This Company Wants To Shake Up Real Estate’s Archaic Fee Structure
The way real estate investors and owners pay fees could be reducing the value of their buildings. Not the level of the fees they pay brokers, asset managers and fund managers, but the very structure of the way fees are charged.
Real estate has changed enormously in the past two decades, and that pace of change is increasing seemingly every week. So why has the way fees are paid to brokers and asset managers not changed as well?
That is the question being asked by UK company APAM, which has called out the “archaic” and “misaligned” way real estate service providers are paid. It said that current fee structures incentivise short-term thinking and encourage brokers, in particular, to get a deal done as quickly as possible in order to move on to the next transaction, rather than thinking about the long-term benefits for their clients.
Although the way brokerages are structured in the UK and U.S. is different, the charge can be levelled at advisors in both countries: short-term thinking creating short-term gain for advisors but long-term pain for owners.
APAM is an asset manager that owns assets and manages them for third parties, so sometimes it is the client, and sometimes it is the service provider. It is changing the way it both pays its service providers and charges its clients, in order to create better alignment of interest.
“We’re seeing a lot of advisors wanting to do soft deals just so they can move on to the next fee,” APAM Asset Manager Ben Dickins said. “Advisors should be there not just to broker deals but to provide advice.”
One particular problem area is leasing deals, Dickins said. In the UK, the standard way that leasing agents are paid is to receive a flat fee based on annual gross headline rent, and this has been standard practice since time immemorial.
But over the past two decades, average office lease lengths in the UK have dropped from more than 15 years to less than seven, according to MSCI. If a leasing agent gets the same fee whether the lease is five years or 15 years, there is no incentive for them to negotiate a longer lease, which would improve the investment value of the asset for the owner.
“This structure is no longer fit for purpose as fees are not proportionate to total guaranteed income received by the landlord,” Dickins said. “What we are proposing is a move towards a fee calculated from total rent guaranteed over the term of the lease. This proportionately rewards those that can secure longer lease terms and better incentives for landlords: in particular longer lease terms which generally are investment value accretive.”
Will brokers go for it?
“No one has turned us down yet,” Dickins said. “If it is the choice between a different type of fee or no fee at all, people will change.”
The different structure means that if a broker can negotiate a longer lease, they will earn more, incentivising them to strike the best deal for their client. It is more speculative, but Dickins points out that advisors could be nudged in other ways toward providing advice that rewards longer-term thinking, such as deferring fees until business plans have been executed and proved successful.
The ultimate form of alignment is co-investing alongside clients. This is unlikely to happen for leasing or investment agents, but Dickins said for asset managers, fund managers and property managers it should be common practice. That would ensure that over the long term these professionals share the rewards if an asset is managed well, and share the downside if an asset is managed badly. It is common in some parts of the industry, such as private equity fund management, but not as common as it should be, Dickins argued.
He said that often, big firms providing property or asset management services would cross-sell other services provided by their firm in order to extract as many fees as possible, and he believes that does clients a disservice.
“Properties with multi-service, single-consultancy representation, often as a result of cross-selling, is an example of where having no skin in the game can lead to significant downsides to the investor,” he said. “Regardless of performance, the consultancy profits at multiple levels so there is little incentive to provide the best external service provider. The client, especially if it takes a hands-off approach, is often unaware that a substandard service might be being provided. The opportunity cost of this is worse performance and potentially a loss of equity.”
Then of course there is the matter of fees paid that relate to the amount of assets under management. Dickins said this creates hugely perverse incentives for asset and fund managers, who are incentivised to build up assets just to receive higher fees. There is no incentive to sell an asset once it becomes “ex growth” as this reduces assets under management and hence reduces fees.
“As an asset manager, we base our fees not on amount of assets under management and transaction-based fees but using incentivised performance fee structures that are only received at exit once returns have been crystallised or in the event of long-term investments paid out once initial business plans are successfully completed,” Dickins said. “Our true skin in the game is the financial risk of underperformance. If our clients were to lose out financially, so would we.”
This kind of fee structure is common in private equity and hedge funds, but less so in traditional real estate fund and asset management. The “two and 20” fee structure common in that world, where the manager takes a flat fee of 2% of assets under management and then receives 20% of the profits from investments that beat a certain target has an interesting backstory.
It was the structure used by Phoenician sea captains in the ancient world: They would take a payment of 20% of a ship’s cargo upon completing a voyage successfully. The man credited with inventing the first hedge fund in 1949, Alfred Winslow Jones, decided on a whim to use it to charge his clients. It has ancient roots, but is still applicable today.
If the current system is so bad for investors and asset owners, why do they put up with it? Changing an entrenched system is difficult, Dickins said, especially for asset owners who themselves might not have huge manpower, hence the need to outsource services.
“Institutional investors should be leading the charge, but it can be difficult when you are so busy,” he said. “Then there is the fact that a lot of capital is global, comes into a new market and is told, this is how it is done here. It can be very difficult to research everything about buying and owning in a market, and how the fees work. But we are finding, when we are talking to clients and suggesting these different structures, they are very keen.”
While there is little incentive for advisors to change, if their clients decide the current system is broken, they may not have much choice.