Hotel investment

[Dr P]

I was hoping to get some feedback on a proposal.  I'm in early talks with a friend who has experience in the hotel industry.  He is in the process of evaluating a property in a "destination" market for purchase.  I won't get into too many of the particulars, but I have a specific question.  His proposal is that he will be awarded 51% of the ownership of the property based on sweat equity and a "finder's fee" while those investing capital will collectively own 49%.

I wanted to know if this seemed normal?  I have a couple concerns.  Without investing capital, what incentive, besides collecting distributions, does he have to make this successful?  It seems that regardless of whether the property increases in value or not, he will come out ahead after the initial work put in.  With a proposed investment of over $1M for 49%, the initial effort will net him at least this much, given the 49/51 split.  It seems like a pretty good deal for him for a few months work in setting up the proposal.  On top of that, he would be managing the hotel for a salary.

He's willing to impose certain restrictions on the sale of the property for the first few years and he will take a reduced distribution in these years as well.

This would be my first real estate investment and I don't know what industry standard is, but does this seem like a reasonable venture?

Thanks

[Doctor Money Matters]

I have no idea if this is standard, but it seems very high to me. Someone pitched buying raw land to a group of doctors I am friends with last year and he wanted 25% stake without putting anything in as a finders fee. He also wanted 2% fees annually for the land value as a management fee. I thought it was crazy high so I said no.

[Donnie]

No, this is not standard.  About 100x less, or 50 bps is more reasonable for a finder's fee.

For sweat equity, I would put in a hurdle return to the investors putting capital at risk before the sweat equity would be paid out.  Not sure what the expected IRR is, but if it is say 10%, I might let the guy have 10% once the investors realize an 8% IRR or something like that.  Basically, this guy shouldn't get a penny before the investors with capital at risk get back their principal and some return.

Overall I would just get far away from someone proposing something like this.  He's going to steal your money one way or another.

[StarTrekDoc]

+1 - not much of a friend here. -   Finder's fee, and manager fee for operations if that's what he wants, but equity shares 51%?  That's crazy.

[antheus]

So if I'm reading this correctly, your friend would invest nothing and have 51% equity? Essentially you are taking on all the risk and he's getting a majority of the reward. Technically, from day 1 your investment is down 50%. Assuming you took that $1 million (I know that you're not investing the entirety of the capital but the numbers work out the same) and invested it in the stock market instead at an average return of 7% per year, your return on the hotel investment would need to be 15.5% per year to break even at 10 years compared. I'm not in the hotel industry so I don't know what kind of margins there are but this seems like a fair bit of risk and would require pretty good returns just to break even at 10 years.

[Hatton]

Maybe Kamban will comment on this thread.

[Ryan]

Dr P wrote:

I’m in early talks with a friend who has experience in the hotel industry

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That's your first red flag. Your analysis is spot on, your friend has an enormous incentive to cash out.

And 50-50 partnerships are more common with much less money down from what I've seen online (never been in one myself). 49-51 is frankly absurd.

[mobilehomegurl]

Most commercial deals I know of involve some form of investment by all parties involved. If no investment is made by one of the parties, it's more of a management type deal with a percentage going towards the manager overseeing the operation. Regarding a finders fee, usually that's on a per deal basis but I haven't heard of any of these type transactions involving an additional percentage of ownership without some form of capital involved.

One thing about hotels, their probably the most intense asset class in commercial real estate. It's more than a business than anything. Restaurants come at a close second.

Many docs I've known to venture into commercial real estate buy office buildings usually staying in the same asset class: healthcare. It's definitely a long-term category for commercial real estate with the aging population.

Hope that helps!

[jfoxcpacfp]

I second the comments of others that you are highly unlikely to get anywhere near the returns needed to even break even on your investment, at least based on the returns of our hotel clients (admittedly, not in a "hot" destination spot). Plus, if your "friend" is getting paid for ongoing management, at 51% ownership, he will have the majority vote to determine ongoing compensation.

[Kamban]

Go through this thread and read my comments

https://www.whitecoatinvestor.com/forums/topic/real-estate-anyone-with-hotel-investing-experience/

Essentially you are getting royally screwed. The max I would pay as commission is about 10% initial project development ( especially if it a new construction and getting the franchise approved - sometimes that is a long process). The investment is repaid as distributions over the years and if there is a profit at the time of the sale after the investment money is repaid, the managing partner gets anywhere between 20-30% of the profits based on the initial amount you contributed, and the rest is distributed percentage wise to the partners who put the money.

