Commercial Real Estate Podcast

JF1597: How to Structure GP & LP Compensation Part 1 of 2

Written by Joe Fairless | Jan 16, 2019 5:00:00 AM

One slightly important part your apartment syndication career is how you will be getting paid, as well as how you will be paying your investors. Today Theo will cover how to pay the General Partners in your apartment syndication deals. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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TRASNCRIPTION

Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process, but how to actually do each of the things, and go into it in detail… And we thought “Hey, why not make it free, too?” That’s why we launched Syndication School.

Theo Hicks will go through a particular aspect of apartment syndication on today’s episode, and get into the details of how to do that particular thing. Enjoy this episode, and for more on apartment syndication and how to do things, go to apartmentsyndication.com, or to learn more about the Apartment Syndication School, go to syndicationschool.com, so you can listen to all the previous episodes.

 

Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series –  a free resource focused on the how-to’s of apartment syndication. As always, I am your host, Theo Hicks.

Each week we air a podcast series about a specific aspect of the apartment syndication investment strategy, and for the majority of this series we’ll be offering free documents or spreadsheets for you to download. All of these free documents and previous Syndication School series can be found at syndicationschool.com.

We just finished up an eight-part series about raising capital from passive investors, so I highly recommend that you listen to that episode. It moves us one step closer to you launching your apartment syndication empire. In this episode – this will be part one of a two-part series entitled “How to structure the GP and LP compensation.”

As a refresher, the GP (general partnership) will be you and anyone else that you bring on as a team member – a partner, a loan guarantor, a sponsor, people like that. And the LP are going to be your passive investors. So GP is general partnership, LP is limited partners.

By the end of this episode you will learn how to structure the general partnership. We’re gonna go over the five parts of the general partnership, as well as the responsibilities and ownership percentages of each of those rules. Then tomorrow – or if you’re listening to this way in the future, the next episode (part two), we will go over the limited partner compensation.

If you remember back when you were forming a team, you discussed the reasons why you would bring on a partner, as well as we talked a little bit about the loan guarantor/sponsor/key principal. Those are going to be two people that are potentially on the general partnership, including yourself, so there’s a total of three people.

Most likely when you’re first starting off it’s not just going to be you on the general partnership, because you haven’t done a deal before – we’ve talked about this before, but you’re gonna have a credibility challenge with your investors, because they’re gonna say to themselves “Hey, you haven’t done a deal before, so why should I trust you with my money?” And one of the ways to address that objection is to bring on partners and team members who have done apartment syndications in the past.

So starting out, the GP will likely be a group, but it is possibly, technically, starting out, and more likely in the future for you to be the general partner yourself. So it’s possible, but most likely it’s gonna be a group.

For example, Joe and Frank are partners on the general partnership, as well as for my business it’s going to be me and Matt, are the main general partners. I know for Joe and Frank they bring on other general partners to help them raise capital, and me and Matt will do the same, as well as having to bring on a loan guarantor to help us qualify for financing.

So the general partnership can be structured in any way, and all the ownership percentages are completely negotiable between the two partners, so what I’m gonna go over in this episode is going to be kind of a generic overview of how the general partnership can be structured… But there are always gonna be exceptions.

For example, if I don’t really know anything at all about apartment syndications, but I’ve got access to maybe 200k in capital, I could partner with someone, raise part of the capital for that deal, but I’m likely not going to get a percentage of the GP that’s in proportion to the amount of money I raise, because I’m not necessarily bringing a lot of value. This is just one example, but again, it’s completely negotiable, and I just want to give you an idea of how general partnerships are commonly structured.

Overall, there are going to be five different parts of the GP, and for each of these parts there’s a specific responsibility, as well as a specific ownership percentage. The first part is going to be the person(s) who front the due diligence costs. We haven’t discussed the  due diligence on this Syndication School series yet, but overall, the due diligence is going to be the period between the time you sign the purchase and sale agreement, so once you get the property under contract –  from then until you close on the deal. Between then there’s a variety of different tasks that need to be completed in order to close on the deal – having the property inspected, getting the appraisal, getting the environmental, doing lease audits, getting the operating agreements and all the different agreements between you and your investors signed, securing the financing, things like that. That’s going to cost you some money, and since you haven’t closed on the deal yet, you’re not going to have access to your investors’ capital to cover this, so someone’s going to have to come out of pocket and front these costs. Of course, you can raise extra capital to reimburse these costs at closing, but you still  need the money.

