How Real Estate Syndicates are Structured

Contracts are a crucial component of maintaining order among all parties involved in a real estate syndicate. Each investor has their interests and priorities. Rules about decision-making, contributions and exit strategies need to be clear.

Money partners are not managing the property, so they need regular financial reporting to keep them informed of the status of their investments. The money partners may wish to retain the right to use an auditor when necessary.

When it comes time to sell a property, the general partner makes the decision, but the money partners have the right to agree on an exit strategy. They might decide to sell once the property reaches a 30 percent increase in market value, or after a certain amount of time. The contact may also detail how an individual can leave the syndicate when desired, and how the buyout from the other partners would work.

Money partners have a direct ownership interest in the purchased property. This gives them a proportional share of income, capital gains, depreciation and losses. Money partners are only responsible for the amount of their capital contribution, so long as they do not take part in managing the property.

Return on investment varies depending on the syndicate type. Income-generating properties are less risky, so the return is secure but relatively smaller. An apartment building in an urban area might see 6 to 18 percent returns. If the syndicate is investing in land, there is a greater risk, but also the potential for greater returns.

Regulations on Real Estate Syndicates

There are currently no federal laws governing real estate syndicates. Each state has eligibility requirements for syndicate investors, so you’ll want to check that you qualify before getting started. Typically, the requirements are centred around ensuring that the general partner is a legitimate third party.

Typically, money partners might need an exemption such as an accredited investor clause. This requires investors to have a salary of at least $200,000 ($300,000 combined with a spouse) and a net worth of at least $1 million. The goal is to ensure these investors have enough resources to weather a big loss.

Because you’ll be profiting from the syndication, you’ll have to pay taxes on your income. Income and net taxable gains are allocated proportionally the same to the money partners as the general partner.

Distributions can come in any of the following forms of income:

  • Distributions representing part of the capital gains allocated to investors as a result of a gain on a property sale
  • Distributions considered a dividend from a Canadian or U.S. subsidiary corporation
  • Distributions that are defined as taxable under current law
  • Distributions that are not currently taxable and will be treated as capital returns on the tax return

SEC Regulations On Your Radar – 506(b) vs. 506(c)

Although no regulations explicitly exist that relate directly to syndications themselves, syndications, and the raising and selling of real estate assets as investment vehicles typically fall under the heading of ‘exempt’ securities offerings.

These exempt securities are also called ‘Reg Ds’, since they fall under SEC Regulation D. Reg D offerings are advantageous to private companies or entrepreneurs that meet the requirements because funding can be obtained faster and at a lower cost than with a public offering. It is usually used by smaller companies. The regulation allows capital to be raised through the sale of equity or debt securities without the need to register those securities with the SEC. However, many other state and federal regulatory requirements still apply. Generally speaking, for the purposes of syndications, the most prevalently used Reg D sections are 506(b) and 506(c). These are highly related but importantly different regulations under which you must file your ‘Form D’ declarations to the SEC.

506(b)’s defining feature: A GP can raise an unlimited amount of money as long as they do not publicly advertise or solicit investments for the fund.

Rule 506(b) permits GPs to raise money from an unlimited number of accredited investors and as many as 35 non-accredited investors. Non-accredited investors in the offering must be sophisticated investors, and they must be given additional disclosure documents similar to those typically provided in Regulation A offerings. Issuers cannot publicly market a 506(b) offering; this means that GPs raising a VC or syndication fund under the 506(b) exemption can’t advertise the fund or generally solicit investors.

506(b) benefits 

  • Rule 506(b) offerings are not regulated by state blue-sky laws.
  • Purchasers can self-verify their accreditation status; GPs aren’t responsible for verifying accreditation. 
  • If a GP only takes on accredited investors, they can avoid filing burdensome disclosure documents with the SEC that would need to be provided to non-accredited investors.

506(b) limitations 

  • GPs are prohibited from talking about the fund publicly while fundraising, and from running a crowdfunding campaign to bring in capital. 
  •  GPs can’t take on non-accredited investors without offering the same disclosure documents typically required under Regulation A of U.S. securities laws.

For an established firm, raising capital under 506(b) is often a no-brainer. It allows them to draw on their network of LPs and avoid going through the time and expense of actively verifying each LP’s accreditation status.

506(c)’s defining feature: A GP can perform general solicitation and advertising without any limitation on how much capital they can raise. 

Accredited investors are eligible to invest in 506(c) offerings, but unlike with the 506(b) exemption, the fund’s GP must take “reasonable steps to verify” that the purchasers are accredited or hire a third party to perform the verification. This is the main ‘obstacle’ to implementing the 506(c) raise.

What exactly does “reasonable steps to verify” mean? That depends on how the LP claims eligibility. 