The managing entity gets 4 % of the net revenues per year to help manage the property.

[Kamban]

Wanted to add that in some of the bigger investments the managing partner can get 35% of the equity but this occurs only after the initial investment account is paid off.

Dr P wrote:

With a proposed investment of over $1M for 49%, the initial effort will net him at least this much, given the 49/51 split.

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I hope that the investment amount from your side is at least $2.5-3M if the banks are putting up 75-70 % of the purchase. Hotels that cost less than $8M overall means that they are not in the top 3 - namely Hilton, Marriott and IHG ( unless it is an older top 3 property in decline and ready to lose its franchise). That might cause it to produce lower returns because the room rate is much less and one can get into price wars to try and improve occupancy rate. And they can become roach motels or meth labs quite easily while chasing the race to the bottom.

[Dr P]

Thank you for all the feedback.

[erictait]

Sorry, I know I am late posting.

 

The short answer is there are no "industry" standards, just what the investor market is willing to bear.

 

Would love to get some details which would give some context to deal structure.

 

What was the proposed return you were going to make on the deal?

 

How are the cash flows going to be split between you?

 

Will there be a loan on the property? If so, would you be signing on the loan?

 

If he was projecting for you to make a 25% IRR (internal rate of return) per year on the project with your receiving 49%, would that make you unhappy?

 

In a syndication, the back end equity splits can be anything.

 

A good way to look at this in the future is to decide what you are happy to receive in a real estate investment and look at projects that fit that criteria.

 

Then what the operator is making is irrelevant actually because you will be getting what you want.

[Donnie]

erictait wrote:

 

 

If he was projecting for you to make a 25% IRR (internal rate of return) per year on the project with your receiving 49%, would that make you unhappy?

 

In a syndication, the back end equity splits can be anything.

 

A good way to look at this in the future is to decide what you are happy to receive in a real estate investment and look at projects that fit that criteria.

 

Then what the operator is making is irrelevant actually because you will be getting what you want.

Click to expand...

This is actually a bad way to look at things.  You may say earning a 15% IRR would make you happy, but capping your IRR at 15% would be a horrible idea.  If you invest over a number of different deals, you will have some that underperform a 15% IRR.  You will therefore necessarily earn less than a blended 15% over these investments.

There are indeed "market" standards.  Yes, you can find examples of just about any fee schedule you could dream up, but the average "market" deal would look nothing like the one posted in the OP.

The bottom line is that you shouldn't be giving up 50% of the economics (or anything like that amount) while putting up 100% of the risk capital.  If you find anyone agreeing to such a plan, I will gladly manage the money for 50% less, as would any money manager in the world.

 

 

[erictait]

It is neither a good nor bad way to look at things.

 

It is a philosophical difference on how to approach a question.

 

Everyday mutual fund investors put up 100% of the risk capital why the investment manager is guaranteed his or her fees win or lose.

 

So this is not a foreign concept, it is just framed in a different context.

 

And no where did I say anything about capping a 15% IRR, I used it an example.  As most people who are reading this cannot generate a consistent 15% IRR on their own, if they can find someone who can and they are wanting to put their money with them, I was pointing out the folly of trying to count the other person's money.

What you are doing is assuming there is another project on the table that is an alternative, I was not.

Of course any sane person would look to see if there was a project that might give them more favorable terms, but many people who do that and end up with inferior operators or end up never pulling the trigger on anything at all because they are waiting for perfection.

I know super successful operators that take 65% of the backend and they raise 20 million dollars in a day from investors, because the investor's return in north of 50% IRR.

The most successful and experienced operators know what they are worth and they take a larger portion of the backend equity. They also know that the average individual is relegated to the paper asset markets where they are not going to consistently see those types of returns especially with a decent cash on cash return.

My point in posting is that you do not count other people's money if they can produce returns for you that you cannot consistently get for yourself, if you can, then move onto the next project.  But if you can't, you focus on figuring out if that operator has the chops to deliver on what he or she says they are going to do, not on what their split is if they are going to get you more than you are consistently getting now.