Here’s a list of some of the upfront due diligence costs to expect, as well as the range of costs associated with each of those. You’re gonna have the lender and due diligence fees – those are the fees you pay to the lender for them to do their due diligence; expect to spend about 2k up to 10k on those, depending on how large the project is.

You’re also going to have to perform a property condition assessment (PSA), which is a very detailed inspection of the apartment, and expect to pay anywhere $50 and $250/unit for that.

You’re also going to need to get an environmental survey called a Phase One Environmental. That will cost about 2k.

You’re gonna have to do a unit walk inspection, so each of the individual units is walked and inspected. That’ll be about $25/unit.

You have the lease audit, where your property management company will sit down, or a consultant will sit down and go through all the leases, to make sure that they’re written legally by the book, as well as to make sure all the terms are accurate based on the rent roll and the financials that they provide. So that’ll be about $25/unit as well.

Then there’s the property survey, where they map out the property, check out boundaries, things like that. That’ll be about 5k.

Then you’re gonna have your earnest deposit. That’s something that is going to be negotiable, but expect that to be between 1%-2% the purchase price. That’s just that small down payment that you put into escrow to show your intentions to purchase the property. [unintelligible [00:08:51].18]

You’re also gonna have the lender application deposit. That’s you paying the lender to do the application process for you to qualify for the loan, so credit checks, things like that. That will be about 25k.

Then if you apply for agency debt, which I know we haven’t discussed debt on the podcast yet, but we’ll get into that… Agency debt will be Freddie or Fannie Mae debt, and you have the ability to pay the lender to lock in a rate. Let’s say your due diligence period is 90 days, and the interest rate is 5% right now, but you think that it might be going up to 5.2% or 5.25% by the end of 90 days; you can pay money in order to lock in that interest rate, because a 5% interest loan will have a lot lower debt service than a 5.25% interest loan, and that adds up over multiple years. So that’ll be approximately 2% of the loan balance.

Then you have the legal fees. You’re gonna have to pay an attorney to create the operating agreements, which could be anywhere between $350 all the way up to $15,000, depending on, again, how complicated the partnership structure is.

You’re also gonna need a private placement memorandum, which essentially goes through all of the risks associated with a deal, and describes the deal and the partnership in great detail. That could be anywhere between 5k and 15k.

You will have your subscription agreement with your investors, where they promise to buy shares at a set price, and you promise to sell those shares at a set price, of the LLC that owns the property. That could be anywhere between $350 to $5,000.

You’re also likely going to put the property in an LLC, so you’ll have to pay to have that LLC formed. That could be anywhere between $200 if you’re doing it yourself online, up to $2,000 if you’re having an attorney help you out with that.

Then of course there’s going to be fees associated with your attorney negotiating on the loan documents, and that is most likely going to be some sort of hourly rate.

I went over all the numbers, and that adds up to five figures, and possibly up to six figures, although that’s on a very, very large deal. Someone’s gonna have to front that money, so a couple of strategies for this part of the general partnership – one, you could cover those costs yourself, if you have that money sitting in an account, or if you wanna put it on credit cards. Or you and your business partner can split those costs, and then of course reimburse yourselves at closing.

Another way is to borrow money from a family or a friend, and then sign a personal guarantee promising to pay them back at closing, and I believe this is what Joe actually did for his first deal, to cover those due diligence costs. Or you could ask one of your passive investors to front the cost, and then promise to pay them back at closing with some sort of interest rate, or without an interest rate; it depends on your relationship with that person.

