So you're ready to start a syndicate in 2022? It certainly can be a difficult business that leads to lucrative rewards if you play your cards right. If you plan to be the sponsor, then listen up: one of the most overlooked aspects of planning a real estate syndicate is how the project will be legally and financially structured.
Syndicate structure ultimately determines how everyone in the syndicate will get paid and how you receive compensation for your hard work. It also directs the group's alignment between the motives of each limited partner and the general partner.
Any time a principal-agent relationship emerges in business, it's crucial to make sure all parties have their sails set in the same direction. This way, the syndicate progresses through the investment term harmoniously.
When incentives are aligned and agreed upon by all partners in a legally-structured consensus, the orchestration of the investment, management, roles, and responsibilities of each limited partner and the general partner becomes clear.
So without further ado, let's take a look at the various structures and internal elements of a syndicate structure to consider as you build your real estate investment project.
Legal Considerations for a Real Estate Syndication Structure
The first thing to think about is how you wish to legally expound the syndicate. Syndication is a broad term that defines a group of people, or an association, that is organized to promote a common interest or undertake a certain business transaction as one entity.
In simple terms, it entails a number of individuals who pool their resources together to acquire a real estate asset, or to fund a real estate project.
So naturally, it makes sense to align the interests of all individuals so you can make the syndicate a profitable success.
Which Type of Legal Entity do You Use?
The first decision to make is which legal entity you want to use to structure your real estate syndicate? There are a few options available that cater to various tactical goals. The majority of syndicates emerge as either a Limited Liability Company (LLC) or a Limited Partnership (LP).
Each of these structures comes with advantages and disadvantages so once you are clear on your motives and your partners' motives, it will become more evident which of the two arrangements will work synergistically for your group.
An LLC is inexpensive to establish and combines benefits of a flow-through entity, where the entity's income is treated as income of the individual investors, with a limited liability, where any individuals' liability is limited to a fixed sum. In many cases, this will be the capital investment value.
On the other side of the balance, there are LPs. An LP establishes a general partner (or sponsor) responsible for all aspects pertaining to the investment, including - but not limited to - acquisition, financing, property management, reporting, and project management. The general partner is the one to raise capital for the project.
General partners work with a number of limited partners, predominantly entirely passive investors who produce investor capital into a particular investment to earn a passive income from the project. In a limited partnership, the general partner undertakes the project and the other investors have little control or active engagement in the entity's management.
If partners wish to attain an active role, or if they have a valuable skill set to bring to the table that would benefit the overall operations of the syndicate, a limited partnership may not be the best way to go.
Asset protection is another important consideration as you define your entity's legal structure. In a limited partnership, the general partner may be liable for the entirety of the LPs' debts.
Who Are Your Investors?
Sponsors are accountable to different standards and benchmarks when they choose to syndicate with accredited or non-accredited investors. An accredited investor is someone who meets a certain income or net worth threshold, who can bear the financial risk of a syndicated project on their own. A non-accredited investor does not meet these requirements.
The type of investor you work with will determine the type of registration exemption you can file with the Securities and Exchange Commission, which will further dictate how you manage your syndicate.
Will You Offer a Security?
The two most important Federal Laws for Syndicates are the Securities Act 1933, and the Securities Exchange Act of 1934. The former regulates the offering of securities by an issuer, and the latter is a general regulatory framework for transactions in securities.
Both fall with an umbrella definition of what an "investment transaction" actually is. Keep in mind that it will be beneficial to engage a syndication attorney to help you establish the correct legal framework for your syndicate, but you can use the Howey Test as a screen test to help understand the requirements:
There is a monetary investment
Within a common enterprise
In which there is an expectation of profits
All profits come from the efforts of a third party
Investment syndicates tick all of the boxes in the Howey Test. A general partner and passive investors enter into a real estate deal with the expectation of receiving profits, based on the work the syndicator does.
All members of a joint venture syndicate are entitled to financial compensation, which is determined by the role they play in the group. Generally, passive investors financially benefit more than sponsors because they have greater capital investment in the project.
Sponsors gain some returns through fees because of the efforts, management, and expertise they offer to the project. Though this must be agreed upon by the group at large. The list below is not exhaustive, but it will give you an idea of how fee structures can operate.
Some sponsors charge a fee for the work required in the project's initiation. This sum generally rests between 1-5% of the total capital raised or the purchase price of the asset, depending on the particularities of the investment.
Asset Management Fee
The asset management fee is typically between 1-3% of gross raised capital. This compensates the sponsor for project management, day-to-day oversight of the property, and legal and tax costs. Once again, this will vary depending on the GP's scope of responsibility.
Some sponsors may charge a refinancing fee for creating added value once the asset has been refinanced at a lower rate. The work comes from due diligence and management in refinancing tasks, and the sum is usually about 1-2% of the refinance return.
Upon the sale of the property, the sponsor undertakes significant marketing efforts and is compensated around 2-3% of the sale price in return. Should the sponsor choose to forfeit this task, a broker may be paid the same amount.
Ownership and Compensation
Every deal will have different ownership and compensation delegations, depending on the entity type, risk dispersion, scope of work, and capital investment. This determines the cash flow each investor will receive and the percentage of ownership in the syndicate. All parties involved will negotiate to find a compensation structure that works toward the goals of the individuals and the syndicate.
A clean split is where cash flow and returns are determined by the percentage of ownership in the syndicate. A sponsor can negotiate a larger portion of the split when they have serious skills and experience to offer or when they undertake the majority of the work themselves. In most cases, splits will range from a 50/50 share between LPs and GPs to a 90/10 share between LPS and GPs.
This split applies to cash flow, capital gains, and other forms or returns.
A preferred return is where limited partners are paid a preferred amount on their investment before the general partner touches any of the returns. Once the preferred return reaches a certain barrier, the remaining dividends get allocated with a predetermined pay structure.
For passive investors, a preferred return would usually be somewhere between 6-8%.
A distribution waterfall is a more complex compensation structure for real estate syndications, though may work well in cases where certain partners are more active in the project than others. It prescribes a financial hierarchy between all parties involved. Here's an example of how it may look:
Return of Capital: The ROC dictates that all investors are returned their investment capital in full before the sponsor can yield dividends from returns.
Preferred Return: Similar to the above example, a preferred rate of return is divided between passive investors before the sponsor can receive a return.
GP Catch Up: The sponsor catches up on a large portion of the profits during this stage, once distributions have met the capacity of partners' investment goals. This part is to ensure the sponsor is paid fairly for their contributions.
Carried Interest: The final stage is a percentage distribution of the remaining profits, after all of the requirements in the previous tiers have been met.
Although there are a lot of considerations when you're planning the structure of your syndicate, how sponsors and general partners choose to compose and manage the entity itself, financial compensation, and ownership delegation is determined uniquely by each individual real estate syndication unit.
The best results will emerge by taking into account the type of investors partaking, the skills and experience each member can contribute, the individual aspirations of each party, and the end goal of the syndicate.
In the beginning, nothing is set in stone, so it's up to you and your team to use your creativity and problem solving to find a syndicate structure that works best for you.
To learn more about real estate syndication structures, or to become a passive investor in professionally managed real estate syndications, get in touch with People's Capital Group today.