The Promote Problem

In forty years of forming real estate partnerships, I have experienced many deals that only went wrong on alignment.

Commercial real estate is an intensely complex industry. A great many factors go into the structure of a deal and the eventual yield to each participant: limited partners, general partners, individual investors, entities, families, family offices. Most of the attention in any new partnership goes to the property itself: the rent roll, the debt, the basis, the exit assumptions. That work matters, and it has to be right. But it is not where partnerships actually break.

Where the money comes from

Start with the structure, because the structure sets the behavior.

The vehicle by which most sponsors make their profits is the leverage of other people’s money. The sponsor takes a percentage of the profits from the underlying real estate. The investor, in turn, receives a return above their original invested capital. Those yields are typically commensurate with the risk taken. Ground up development and major renovation carry the most risk and therefore command the highest yields. Stabilized, well-located, income-producing assets carry less risk and pay accordingly.

None of that is controversial. What matters is that every participant understands not just their own return, but where every other participant’s return comes from, and when it arrives.

The structural question Before the first dollar is committed, every party should be able to answer: what does each of us get paid for, and what would each of us have to do to get paid?

Alignment goes past the pro forma

The alignment of interests goes well beyond whether the real estate investment is profitable. A deal can pencil beautifully and still not work because the partners wanted structurally different things from the same asset.

The questions worth asking early, in writing, and out loud:

• Cash flow or capital gains? Some partners need quarterly distributions. Others would rather see everything reinvested and take it out at the end. Both are legitimate. They are not the same objective.
• What is the tax posture? Different entities and different families have very different needs around depreciation, timing of gain, and 1031 treatment.
• What does reporting need to look like? A family office with an investment committee has different requirements than an individual investor.
• Which asset classes are being desired? Retail, industrial, multifamily, and office behave differently and demand different tolerances for risk, reward and capital.
• Where does social responsibility sit? Some investors have real constraints on what they will own and how it will be operated. This is good information to have to tailor an investment program to their needs.
• What is the time horizon? This is the one that separates most investors.

If the answers to those questions line up, and there is sufficient capital to deploy, you have something better than a single good deal. You have the basis for a programmatic relationship: the same partners, doing the same thing, repeatedly, with the underwriting standards and the trust already established. Programmatic investing carries immense potential for both short- and long-term capital gains, and it is only available to groups whose interests genuinely match.

The one bad apple

The old saying about one bad apple is absolutely correct, and I have watched it prove itself more times than I would like.

One person with a different perspective or a different agenda, inside a single investing entity or inside a single family, can create utter chaos. And the damage does not stay contained to that entity. It spreads to the whole investment group. Decisions that should take a week take a quarter. Capital calls get contested. A refinance that everyone benefits from stalls because one participant is quietly running a different playbook. Meanwhile the asset is doing fine; the partnership is not.

Alignment work is risk management. The most careful due diligence in the world on a building does not protect you from a partner who wanted something other than what the partnership was formed to do.

Succession is an alignment question

Details of succession are important for every entity involved, and they must be aligned across all of them.

Families and family offices are, by definition, multi-generational investors. The person who signs the subscription documents may not be the person voting on a sale in year twelve. If the next generation has different objectives, different liquidity needs, or a different view of the asset class, then a partnership that was aligned at formation quietly becomes misaligned without anyone doing anything wrong.

Ask about succession before it becomes urgent. Ask who inherits the position, who will speak for it, and whether that person shares the original objectives. This conversation is uncomfortable exactly once. The alternative is uncomfortable indefinitely.

Flexible on the plan, firm on the values

There are always hurdles and roadblocks. Interest rates move, tenants leave, entitlements take longer than anyone modeled, and the business plan needs to bend. That flexibility is part of the job.

But flexibility on the business plan only works when the underlying values and strategy are shared. Partners who agree on what they are trying to accomplish can adapt to almost anything. Partners who never truly agreed will use the first hurdle to relitigate the entire deal.

As in any business, the manager must stay focused on the business plan with the interests of the investors genuinely aligned. Get that part right at the beginning, and most of what follows is just work. Get it wrong, and no amount of good real estate will save it.