If you cover the costs yourself, or if you and your partner do it, then that’s not really gonna have any sort of impact on the share of the general partnership, unless one partner covers it and the other one doesn’t cover it. But if you have a passive investor front those costs, or if you’ve got some sort of family member that’s fronting those costs, and you don’t wanna pay them an interest rate, you can give them a percentage of the GP, and that could be a low percentage – about 5%. But make sure you consult with your attorney first, because people on the GP have to have an active role in the deal, so just make sure you’re going by the book when offering ownership percentages for fronting those due diligence costs. So that’s kind of task number one of the general partnership.

Number two is going to be the acquisition management. This will be the person or people who are responsible for finding deals. They’re gonna be generating off-market leads, as well as focusing on building relationships with commercial real estate brokers to find on-market deals, and cultivate that relationship, so they increase the probability of being awarded the deal.

Once a deal is identified, they’re responsible for evaluating the deal, so performing the underwriting, visiting the property in person, driving the market, things like that. If the deal makes sense and the result of the underwriting are returns that meet the investors’ goals, then they’re also responsible for submitting offers on those deals.

Then if the offer is accepted, they’ll be the ones that go through the best and final seller call, if that’s what they do, or are responsible for making sure that the PSA is signed, and all the terms are correct.

Once the deal is under contract, they’re gonna be responsible for managing that due diligence process – inspections, appraisals, working with the lender, working with the property management company to make sure that all the due diligence is covered.

They’re also going to work with the lender or mortgage broker to secure financing on the deal, and then they’ll be the one who also oversees the closing process. Essentially, they’re responsible for, as the name implies, the acquisition task. So going from finding the deals, all the way to closing on the deals. This person should be given approximately 20% of the general partnership. Now we’re up to 25% between those first two tasks.

Number three is going to be the sponsor. This is going to be the individual or group of individuals who sign on the loan. The sponsor is also referred to as the key principal, or I like to call them just the loan guarantor.

For a first-time syndicator, you likely will not have the liquidity, net worth or experience requirements to qualify for the loan, so you’re gonna need someone else that has experience with a similar sized deal. The experience requirements are kind of vague, but when talking to lenders that’s what they’re gonna look at, “Does this person signing on the loan have experience taking a similar sized deal and a similar investment strategy full-cycle?”

You’re also gonna need to find someone with the net worth requirements, so that’s gonna be a net worth equal to the loan amount.

Then you’re also gonna need liquidity requirements. These also kind of vary, but a good rule of thumb is 10% of the principal loan amount in liquidity.

Ideally, you can find a sponsor that covers all three of these requirements, that way you don’t have to worry about having too many people on the GP and having to split this role between many people. But again, it’s better to get a deal done and have a ton of loan guarantors than not getting a deal done at all.

The compensation for the sponsor/loan guarantor is gonna vary from deal to deal. It can be a one-time fee that’s paid to them at closing, or it can be an ongoing percentage of the general partnership, or it can be a combination of the two.

For a one-time fee, it can be as low as 0.5% to 1% of the loan balance, or as high as 3.5% to 5% of the loan balance paid at closing, depending mostly on the risk of the loan. If it’s a bridge loan that’s recourse, you’re going to have to pay a larger guarantee fee or a larger one-time fee to that person, as opposed to a 12-year Fannie/Freddie loan that’s non-recourse. That’s also gonna depend on your relationship with that person. If you know them really well, you can probably get away with offering them a lower fee, but if you don’t know the person, then you’re gonna have to attract them with a higher fee.

It also depends on the investment strategy. If you have a distressed deal, you’re probably gonna have to pay more than you would for a value-add deal, than you would for a turnkey deal.

Now, again, you can also offer them an ongoing percentage of the general partnership, and this can be as low as 5%, and the highest I’ve seen is actually 20% for this. 20% obviously seems very high, but again, it’s better to give away 20% of the GP in order to close than to not give away 20% and not have the ability to close on the deal… But more likely you’ll be able to find someone closer to the 10%-15% range.

Again, that range is gonna be based on your relationship with the person, the risks associated with the loan and the risks associated with the investment strategy. Now we’re up to between 30% and 45% of the GP.

