WHAT IS REAL ESTATE SYNDICATION?
Introduction
A real estate syndication is the pooling of money from multiple investors for the purpose of investing together in a specific real estate investment, for instance, an apartment building or a retail shopping center. Real estate syndication is the most effective way for passive investors to pool their capital and invest in opportunities that are much bigger than the opportunities those same investors would be able to afford or to manage individually. Think of a real estate syndication like a group of friends and family putting together their capital to make an investment—however, real estate syndications are organized by “Sponsors,” who are experienced real estate professionals and investors, and the passive investors in a real estate syndication are generally unrelated to one another or have any knowledge of who the other investors are.
The person who organizes a real estate syndication can is generally called the syndicator, sponsor, promoter or GP (if using a limited partnership). I will use these terms interchangeably but will most often use the term sponsor. The entity structures of a real estate syndications are typically in the form of a limited liability company (LLC) or a limited partnership (LP), both generally domiciled in the State of Delaware. The syndication will have a manager (if an LLC is used) or a general partner (if a LP is used). In the most-effective and legally-sound real estate syndication corporate structure, the sponsor is a different entity from the manager or general partner; however, the manager or general partner may be wholly owned by the sponsor.
The sponsor is typically comprised of multiple owners and includes the team members who, through the manager or general partner, will collectively manage the real estate syndication.
WHAT IS A REAL ESTATE FUND AND HOW DOES A REAL ESTATE FUND DIFFER FROM A REAL ESTATE SYNDICATION?
I will use the terms real estate syndicate or real estate syndication and real estate fund interchangeably in most cases, and the use of such terms will refer collectively to real estate syndications and real estate funds. I may also use the term issuer to refer to the specific LLC or LP that is issuing the private placement securities in connection with the real estate fund. However, there is a significant difference between a real estate syndication and a real estate fund. A real estate syndication is an investment vehicle formed for the purpose of pooling capital from passive investors with the goal of purchasing, rehabbing, owning, operating and/or selling one or more already identified properties.
However, in a typical, blind pool real estate fund, the money from passive investors is raised before any properties are identified. Accordingly, a real estate fund is an investment vehicle formed for the purpose of pooling capital from passive investors in order to invest in one or more real estate properties that are not currently identified by the Sponsor or Fund Manager beyond the type of real estate asset and the criteria to be used to select the specific real estate assets that will be acquired later on. The Sponsor invests the pooled capital based on the real estate fund’s investment objectives, which can be extremely broad and diverse or narrow and specific. The investment criteria to be used in selecting a specific real estate asset is often called the real estate fund’s investment strategy. In essence, real estate funds are a “trust me” investment vehicle that requires investors to invest their capital based on the trust investors have in the Sponsor’s vision, reputation, credentials, strategy and track record. A blind pool, discretionary fund can be a harder vehicle to raise capital for because it is a trust vehicle, as opposed to a traditional real estate syndication where the investors can evaluate the specific property or properties at the same time that they evaluate the sponsor: before investing any of their equity or capital. An additional item to note is that a blind pool real estate fund is sometimes called a blind pool, discretionary real estate fund. The “discretionary” component is that the Sponsor has the discretion, subject to the investment thesis to pick the investments the Sponsor wants to invest in without approval by the passive investors.
WHO ARE THE PARTIES INVOLVED IN A REAL ESTATE SYNDICATION OR A REAL ESTATE FUND?
In the simplest sense, real estate syndicates involve two main parties: the sponsor and the investors. Based on the form of the syndicate and sponsor, though, additional parties come into play, including the manager/general partner, the syndicate or issuer, and in some cases, a special purpose entity or a special purpose vehicle.
The Syndication Sponsor
The syndication sponsor is the main real estate investment company that, in most instances, was founded previously by one or more persons for the purpose of investing in real estate assets. The sponsor has likely been doing business for a while either through the use of the founders’ own money in addition to one investor per real estate asset or through debt in the form of traditional commercial, private money loans or hard money loans. The sponsor will be the entity where the employees of the sponsor also reside. Inevitably, most sponsors reach a point where the sponsor wants to grow and scale its real estate investing business, and to accomplish that, the sponsor turns to syndicating deals. The sponsor could be structured as a limited partnership, a limited liability company or a corporation. Note that in some cases, a sponsor can be an entity with only one member and does not have to be a group of people.
Manager/General Partner in a Real Estate Syndicate
The manager or general partner is an entity generally wholly owned by the sponsor, which serves as the manager if the fund is an LLC or the general partner if the fund is a LP. The manager or general partner typically has broad powers when it comes to managing the syndication or fund. Those powers are described in both the private placement memorandum (PPM) of the fund as well as the operating agreement if the fund is an LLC or the limited partnership agreement if the fund is a LP. The manager or general partner is most often structured as a limited liability company for flexibility and ease of operations.
