Real Estate Investment Structures and Essential Fees Explained

Understanding the structure and fees of private real estate investments is essential for any investor. This article will provide a comprehensive overview of how these investments are structured and the common fees associated with them, enabling you to make more informed investment decisions.

How are private real estate investment deals structured?

Private real estate investment deals are structured in various ways, each with its own implications for profit sharing and distribution allocation. Here are the four most common structures:

1. Real Estate Investment Trust (REIT)

Real Estate Investment Trusts (REITs) are corporations that own, operate, or finance income-producing real estate, allowing investors to earn income without directly managing properties. REITs offer higher liquidity vs directly owning real estate, as they are often publicly traded on stock exchanges or non-traded with share redemption programs, making it easier to buy and sell shares.

They are required to distribute at least 90% of their taxable income as dividends, providing regular income to investors. However, these dividends are taxed as ordinary income, and REIT investors have no control over management decisions, which are handled by the REIT’s management team. REITs are also heavily regulated, which offers investor protection but limits operational flexibility.

2. Limited Partnership (LP)

A Limited Partnership (LP) is a common structure in real estate investments. In this arrangement, there are two types of partners: general partners (GPs), typically the sponsors who manage the business and assume full liability, and limited partners (LPs), who are the investors that provide capital and enjoy limited liability. This setup allows the LPs to invest in real estate without being involved in daily management, offering them protection from business liabilities.

Unlike public and private NAV REITs, a limited partnership is an illiquid investment and usually requires a long-term commitment, often spanning 7–10 years. Exiting the partnership before the end of this period can be challenging for investors. Distributions are outlined in the limited partnership agreement (LPA) and varies according to the capital contributed by each partner. While limited partnerships can deliver high returns, especially in successful commercial real estate ventures, LPs have no control over management decisions, which are solely the responsibility of the general partner.

3. Limited Liability Company (LLC)

A Limited Liability Company (LLC) is a flexible business structure that combines the liability protection of a corporation with the tax benefits of a partnership. LLCs are commonly used in real estate to own and manage properties. Members of an LLC enjoy limited liability, meaning they are not personally responsible for the company’s debts or liabilities. One of the key advantages of an LLC is its flexibility in management. It can be managed by its members (owners) or by appointed managers. Additionally, LLCs benefit from pass-through taxation, where income is only taxed at the individual level, avoiding the double taxation that corporations face.

However, like LPs, LLCs are generally less liquid than public and NAV REITs, and transferring ownership interests can be more complicated. LLCs also offer more control to their members compared to REITs and LPs, making them a preferred choice for investors who want both liability protection and involvement in management decisions. The management structure and profit-sharing arrangements in an LLC can be tailored to the specific needs of the members, offering a level of customization that is not available in the other structures.

4. Delaware Statutory Trust (DST)

The Delaware Statutory Trust (DST) has gained popularity as an alternative real estate investment vehicle, especially for those looking to leverage 1031 Exchanges for tax benefits. A DST is a separate legal entity that allows multiple investors to co-invest in real estate while placing full control in the hands of a trustee—usually the sponsor. Investors hold beneficial shares in the trust, giving them a direct interest in the property.

Operating similarly to a Tenants in Common (TIC) structure, a DST offers several advantages, such as greater individual investor autonomy and the ability to participate in the widely used 1031 exchange marketplace. This structure has widely replaced TICs among common investors due to its favorable characteristics.

Benefits for Sponsors: Sponsors favor DSTs as a way to access the 1031 exchange market, thanks to changes in tax legislation in 2004, and as an alternative strategy for recapitalization. DSTs allow sponsors to maintain control over the investment while offering a tax-efficient vehicle for investors.

Benefits for Investors: Investors appreciate DSTs as a passive alternative to self-managed real estate investments or as a tax-friendly option compared to ground leases or REIT investments. Due to specific tax laws, the promote or waterfall distribution models commonly seen in other structures do not apply to DSTs. Instead, distributions from fractional interests are handled on a true pro-rata basis.

