The Promote Problem

Most real estate fund GPs get paid when they sell. That one fact explains most short-hold behavior in the industry.

The discipline of holding institutional commercial real estate for twenty years or more is structurally unavailable to most operators. This post explains why.

The Waterfall

When you invest in a typical commercial real estate fund, the economics are divided in a sequence called the waterfall. Your invested capital comes back first. After that, you receive a preferred return, usually eight percent on the unreturned capital, payable when there is cash to pay it. Then comes a catch-up provision, where the sponsor receives a disproportionate share of distributions until they reach a target split. Only after all of that does the remaining cash split: typically eighty/twenty in favor of the limited partners, or seventy/thirty, depending on the fund documents.

That twenty or thirty percent the sponsor receives from the residual cash is called the promote, or carried interest. It is, almost without exception, where the sponsor makes their real money.

When the promote actually pays

Here is the catch: most of the promote is realized at sale. Quarterly cash flow during the hold pays operating distributions and the preferred return. The big slug of sponsor compensation comes off the back of a sale event. That is the money that funds the GP's house, their kids' college, and the next fund.

The annual management fee is a respectable income, but it is not transformational. The promote at exit is. That is the rational shape of fund-manager compensation, and there is nothing inherently wrong with it. What matters is what it does to behavior.

The implicit conflict

When the LP and the GP have different timing on their cash, you have a structural conflict. The LP, especially one with a long view, is often content to compound inside a high-quality asset for another decade. The GP cannot afford that. By year seven, the math on the next fund vintage dominates the strategic conversation. By year nine, the property is on the market.

Malfeasance has nothing to do with it. A sponsor responding rationally to how they get paid behaves exactly this way. Read the fund documents and you will see it described in formal terms. Sit through a few sponsor strategic reviews and you will see it play out in practice.

How a private partnership inverts the incentive

The private partnership structure we run at CIP is built differently. Distributions go to everyone, partners and investors alike, every quarter, for the entire time we hold the asset. The compensation to all partners is partially the cash flow rather than only the exit event. There is a carried interest dependent on a sale, but our interests are aligned along the way.

The result is that our interests and our investors' interests sit on the same side of the table for every hold-period decision. When the question is "should we sell this in year ten?", the honest answer for everyone in the room is usually "no, why would we?" The asset is doing exactly what it is supposed to do.

We look to programmatic relationships and have not built a war chest off exit events. That is the trade. We think it is the right one for the strategy.



A useful question for any sponsor

When evaluating a sponsor, the most useful question is not "what is your IRR target" or "what is your stabilized yield." Those numbers can be modeled to whatever answer the sponsor wants.

The most useful question is: where does your money come from?

If the answer is "the management fee and the promote at exit," you know that sponsor is structurally incentivized to sell. If the answer is "the operating cash distributions," and the math supports it, you know they are structurally incentivized to hold or sell, especially if the property is purchased below basis.

The work of a long-horizon investor is to find sponsors whose incentives match the actual strategy. There are not that many of them. There is a reason for that, and it is the same reason we wrote this post.