Fairly Negotiating Real Estate Placement Fee Splits
INTRODUCTION
Within the real estate capital industry, deciding equitable fee sharing arrangements is often one of the more debated issues between various professionals involved in structuring a specific transaction. Not to be confused with overall fee structuring, this discussion is completely separate from the actual negotiations with the property owner (e.g., exclusive vs non-exclusive and pricing). Otherwise known as “fee distribution”, “splits” or “co-brokerage” agreements, fee sharing arrangements cover all types of real estate capital activities including consulting, sales, financings, partial-equity and joint venture assignments.
Fee sharing discussions don’t apply to certain situations, including smaller fees and individual assignments. Although no fee is too insignificant, for smaller fee assignments that are typically $25,000 or less, fee sharing arrangements are more casual as the depth and scope of such assignments seldom require multiple disciplines. These fee sharing arrangements are usually more standardized. Also, capital transactions limited to single individuals and organizations may be irrelevant or subject to internal compensation policies.
Fee sharing discussions are usually structured based upon rules of thumb. Brokers, investment analysts, administrative personnel, closing professionals and others within an organization — as well as outside parties involved in a transaction — will each have individually-biased views on fee distributions. Such discussions typically lead to heated debates on “fairness”, “reasonable”, “standard”, “market rate”, “customary” and “typical” as defined by each party. Of course, everyone normally believes that their position is “right.”
THE FAIRNESS DOCTRINE
Rather than debating about right or wrong, or what is considered fair, fee sharing discussions need to center around facts and circumstances. To avoid conflicts, each party should agree beforehand about the “fairness” of the fee sharing allocations based on determining responsibilities and dedicated resources.
Needless to say, defining “fairness” in fee sharing arrangements is both an art and science. The science identifies specific variables in the fee split equation; the art applies the importance of the variables using weighted averages. For instance, how much importance does experience and market knowledge factor into calculating an individual’s contribution to the transaction?
More often than not, fee sharing agreements are blended with management policies, experience and instinct — normally resulting in “fair” distributions. In most instances whereby fee split allocations are not deemed fair by all parties, conflicts will develop. Therefore, the goal of fee sharing arrangements, like any other business ventures, is based on an equitable “win-win” outcome.
For all parties to view the process as completely fair and unbiased, experience and instinct should be supported by applying clearly defined criteria measuring personnel contributions to the entire real estate capital placement process. Control and Placement are the two such components forming the basis of measuring time and resource allocations in this process.
CONTROL AND PLACEMENT – THE FOUNDATION OF FEE SHARING DISCUSSIONS
Fee sharing based on fairness guidelines are rooted in Control and Placement. These two components equally form the balancing point of fee distribution. Control focuses on capturing a real estate capital placement opportunity such as a project sale, mortgage origination or joint venture. Placement forms the counterweight for successfully completing a funding assignment. Said another way, Control represents the capturing the opportunity and Placement converts the opportunity into a successful transaction.
Understanding Control and Placement is relatively simple. However, identifying the various components and subcomponents can become a daunting task. And more often than not, Control and Placement will be interrelated as elements within each of these components mesh together to make the process successful in totality rather than piecemeal.
Control and Placement discussions assume all parties involved in fee sharing discussions are professionally qualified and licensed. For example, an individual with accounting and real estate analysis software training should be responsible for project cash flow analysis. Before any sharing arrangements occur, parties must be properly licensed to conduct business and collect fees in the various States where projects exist. Typical licensing requirements include sales brokerage, appraisal and loan origination. Otherwise, any agreements are not legally enforceable, regardless of professional qualifications and Control/Placement responsibilities.
In addition to the qualifications and licensing requirements, three other factors to consider in formulating Control and Placement responsibilities to additional professionals while insuring that the client’s best interests are served include:
- Outsourcing services to professionals with specialized expertise for document reviews, physical inspections and demographic reports
- Portfolio vs. single-asset assignments
- Project timelines – how quickly does the assignment need to be completed
While few professionals actually break down fee arrangements using such components, more disciplined approaches to these decisions rely upon identifying various subcomponents and applying formulas for calculating contribution/compensation levels apportioned to all parties involved in the transaction. The CAP Fee Sharing Model is one such tool used for identifying and quantifying contributions with the goal of computing fee split allocations to all parties involved in the transaction.
FEE SHARING CALCULATIONS
Realty professionals will certainly have different definitions of how to identify and weight Control and Placement, or other variations of these components. As a result, The Real Estate Capital Institute interviewed a wide spectrum of industry leaders in the debt and equity capital markets including investment sales specialists, consultants, mortgage bankers and other brokers for the purpose of creating a fee distribution model that reasonably and accurately reflects Control and Placement measurements, resulting in the CAP Fee Sharing Model.
The CAP Fee Sharing Model demystifies the process of systematically computing equitable fee splits. As mentioned earlier, this model centers on Control and Placement for quantifying fee sharing arrangements. The goal of this model is to generate interactive fee sharing calculations based on “Win- Win” objectives for all parties. The calculations require applying weighted-averages to important tasks within the process.
