Is Your Family Office Compensating Your Internal Real Estate Professional Correctly?

Real Estate Compensation Packages

Pay for Performance Compensation Packages Help Family Offices Attract and Retain Top Real Estate Professionals

By Jarret Sues & Mark Rubin – FTI Consulting

Publisher’s Insight: As more families look to hire outside professionals to help with the development and management of their real estate portfolios, hiring will increase. As family offices are typically UNDER market for compensation or not in line with industry compensation structures, it remains to be seen when or if these factors will align in the future.

Pay for Performance? philosophy is an integral tool to attract and retain top real estate talent. The philosophy is often alluded to in general industry but the shoulder-to-shoulder alignment that can be created in real estate is unique.

The stated goal of most compensation programs is often three-pronged: incent, motivate and retain. The long-term nature of most real estate investments assists with aligning retention goals. Incent and motivate are covered by the ability to tie compensation directly to the profitability of a single asset or portfolio of assets.

To make a compensation plan work, experienced leadership is essential to developing and implementing an investment philosophy and strategy specifically for real estate. Whether led by a family member or other governance structure, a comprehensive compensation program that aligns all stakeholder interests is critical. Here are some key considerations and best practices for successful compensation plans.

PROPERTY MANAGEMENT VS ASSET MANAGEMENT

Pay for Performance compensation policies in a family office are typically most appropriate for “asset management” as opposed to “property level management.” Succinctly put, property level management of real estate includes ongoing maintenance, response to tenant requests, and other daily interactions at the property. While certainly important, property level management activities can be outsourced. Unless a family office has evolved out of an existing real estate business with its own highly functioning property level management company, it would be wise to outsource that function.

In contrast, asset managers focus on identifying potential properties for investment, deal structuring and financing, financial return and reporting, as well as investor relations. Whether or not the property level management function has been outsourced, it is also important for asset managers to have a direct, ongoing relationship with property managers.

PAY FOR PERFORMANCE

The concept of using long-term incentives to motivate professionals is a case of public company practices informing private enterprise. Most public REITs and real estate investment companies have developed long-term compensation programs that measure performance metrics over time, often over a three-year period. These compensation plans often reward senior executives for meeting clearly identified benchmarks, such as achieving stock price and dividend returns to shareholders. These plans can be potentially structured to take advantage of taxation at capital gain rates, but are more often than not taxed as ordinary income.

As is frequently the case, these sophisticated compensation plans of public companies, which are fully disclosed in public filings, have influenced private company (including family office) compensation planning. Following public company precedent, rewarding key executives for value enhancement is the cornerstone of a successful compensation philosophy. Often referred to as “Pay-for-Performance,” this approach clearly incents behavior, motivating the “team” and aligning interests of the family office, which is providing the capital for those directing the investments. And while in different forms than their public company counterparts, family offices arguably have the advantage of capital gains taxation and, perhaps the biggest benefit of being a private real estate entity, exclusive ties to successful real estate transactions not subject to the whims of public markets.

While “Pay-for-Performance” can be the cornerstone of a well-crafted compensation structure, it is not the only element to consider. Compensating professionals for their time and efforts in a more systematic way, through base salary and annual achievement bonus, is equally as important to ensure the real estate professionals are actively engaged. Despite best efforts, successful real estate deals and transactions are not guaranteed and if compensation is solely tied to successful outcomes, most professionals will seek to limit risk.

Although not the norm, family offices do on occasion allow their senior executives to “co-invest,” either with their own funds or funds lent by the family office. The “skin-in-the-game” mentality breeds a sense of ownership and further aligns the interests of all parties.

Family offices also need to make decisions regarding which real estate projects are included in the plan. Generally, a broad view which includes all projects is used to avoid the human tendency to focus only on successful projects yielding positive compensation results.

Another compensation consideration is vesting. As in public company plans, family offices can still require several years of vesting even after value has been created. The long-term nature of successful real estate transactions and value creation is a natural fit with good vesting provisions and retention objectives.

VALUE ENHANCEMENT

Value enhancement can be achieved in a variety of ways depending on the overall real estate investment strategy. Merely deploying capital without regard to strategic financial assessment could be counterproductive to the family?s goals. Investment type, capitalization rate and exit strategies are just several of the factors that should be discussed before committing capital and establishing a compensation plan.

Categories of real estate can also be rewarded differently. For example, it would make sense to allocate disproportionate amounts of value enhancement to “Value-Added” and “Opportunistic” investments as opposed to steady income-producing “Core” and “Core Plus” investments which tend to reflect different strategic plans.

TAX CONSIDERATIONS

There are both income and estate tax considerations at play when developing an executive compensation plan. Public companies structured as Umbrella Partnership REITs or “UPREITs” have the ability to compensate executives and employees with operating partnership units “OP Units,” which, if earned, pay out as income subject to favorable capital gain rates. OP Units were slightly affected by 2017 Tax Reform, which requires carried interest vehicles to be held for three years before qualifying for favorable treatment. Family offices have more latitude than the public markets to take advantage of capital gains tax rates, especially given that real estate investments typically take more than three years to mature.

Strategic advanced estate planning is also possible, particularly when the executive contributes capital. This is another example of a clear sense of alignment of interests, and often takes the form of a “vertical slice,” whereby a proportionate amount of each interest held in a real estate project is transferred, potentially by both the family and the executive, to their respective younger family members (typically through a trust) as a way to meet certain statutory safe harbors.

Interestingly, even though meaningful tax savings can be achieved, many family leaders are reluctant to structure their compensation to do so. Some families prefer straightforward W-2 based compensation or eschew plans they perceive as tax aggressiveness. Others do not like the idea of being ?partners?with their employees, whether that partnership is real or notional in nature.

BENCHMARKING

Public company disclosure of compensation practices continues to become more detailed and robust, and private company data through subscriptions quantifying executive compensation has become more accessible. In addition to surveys conducted and subsequently published by Northern Trust and Family Office Exchange (FOX), private company databases have expanded their reporting by geographies and executive level. Used as guidelines, these resources can help to normalize negotiations that might otherwise become acrimonious. Family offices with boards of advisors, as well as those with family-dominated boards of directors, often cite these resources in gaining approval for paying talented non-family executives amounts which might otherwise be viewed as excessive.

CULTURE

Often, talented real estate executives choose to work for family offices after they have succeeded in other industry roles. As an outsider, there can be a tendency to view family offices as appealing alternatives to institutions because of their implied relational culture and flexible work environment. When negotiating employment and related compensation, test these assumptions. While those ideas may be reality, they can also

simply be first impressions, and compensation arrangements can be negotiated in greater or lesser amounts based on the type of work environment. Culture can also affect the investment direction. Core and Core Plus real estate investments are certainly more comfortable than when the level of risk rises in Value-Added and Opportunistic categories. Understanding up front the level of risk that a family office has experienced and is comfortable with will also influence compensation levels.

Cultivating collaborative and consistent efforts and behavior can go a long way toward the sustainability of a successful real estate platform. Motivating talented individuals with compensation structures that resonate with real estate savvy professionals is paramount in the competitive employment landscape.

SUMMARY

Understanding your strategy and vision as it relates to real estate will allow for the creation of a compensation structure that is uniquely tailored to the needs of each family office.

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