Fee Structure: Similar to other structures, DSTs include Disposition, Property, and Asset Management fees collected by the sponsor. However, DST sponsors often seek higher Acquisition Fees (typically 2-5%), especially when looking for recapitalization opportunities.

Common fee structures in real estate investments

Understanding the fees charged by real estate sponsors is crucial, as these fees can significantly impact your returns. Here are the five most common types of fees:

1. Acquisition Fee

The acquisition fee compensates the sponsor for sourcing, evaluating, and acquiring the property. Typically ranging from 1% to 2% of the total deal size, this fee is paid based on the entire transaction value rather than just the equity portion.

Impact on Cash Flow: Acquisition fees increase the upfront capital required from investors, as they are often included in the initial cash requirements, impacting the overall cash gap in a deal.

2. Management Fee

The management fee covers the ongoing costs of managing the property, including tasks like rent collection, maintenance, and tenant management. This fee, typically between 3% and 5% of the property’s gross income, is treated as an operating expense.

Property vs. Asset Management: It’s essential to distinguish between property management fees (for day-to-day operations) and asset management fees (for overseeing the investment as a whole). Asset management fees typically range from 1% to 2% of the invested equity and are charged annually.

3. Disposition Fee

When the property is sold, the sponsor may charge a disposition fee, typically a percentage of the sale price, to compensate for the work involved in preparing the property for sale and executing the transaction. This fee is often similar to or slightly less than the acquisition fee.

Performance-Based: In some cases, the disposition fee may be tied to the property’s performance. If the property underperforms, the sponsor might waive this fee.

4. Organizational and Marketing/Placement Fees

Organizational and operational fees (O&O) and marketing / placement expenses in a real estate investment fund encompass the costs of establishing, managing, and attracting investors to the fund. Organizational and operational expenses, such as legal fees, formation costs, accounting and initial marketing, are typically one-time costs incurred during the fund's setup.

Marketing / placement fees are paid to intermediaries like placement agents or broker-dealers who help secure investors. These combined expenses, typically ranging from 6-10% per deal, can impact investor returns and are detailed in the fund’s offering documents, making it crucial for investors to understand them before committing to an investment.

5. Incentive/Performance Fee

This fee, often referred to as a "promote," is designed to reward the sponsor for achieving certain performance benchmarks. The fee structure usually follows a "waterfall" model, where the sponsor receives a larger share of the profits if the property exceeds a predefined return threshold (e.g., 10% annual IRR).

Example: If a property generates returns above the hurdle rate, the profit split might shift from 90/10 (LP/GP) to 80/20, with the sponsor receiving the additional 10% as an incentive fee.

Conclusion

Understanding the structure and fees of real estate investment is key to making informed decisions and maximizing returns for investors. By familiarizing yourself with common structures like REITs, LPs, LLCs and DSTs, and by knowing how fees like acquisition, management, disposition, and performance fees work, you can better evaluate potential investments. Always ensure that the fees are reasonable and are aligned with industry standards and with sponsor incentives. Misalignment of incentives between sponsors and investors can be very problematic if the given investment strategy does not pan out, ultimately hurting investors.

Navigating your choices

At Wealthstone Group, we understand that navigating the complexities of real estate investment structures and fees is crucial to maximizing your returns. Whether you’re exploring REITs, LPs, LLCs, or DSTs, our team of experts is here to guide you through every step of the process. Connect with us today to ensure your investments are aligned with your financial goals and optimized for success.

General Disclosure

This material is provided for informational and educational purposes only and is based on information from sources we believe to be reliable. However, its accuracy is not guaranteed, and it is not intended to be the sole basis for investment decisions or to meet specific investment needs.

Wealthstone Group does not offer tax or legal advice. This content should not replace professional advice tailored to your individual situation.

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk of loss of some or all principal invested. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Any information provided is for informational purposes only. Securities offered through Arkadios Capital, member FINRA/SIPC. Advisory Services offered through Arkadios Wealth. Wealthstone Group and Arkadios are not affiliated through any ownership.