Improving Alignment in Real Estate Asset Management

The operating environment for asset managers across all industries is evolving with increased pressure and challenges. Over the last decade, there has been a strong migration from active management toward passive strategies focussed on fee minimization. Simultaneously, pension funds, sovereign funds, and high net worth individuals have been increasing portfolio allocations toward real assets and accepting liquidity premiums as a means of preserving historical returns in a low interest environment. This appetite for commercial real estate (CRE) has been welcomed by asset management firms in the industry who benefit from increased access to capital for potential projects. Such demand for real assets has created favourable deal terms for these firms featuring lucrative fee structures while contributing minimal equity.

During this time period, the Canadian CRE market has flourished with the S&P/TSX Capped REIT Index generating an 11.12% average annual return between 2010-2019. The robust performance of Canadian CRE has in many cases enabled limited partners (LPs) to overlook certain sources of misalignment within their investment agreements as returns have been very strong. With that being said, the uncertainty issued by COVID-19 coupled with the reduced risk appetite of lenders, will make lucrative deals scarcer, thereby adding increased emphasis on the alignment between LPs and general partners (GPs). Ultimately, a razor-sharp focus on fees has permeated all asset classes and it is a matter of time before this paradigm reaches the real estate asset management industry.             

In a real estate asset management deal, the LP assumes a passive role in the management of an asset, while the GP assumes responsibility for operating efficiency and executional expertise. LPs provide the GP with capital for an extended period of time under the assumption that the GP is acting in the best interest of the LP. However, it is ultimately the details of the deal that determine the level of alignment and stewardship between the LP and GP. In this article, we seek to examine the typical deal structure in today’s environment, identify potential sources of misalignment, and provide an improved model for risk and return symmetry.  

The standard real estate asset management deal involves an acquisition fee, a management fee, and a promoter fee. Each of these fees are worth examining individually in order to understand how they enhance or detract from a manager’s alignment with their LPs. The acquisition fee is common amongst managers syndicating individual deals. This fee is generally 1%-2% of the total deal, depending on the size of the investment. The purpose of this fee is to compensate the manager who has likely devoted time and resources to examine a pool of potential deals. While this fee is necessary, it fails to create increased alignment between the manager and investor, as the manager is being rewarded without having participated in any value creation. Consequently, it is imperative that this fee constitute a minimal part of the manager’s total compensation and solely compensate the manager for expenses that have already been incurred. A 2% fee on a $15,000,000 acquisition results in a quick $300,000 payday and fails to create further alignment between the manager and investor. In our view, a more appropriate model includes a 2% fee on the equity rather than total deal size. This reduces the acquisition fee from $300,000 to $105,000 (assuming 65% LTV) which achieves the objective of compensating the asset manager without compromising their incentive for value creation. 

Moving toward the asset management fee, this form of compensation ranges between 1% and 2% of the deal size and is used to pay for investment management services. Here, we believe that it is reasonable for the fee to be a percentage of the total deal as the size of the asset will likely dictate the resources required for management. With that being said, a firm’s management fee can have the greatest impact on net returns for an LP as cumulative management fees can creep into the millions over the lifetime of a $15,000,000 deal. In a traditional $15,000,000 model, a reduction in the management fee from 2% to 1% improves the LP’s IRR by up to 2.5%. While certain management fees are necessary to properly manage a firm’s operational expenses, it is important that fees do not serve as a manager’s primary driver of long-term economic incentives. As seen below, reducing the annual management fee from 2% to 1% has a significant impact on the percentage of total compensation that is comprised of management fees. We insist that a 1% management fee is necessary for strong alignment as it increases the likelihood that majority of a manager’s compensation will be tied to performance.

We believe that the promote/performance fee is the most essential tool in creating alignment between LPs and GPs. It is the primary incentive for GPs to optimize the asset over the long term. Tiered carried interest structures are extremely useful in creating alignment between the GP and LP. Under such structures, GP’s share of the profits increases at certain return thresholds. For example, a standard promote fee of 20% is paid after a deal reaches a distributed to paid-in (DPI) multiple of 1.0x and a premium promote fee (30%) is paid if the deal reaches a higher DPI target. This ensures that a premium promote fee is only issued in the case of premium performance by the manager.

While the tiered promote structure helps to create alignment, it does not offer a perfect solution. During the lifetime of the deal, if a manager identifies that the premium tier is unattainable, there is minimal incentive to spend time further optimizing NOI. This is because a 1% year-over-year differential in NOI growth on a $15,000,000 5-year deal with a 20% base promote fee only increases a manager’s promote fee by $129,230. From the perspective of the asset manager, this can be viewed as trivial in comparison to the $150,000-$300,000 annual management fee. This creates misalignment as the LPs unlock over $600,000 in value for every 1% improvement in yearly NOI growth. Due to the lack of alignment, it is often in the rational interest of a manager to prioritize time finding other deals and collecting management fees as opposed to optimizing existing assets to the best of their capabilities. This leads us to believe that it is essential for the asset manager to contribute at least 10% of the equity for any deal in order to ensure that the manager is motivated to fight for every last dollar of NOI optimization.

Without contributing sufficient equity to the deal, GPs have an asymmetric risk profile compared to the LPs as they capture the rewards of a deal without facing any penalty for failure. This creates a fundamental asymmetry as the GP’s cash flow curve begins in a positive position and steeply increases while the LP has not received any return on investment. Alternatively, when the GP has contributed equity and the fees are minimized, their cash flow curve mirrors the trajectory of the LP’s cash flow, thereby creating maximum alignment.

While most asset managers prefer the traditional method as the payouts are less delayed, we believe our proposed structure is a much more sustainable way of conducting business. Ultimately, as essayist and mathematical statistician Nassim Taleb describes “people have two brains, one where there is skin in the game, one where there is none. Skin in the game can make boring things less boring. When you have skin the game, dull things like checking the safety of the aircraft because you may be forced to be a passenger in it cease to be boring”. An asset manager with skin in the game and maximum alignment on 4-5 deals rather than minimum alignment on 8-12 deals is more diligent when conducting due diligence, more selective when selecting tenants, and more focussed on NOI optimization.

The increased impetus that can only come with having one’s own capital at risk better positions an asset management firm in an increasingly competitive environment to generate required returns for LPs. Consequently, their survivorship will be longer with more capital partners hoping to work with them compared to firms who fail to prioritize alignment with their investors. Ultimately, extraordinary alignment and the reduction of adverse incentives are precursors to driving the necessary returns for investors in an increasingly challenging CRE landscape.