The Model divides Control and Placement on a 50/50 basis, further subdividing these components into subcomponents along with assigning weighted averages. Control/Placement is a straightforward computation since both components carry equal weight. Measuring subcomponents is a more challenging task as their respective values are more subjectively analyzed. Regardless, the modeling formulates a basis for further discussion of the value of services provided by the various parties in the capital placement process.
The Control variable is subdivided into three components: Referral/Generating Leads, Handling Client Communications and Procurement of Exclusive Agreement — accounting for half of the total fees. Placement, the other half of the fee split calculation, includes Underwriting, Marketing and Closing subcategories. Each of these major components and their respective subcomponents are further outlined below, including definitions and weighted average values in relationship to the entire fee.
CONTROL
Control is defined as the ability to secure a transaction for capital placement including sale, refinancing, joint venture, etc. The control results collected efforts in negotiating the agreement (mortgage banking application, exclusive sale agreement). Control is not necessarily limited to a single individual or organization and often involves multiple groups of professionals, depending upon the scope of the capital placement assignment.
The key subcategories of Control include: Generating Leads, Handling Client Communication and Procuring an Exclusive. These Control subcomponents are presented in sequence of a typical transaction beginning with identifying the project through obtaining an exclusive.
Referral/Generating Lead (10% of Total Fee): Generating leads and mining for new client relationships is the initial step necessary in initiating a transaction. Cold-calling is the most common method of finding leads. Attending various real estate seminars and conventions, actively participating in professional organizations and other more effective methods of meeting clients also produce effective results. Regular follow-up based on additional meetings, phone calls, e-mailing campaigns provide continuous links of communication. In some cases this process may take days, months or even years. This activity has a value of about 10% of the entire transaction, and is typically known as a “referral fee” if no other action is taken by the broker involved in the process.
Handling Client Communications (10% of Total Fee): Naturally speaking, client communications on an ongoing level take the referral process to the next level. More frequent communications help to establish stronger links with the client, requiring more time and energy, as well as information gathering and analysis work to secure project control. As with the referral process, client communications can be an ongoing situation spanning a long time period. Handling communications is typically interwoven with the referral process and accounts for a total of at least 20% of the fee.
Procuring the Exclusive (5% of Total Fee): Procuring the exclusive is the final step in successfully establishing project control. Securing the exclusive, whether a loan application or a listing agreement, indicates that the referral process and client communications have culminated to a fruitful conclusion. Most professionals will agree that tying up an exclusive clearly indicates that half of the fee has been earned. Without this last step, the parties involved in securing the fee are working under more challenging conditions as other non-exclusive brokers may also be competing for the transaction.
PLACEMENT
Upon securing Control, Placement completes the process of successfully marrying capital with a project. Placement subcomponents include Underwriting, Marketing and last but not least, Closing — all discussed as follows:
Underwriting (20% of Total Fee): As part of securing control and processing the transaction, underwriting bridges the gap between securing and funding the transaction. The key ingredients for underwriting — which accounts for 20% of the fee — include analysis, review of various documents and preparing a complete and detailed offering memorandum for sale, refinancing or other realty capital structure. Each of these components is described as follows:
- Document Reviews: Review of documentation involves reading and understanding key variables in a specific real estate capital transaction including leases, rent rolls, historical performance, physical property information and overall market dynamics such as supply and demand, vacancy, comparable property performance.
- Financial Analysis: Simple ratio tests, discounted cash flow analysis and other capital budgeting techniques are used for translating documents into financial ratios for further discussion.
- Offering Memorandum: The last component of underwriting is tying together all of the salient facts of the transaction including document highlights, location and property dynamics, financial analysis and sponsorship information
Marketing (20% of Total Fee): Marketing is the third component in sequential order, also representing a weighted average of 20% of the total fee. After the project has been secured for Placement and the information has been processed into a detailed offering memorandum, the marketing process begins. The goal of the marketing process is to deliver the optimal capital placement source for the project based upon contacting qualified capital sources, negotiating and filtering offers and conducting tours.
- Contacting Prospects: Contacting prospects is an ongoing process as the marketing team needs to identify the appropriate real estate capital sources including buyers, lenders and joint venture partners. The process is more extensive than simply cold calling as these prospects must be prescreened as to performance and reliability. More often than not, prospect relationships span a number of years and transactions. Furthermore, contacting prospects may also be challenging depending upon market conditions (prosperous economy vs. recession) and property types such as senior living deals and more complex mixed-use developments, for instance.
- Negotiating Offers: The second step of the marketing process, negotiating offers, is equally as critical as finding the qualified prospects. Market knowledge and negotiating expertise always play key roles in determining the direction and scope.
- Tours and Inspections: Finally, property tours in various other inspections can mean the difference between success and failure. Overall knowledge of the property, locational dynamics, immediate area, ingress and egress issues as well as overall market conditions, all lead to successful property tours.
