8% IRR, and it is NOT 25% of all profits. It’s 25% of the 90% that you are getting to split your total cash flow as a general partner. It means that for every $1 of profit over 8% IRR, you are going to take 25% of your LP’s profit or 25% * 90% = 22.5% of the total profit. Plus your initial 10% of the profit. 25% + 10% = 35% of total profit for every $1 of profit over 8% IRR.
Sponsor promote is the amount of profit that a sponsor receives above what he would typically earn according to his contributed capital to the deal. It also also has tiers.
For example, above 8% IRR, the sponsor earns 25.6% of all the excess profits above his pro-rata share. Above 8% IRR and up to 15% IRR, since John contributed 93.4% of total equity, he receives 80% of 93.4% or 74.4%. The sponsor gets the balance of 25.6% of the excess profit above his pro-rata contribution of 6.6%.
This split continues till the deal reaches 15% IRR. Once this threshold is hit, any remaining net profit is distributed 60% to LPs and 40% to GPs as promoted interest.
What does it mean?
It means that the investor receives 60% of 93.4% or 56% of profits above a 15% IRR and the GP gets 44% of excess profits, including his 6% contribution.
Why does the sponsor earn a promote?
Among other things, the sponsor does the following crucial activities that are necessary to ensure that investors receive profits:
The deal sponsor does all of the heavy lifting and has his sweat equity in the deal. At the same time, investors have purely passive income and rely on the GP to execute all the items we listed above. Therefore, the sponsor promote motivates general partners to exceed initial goals and go beyond the original business plan. If the GP exceeds expectations, he earns a bonus in the form of promote.
The promote structure can vary from deal to deal, depending on the property type and GP. Usually, the more work the sponsor has to do to achieve targeted IRR, the bigger piece of the pie he receives.