What is Carried Interest?

Carried interest, commonly known as the “carry,” refers to the profit share that the managers or general partners of a real estate investment receive, beyond any capital they might have invested. Essentially, the carried interest is a performance fee, rewarding managers for the risks taken and, hopefully, for successful management of the project.

Why Does Carried Interest Exist?

Think of carried interest as an incentive. In a commercial real estate project, there are typically two main parties:

1. Members/Limited Partners (LPs): These are the primary investors who contribute most of the project’s capital. They want to see their investment grow, but might not have the expertise or time to manage the property or development themselves.

2. Managers/General Partners (GPs): These are the project managers, developers, or real estate professionals who oversee the day-to-day operations, leverage their expertise and networks, provide critical guaranties and make major decisions about the project. GPs might invest some of their own money, but they often contribute significantly less cash capital than the LPs/members.

For GPs to be motivated to ensure the project is successful, they are given an incentive in the form of carried interest. If the project prospers, they earn a percentage of the profits, above and beyond any capital they’ve invested.

How Does It Work?

Carried interest is rarely paid out right away. First, the project needs to achieve specific financial benchmarks:

1. Return of Capital: Before any profits are divided, the initial capital invested by all parties (both LPs and GPs) is typically returned.

2. Preferred Return: This is a predetermined annual return on investment for the LPs (and GP affiliates investing as LPs). Think of this predetermined annual return, or “pref”, as a hurdle rate. Before the GPs can claim their carried interest, the partners usually get some or all of this preferred return.

3. Profit Split: Only after the above benchmarks are met does the carried interest typically come into play. The remaining profits are then split between the LPs and GPs according to a pre-agreed ratio. A common split might be 80% for the LPs and 20% for the GPs, but this can vary depending on the particular deal.

An Example:

Imagine a commercial real estate project with $1 million invested by LPs and $100,000 invested by the GP. The preferred return is set at 8% annually.

At the end of the year, the project realizes a profit of $200,000.

1. Return the capital: $1.1 million is returned to the LPs and GP based on their contributions.

2. Pay the preferred return: 8% of $1 million (LP’s contribution) is $80,000.

3. Split the remaining profit: $200,000 (profit) - $80,000 (preferred return) = $120,000. If the profit split is 80/20, LPs get $96,000, and the GP gets $24,000.

So, despite only investing $100,000 cash and not participating in the LP’s pref, the GP receives a total of $124,000 (their original investment plus $24,000) due to the carried interest.

Takeaway:

Carried interest is a tool to better align the interests of investors and managers in commercial real estate projects. By offering a slice of the profits, the carried interest encourages managers to work diligently and maximize returns for all parties involved.

When considering entering into a commercial real estate partnership, the role of carried interest, and how it might affect your returns, should be carefully considered.

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