Closing (10% of Total Fee): Without a doubt, the closing must be handled with the same amount of importance as all other elements of the fee placement process. Too many things can go wrong if all parties assume that the transaction is on track by simply passing the closing process to the attorneys, title company and others. However, the transaction team should not provide legal advice unless properly staffed and authorized by the client to do so. Instead, the responsibility lies in following through on any paperwork flow relating to the key business terms of the transaction based on the following:
- Document Review: As to the business points of the transaction, the documents should be reviewed with the client to be sure that the negotiated items are identified. Once again, any legal, tax, title or other technical document review issues should be left with experts such as accounts, lawyers and other third-party vendors.
- Processing Documents: Processing the documents includes communications with attorneys, surveyors, municipal officials and other parties involved in documenting the transaction. However, to the extent that documents need to be collected and assembled for further processing and review, the transaction team’s role will be defined as necessary, depending upon expertise and circumstances.
OBSERVATIONS
A host of other factors need to be considered when discussing fee sharing arrangements among real estate professionals including teamwork, sliding scales and of course, qualifications.
Teamwork: In today’s marketplace, most success real estate capital placements involve integrated teamwork, often in the same office. In addition, highly specialized disciplines such as hotel consultants and healthcare professionals are involved in packaging and marketing special-purpose assets. Even more expertise is required when working with single-purpose financing sources such as FHA/HUD and when equipment leasing is included with the property.
Sliding Scales: Upon completing an initial transaction, various parties may decide to change roles and become more, or less involved. Subsequent transactions involving the same client may have lower fees splits with parties that have already initiated a transaction, but only want to share in the referral process. Other parties would therefore have more responsibilities, and take larger percentages of the fees.
Qualifications: The skill set and experience are tantamount variables for sizing fee splits.
PROS AND CONS
The advantages of using the Chicago Fee Distribution Model are as follows:
- Established baseline formula as a tool for further discussions.
- Systematic weighted-average point system providing benchmarks for measuring variables involved in determining equitable fee sharing arrangements.
- “Fine tuning” of key variables present indices for further discussion and weighted averages may be altered depending upon specific circumstances.
- Weighted average is for each variable helps define importance of various levels of resources, including labor allocation.
- Objective and independent methodology available to supplement existing fee arrangement policies within an organization.
Limitations include:
- Very difficult to address and weight intangibles such as professional experience, corporate loyalty, and other factors not included in the model.
- Variable and weighted-averages are subject to wide variety of interpretations.
- Weighted-average points are applied subjectively.
- Not all variables may be included.
Measurements are only as good as inputs.
EXAMPLES
Traditional 50/50 Arrangement: The classical example of a fee sharing arrangement assumes two parties, the listing agent and the buyer’s representative, share fees on a 50/50 basis. In this example, the listing agent has Control and the buyer’s agent executes the Placement. Fee Placement modeling is hardly needed as the roles are clearly defined.
Intra-office Arrangement: Medium and larger real estate organizations offering full services such as appraisal, consulting, brokerage and management normally have fee sharing policies. Even so, disputes surface various professionals view their roles differently in fee sharing. For instance, an appraiser who has a long-standing relationship with a property owner can get control of an exclusive listing and performs a substantial amount of investment analysis. Under such a scenario the appraiser would most likely not have a broker’s license, as well as play a very limited role in marketing and processing the closing.
These circumstances justify a fee split of as much as 40% of the total fee calculated as follows:
- Control 20% – composed of 10% referral and generating lead plus 10% handling client communications and no credit for procuring exclusive as the 30% should be paid to the broker with the license responsible for securing listing and communicating with potential buyers.
- Placement 20% – full credit for underwriting including document review, financial and packaging. Again, the remaining 30% of the total fees relating to marketing and closing are not included in the appraiser’s list of responsibilities.
Structured Transaction Arrangement: The more difficult and technical the realty capital placement assignment, the more scrutiny is required to determine equitable fee sharing arrangements. In the case of highly structured transactions such as joint ventures, land sale leasebacks, mezzanine loans, preferred equity deals and other hybrid debt/equity vehicles, multiple disciplines merge to complete the transaction.
The most common arrangement may include a combination of fee splits along with payments to outside vendors. These outside vendors — including lawyers, accounting firms and financial consultants – will handle highly technical details relating to the marketing and structuring efforts of such transactions. Fee sharing arrangements will often include flat-fee, hourly billing or other non-commission type payments.
In summary, structured-transaction fee sharing arrangements are difficult to illustrate. Yet more often than not, highly sophisticated property owners work with equally sophisticated capital funding sources, demanding highly-professional, multi-level services.
CONCLUSIONS
The Real Estate Capital Placement Fee Split Model presents a clear and concise that of discussing the sharing of fees and distribution of responsibilities. In and of itself, this process is not a substitute for clear communications between all parties, a rather a guideline of how fees should be shared along with responsibilities.
The most important element within this process is open and honest dialogue. Also, should circumstances change, including allocation of time and resources, all parties need to be flexible on fee sharing modifications.