  • If an LP is claiming accreditation based on income, the GP may need to obtain the LP’s tax forms for the previous two years. GPs also would have to obtain confirmation that the LP’s income will continue to meet the minimum threshold for accredited investors (which is $200,000 annually for an individual and $300,000 for a married couple) in the current year. 
  • If the LP claims accreditation based on net worth, GPs can review the LP’s assets by collecting proof of the purchaser’s assets and liabilities (for example, bank statements and brokerage reports) within the past three months. GPs must also obtain confirmation from the LP that all liabilities that could impact net worth have been disclosed. To be an accredited investor, an individual must have a net worth of more than $1 million, excluding their primary residence.
  • If the LP claims accreditation based on one of the SEC’s recognized professional certifications, the GP would need to obtain a copy of that certification.

506(c) benefits: 

  • Rule 506(c) offerings are not subject to state blue-sky laws. 
  • GPs can publicly market their capital-raising offer to a larger investor base, beyond just one-on-one conversations and emails within their personal and professional networks.

506(c) limitations: 

  • Verifying accredited investors takes up time and money. 
  • Many investors are reluctant to give sensitive information to GPs they don’t have a personal relationship with.
  • Given the potential liability third parties take on when they certify investor accreditation, accountants and lawyers are unlikely to make these certifications except perhaps for very large, lucrative clients.

Under the current rules, GPs that file a fundraise as a 506(b) offering are allowed to change the offering’s exemption status to 506(c) if they want to advertise their fund. But GPs who originally filed under 506(c) can’t reverse course and retroactively become a 506(b) if they’ve already advertise

Generally speaking, if you are a ‘newer’ GP or starting out with syndication generally, or you are looking to expand your network of qualified LPs, you should seriously consider 506(c) as an alternative to the more widely used 506(b).


The Legal Documents that Matter and Why

  1. The Private Placement Memorandum (PPM);

An offering memorandum, also known as a private placement memorandum (PPM), is used by business owners of privately held companies to attract a specific group of outside investors. For these select investors, an offering memorandum is a way for them to understand the investment vehicle. 

An offering memorandum, while used in investment finance, is essentially a thorough business plan. In practice, these documents are a formality used to meet the requirements of securities regulators since most sophisticated investors perform their extensive due diligence. Offering memorandums are similar to prospectuses but are for private placements, while prospectuses are for publicly traded issues. 

In many cases, private equity companies want to increase their level of growth without taking on debt or going public. If, for example, a manufacturing company decides to expand the number of plants it owns, it can look to an offering memorandum as a way to finance the expansion. When this happens, the business first decides how much it wants to raise and at what price per share. In this example, the company needs $1 million to fund its growth at $30 per share. 

  1. The Operating Agreement for LLCs (OA);

Although writing an operating agreement is not a mandatory requirement for most states, it is nonetheless considered a crucial document that should be included when setting up a limited liability company. In states such as California, Missouri, and New York, it is mandatory to include this document during the incorporation process. While most other states do not insist on including it, it is always considered wise to draft an operating agreement, as it protects the status of a company, comes in handy in times of misunderstandings, and helps in carrying out the business according to the rules set by the members. The document, once signed by each member (owner), acts as a binding set of rules for them to adhere to.

The agreement is drafted to allow owners to govern the internal operations according to their own rules and specifications. The absence of an operating agreement means that your business has to be run according to the default rules of your state. 

  1. The Subscription Agreement for Limited Partnerships (SA);

A subscription agreement is an investor’s application to join a limited partnership (LP). It is also a two-way guarantee between a company and a new shareholder (subscriber). The company agrees to sell a certain number of shares at a specific price and, in return, the subscriber promises to buy the shares at the predetermined price.  

In an LP, a general partner manages the partnership entity and brings in limited partners using a subscription agreement. Candidates subscribe to become limited partners. After meeting standard requirements, the general partner decides whether to accept the candidate.

Limited partners act as silent partners by providing capital, usually a one-time investment, and have no material participation in the business’s operations. As a result, partners typically have little to no voice in the day-to-day operations of the partnership and are exposed to less risk than full partners. Each limited partner’s exposure to business losses is limited to that partner’s original investment. The subscription agreement for joining the LP describes the investment experience, sophistication, and net worth of the potential limited partner.

In many cases, a subscription agreement accompanies the memorandum. Some agreements outline a specific rate of return that will be paid to the investor, such as a particular percentage of company net income or lump sum payments.

Also, the agreement will define the payment dates for these returns. This structure gives priority to the investor, as they earn a rate of return on the investment before company founders or other minority owners.

Conclusions

Real estate syndications are a way to pool both capital and knowledge to create a winning situation for investors. They can be complex legal entities, so it’s important to read the fine print and trust your colleagues – especially the general partner – when deciding which syndication to join.

Regulations to look at when raising cash and being a General Partner: https://www.sec.gov/education/smallbusiness/exemptofferings/exemptofferingschart 
Key regulatory differences between 506(b) and 506(c): https://www.dunncarney.com/wp-content/uploads/2020/03/506b-vs-506c-Comparison-Chart-FINAL.docx