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Fees erode more equity than you think

Happy Thursday! 👋

I spend a lot of time trying to explain why fees are such a big deal, and acquisition fee drag was actually the topic of my first article on August 30th, 2023 (time flies when you’re having fun).

We all know about return of capital (if you don’t, you should) clauses, but in reality getting your capital back after investing isn’t as simple as it sounds.

Today, I’ll illustrate how losing 25% of invested equity day 1 to fees and transaction costs can easily occur in a real estate transaction. This doesn’t mean you shouldn’t invest, but it does mean that you need to be certain that the assumptions are achievable since the investment has to recover that initial loss on equity.

Alright, time to get practical.

Let’s walk through a $100 million multifamily acquisition with 70% leverage, break down the fees, and show how, in a hypothetical sale at the same price, nearly 40% of the initial equity can disappear.

Deal Assumptions:

• Property Price: $100mm

• Leverage (Loan-to-Value): 70%

• Equity Contribution (30% of purchase price): $30mm

• Loan Amount: $70mm

Now let’s talk about expenses to buy such a property:

Note that:

• Fees/costs can vary across deals, and in some cases the percentages will be much higher or lower

• some of this varies with deal size - larger deals come with lower acquisition fees, for example.

• There are also usually considerable fees paid for the lender at acquisition, and sometimes at payoff, which I am currently not including above (this would only make the overall point stronger).

• Above, I am assuming there’s a 1% broker’s commission - this varies, and in many cases (but far from all) this fee is paid for by the seller. Having said that, I decided to run with it for the purposes of the illustration .. and the fact that this 1% fee expense could easily be filled up by some other costs/fees

Since these transaction costs are not covered by the loan or original equity of $30mm (which goes to seller), the equity raise needs to increase to account for these costs .. that gets us to a sources and uses table (which you should always look for in a deck, among other things):

Now let’s suppose that the next day the GP decides to sell.. and he can even get the same price he sold it for. Here are typical fees charged at disposition:

Now notice:

• On the acquisition, only $30mm actually “made it” (net of fees) to the property investment, even though $34.7mm was invested

• On the sale, there’s no cash sitting around to pay the fees, which means we’d have to assume that they come out of closing (i.e. reduce the $30mm in equity after paying off the mortgage by $3.5mm)

To summarize, we just incurred $8.2MM of fees which were a “drag” on the equity investment of $34.7MM, or a 23.6% equity loss… **but you sold the same property, for the same exact price you bought it for! **This is why fee drag is important.

I hope this illustration helped you understand the fees of your next investment. Fees are a very normal part of this business and GPs need them to pay their expenses, but you should also have a full understanding of how such fees impact your net returns.

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