The next part, part number four, is going to be the person who is responsible for investor relations. This is a person who is responsible for finding the passive investor, so they’ve spent time on the thought leadership platform and reaching out to different people they know on LinkedIn, or on Bigger Pockets, posting a ton in order to generate interest from passive investors before a deal is found.

Once a deal is actually found, they’re gonna be responsible for presenting that deal to the investors, as well as securing commitments from those investors in order to fund the equity investment for the deal.

Then once the deal is closed, they’re responsible for notifying the investors, setting expectations for communication and distributions moving forward, and then execute on those expectations of sending out monthly updates, sending out financials quarterly, and making sure that the person responsible for sending out the distributions is doing so on time, and those distributions are accurate.

This person should be/could be given about 35% of the general partnership. This could be one single person raising all the capital, or a combination of people raising capital. I guess the most fair way would be to allocate that 35% in proportion to the amount of money that the individual raised… But again, that’s going to be completely negotiable between you and those people raising the capital. 35% is what Joe does. For me, we actually do 40%; just because we’re so new, we’re likely not going to be able to raise all the capital ourselves, so we wanted to allocate a large chunk of the GP to the person responsible for raising capital, so that we could attract people to fund our deals, as opposed to someone else’s deal, who maybe only has 20% allocated to the person responsible for raising money.

So that’s number four, and now we’re up to 65% to 80%. That remaining 20% to 35% will go to the person who is responsible for task number five, which is going to be the asset management. This is the person who ensures that the property management company is implementing the business plan after the property is closed on. This includes things like conducting weekly performance reviews with the site manager, frequently visiting the property in person, analyzing the market and the competition on a consistent basis, and addressing really any issue that arises during the hold period. And again, this person will be given 20% to 35%, depending on the previous four tasks.

So those are the five different tasks. There’s asset management, investor relations, the sponsor, acquisition management and due diligence costs.

Now, those are five tasks, but they don’t necessarily need to be assigned to five different people. For example, you and your business partner could both go 50/50 on the due diligence costs, and then maybe one of the partners is responsible for acquisition management and asset management, so they do essentially all of the operational tasks, and then the other partner could be responsible for the investor relations, and then they both could find someone to sponsor the deal, and that person is given an ownership percentage in the deal. Then ideally, eventually, they could be the people who are able to sponsor the deal, so there’s only two people on the general partnership.

Or it could be something like one person is responsible for acquisition management executive, who just does acquisitional tasks, and then once they’re done, they hand it off to the asset manager, and then they go back to finding more deals. So you’ve got an acquisition person, an asset management person, and then maybe you’ve got five people who are focused on raising money; or maybe you’ve got two people who are focused on raising money and then one person does the ongoing communications. Then maybe you’ve got three different people sponsoring the deal, and those people who are sponsoring the deal are also helping you cover the due diligence costs.

So really, everything is possible. The general partnership could be a few people, to 10-20 people. It really varies from deal to deal and group to group, but most likely on your first few deals there’s gonna be multiple people on the GP, because again, you’re likely not going to be able to sponsor the deal yourself, you might also not be able to cover the due diligence costs, and then you might also need to have someone with experience do the asset management or the acquisition management while you focus on just raising money, for example.

Again, just to summarize, the five main parts of the general partnership are the due diligence costs, which could receive 5% of the GP, then there’s the acquisition manager, who could get 20% of the GP, there’s the sponsor/loan guarantor/the person who signs on the loan with 5%-20%, there’s the person responsible for investor relations, around 35%, and then there’s an asset manager with 20% to 35%. Again, these are just very high-level percentages, and kind of breaking apart the tasks. It’s all negotiable and it’s definitely gonna vary from deal to deal and syndicator to syndicator.

That concludes the GP compensation. In part two we’re gonna discuss the other side of the coin, which is how to structure the limited partner or the passive investor compensation.

To listen to other Syndication School series about the how-to’s of apartment syndications, and make sure you download those free documents that we offer – those are all available at SyndicationSchool.com.

Thank you for listening, and I will talk to you tomorrow.