A common term you here in real estate investing is a general partner (GP) promote. A general partner or sponsor is the individual or company who makes day-to-day decisions regarding a real estate investment. The GP promote goes by several terms including sponsor promote or carried interest. These terms describe a GP’s disproportionate share of profits in a real estate deal above a predetermined return threshold. In this article we’ll go over:
- What is a GP Promote?
- How Promotes Work.
- Why Are Promotes so Common?
What is a GP Promote?
Real estate sponsors generally invest their own capital into a deal alongside third-party equity partners. The sponsors contribution is generally between 10-25% of the total equity requirement on a real estate project. During the early stages of the investment, the profits from the project are generally split pro-rata (also known as pari passu) based on everyone capital contribution percentage. For example, if a general partner contributes 10% of the total equity requirement and the project had $100,000 in profit to distribute then the sponsor would receive $10,000 (10% of the distributable cash or the capital contribution percentage). Profits are split this way until the third-party equity partner hits a predetermined threshold. It’s important to note here that this predetermined threshold is established at the beginning of the relationship between the general partner and the third-party equity partner. In a real estate development project this is prior to the start of construction of the project. Once that predetermined threshold is met (and there can be one or many predetermined thresholds) then the sponsor starts to receive a disproportionate share of the profits generated by the project.
How Promotes Work.
Let’s go over an example and say a sponsor contributes 10% of the total equity requirement for a project and a third-party partner contributes 90% of the total equity required. The sponsor and the third-party partner agree upfront that profits are split 90/10 (pro-rata based on capital contribution percentages) until the third-party receives a 10% IRR. After a 10% IRR is obtained by the third-party then profits generated by the project are split 80/20. This disproportionate share of the profits is the GP promote.
Oftentimes, there are many predetermined thresholds in a project. All of these thresholds are generally known as a distribution waterfall or waterfall for short. Here’s a quick example of how a waterfall make be structured between a sponsor and a third-party equity partner at the beginning of a project.
|Sponsor or General Partner||10% of the equity requirement|
|Third-Party Equity Partner||90% of the equity requirement|
|Hurdle Rate (up to)||Sponsor Distribution %||Third-Party Equity Distribution %|
|10% IRR to Third-Party Equity||10%||90%|
|14% IRR to Third-Party Equity||20%||80%|
|18% IRR to Third-Party Equity||30%||70%|
|22% IRR to Third-Party Equity||40%||60%|
Why Are Promotes so Common?
One of the questions new real estate investors often ask me is “why would any third-party equity partner agree to this?” Especially institutional equity partners who are investing billions of dollars in real estate transactions all over the world. However, it is important to remember that investors are relying upon the sponsor, among other things, to do the following:
- Source and identify assets
- Underwrite and discover hidden value
- Pursue, negotiate and win deals
- Develop asset business plans
- Negotiate purchase and sale agreements
- Conduct thorough due diligence
- Secure financing
- Close deals
- Manage assets
- Lease to new tenants
- Renew leases with existing tenants
- Perform and manage capital expenditure projects
- Execute asset business plans
- Dispose of assets; and
- Deliver investment returns
Considering that the sponsor does day-to-day management in a deal, it is obvious that that success of any given project rests heavily in the sponsor. Therefore, it makes sense that the sponsor is rewarded if it leads a successful project. It’s important to note that the promote does not disadvantage third-party equity partners. In fact, the GP promote incentivizes sponsors to exceed expectations and beat the original pro forma or business plan. If a sponsor exceeds expectations then they receive a bonus that is tied to the success of a project, ie the promote. Third-party equity investors also share in those additional profits, just to a lesser degree than the sponsor. Third-party equity partners want to incentivize the sponsor in order to keep them focused and invested on the project. The GP promote does this and provides a potential win-win scenario for all parties.