Issuer in a Real Estate Syndication and Fund
The issuer (the fund) is the investment vehicle itself that investors are a part of. The investors will invest capital in exchange for an ownership interest in the fund (if the fund is structured such that it is selling equity ownership interests) or the investors will invest their capital in exchange for a promissory note (if the fund is structured such that it is selling promissory notes instead of selling equity ownership interests). The issuer is generally structured as an LLC or a LP.
Passive Investors in Real Estate Syndications and Funds
Investors are those persons or entities that invest capital into a fund so that the fund can use that capital to purchase real estate assets as described in the issuer’s private placement memorandum. If the investor holds an equity ownership interest in a limited liability company, the investor is called a member. If the investor holds an equity ownership interest in a limited partnership, the investor is called a limited partner. With the exceptions of those syndications conducted under Regulation A+, Regulation Crowdfunding or certain Regulation D, Rule 506(b) offerings, investors are required by the SEC to be accredited investors. Note that under Regulation D, Rule 506(b), the fund may accept up to 35 non-accredited investors but the fund will have to meet other criteria in order to do this.
Special Purpose Entity or Special Purpose Vehicle
Some real estate syndications may elect to hold the underlying real estate asset in a separate, special purpose entity or special purpose vehicle that is wholly owned by the fund entity. This is most often the case for larger real estate assets. A special purpose entity adds an additional layer and complexity to the structure, but the purpose of doing so is to help provide additional liability protection to all the parties involved; in the event of an issue with one real estate asset, the other real estate assets shielded in unrelated and separate entities. If the issuer is borrowing money for the acquisition or rehabilitation of the real estate assets, most lenders will often require that the property be segregated and held in a special purpose entity anyways.
COMMON STRUCTURES OF REAL ESTATE SYNDICATIONS
There are two structures that are common in many real estate syndications and funds. The one class structure and the two-class structure.
Syndication One Class Structure
In the one class structure, there is only one class of equity in the fund. Investors purchase equity in the fund and the manager or sponsor may or may not purchase equity interests in the fund. In the one class structure, the manager or sponsor does not hold its equity interest, if any, in a separate ownership class within the fund.
Syndication Two Class Structure
The second structure is the most recommended structure and in a standard two class fund structure, the manager, sponsor or a separate holding company wholly owned by the sponsor owns an ownership interest in a separate equity class from the passive investors. The use of a two-class structure is also used in instances where the manager, sponsor or a separate holding company wholly owned by the sponsor is not making a capital contribution to the fund itself. For example, the manager, sponsor or a separate holding company wholly owned by the sponsor owns Class B Units and the investors purchase Class A Units as part of the offering (or vice versa). Common reasons for using the two class fund structure are that (1) the ownership of Class B Units by the manager, sponsor or a holding company owned by the sponsor preserve distributions (also called the carried interest or the promote) for the sponsor if the Manager is removed; and (2) segregating fees from distributions so that earnings on distributions through the ownership of Class B Units may be taxable at capital gains rates, versus the manager’s fees, which will be taxed as ordinary income.
WHAT ARE THE THREE TYPES OF SYNDICATION AND FUND OFFERINGS?
There are three general types of syndications or funds – specified, semi-specified and blind pool. Each has its own characteristics which are explained below. Determining which is right for the sponsor or fund manager is a discussion for the sponsor or fund manager to have with its team, including the sponsor’s real estate securities counsel. Before making a decision, the sponsor should evaluate the pros and cons of each private placement offering type in light of the sponsor’s experience level, track record and property type.
Specified Offering Real Estate Syndication
A specified offering is one in which the real estate investment that will be owned by the syndication is identified before any capital is raised from passive investors. A specified syndication offering usually involves one property but could also involve multiple properties. A specified syndication offering is for a syndication that has one or more commercial properties under contract but needs to raise money from investors to complete the acquisition and do execute the business plan such as renovations. Typically, in a specified syndication offering, the syndication will use its own money in the beginning for items such as the earnest money deposit, conducting due diligence, legal fees and similar expenses. The sponsor will not use investor funds until the closing, so this way the sponsor can ensure that it can return the investors capital if the closing does not occur for the acquisition of the property or properties. Once the property or properties are acquired, it is standard for the investors’ funds to then be used to reimburse the sponsor for all of those out-of-pocket costs and expenses incurred by the sponsor in connection with the acquisition of the property and for putting together the syndication, including legal and accounting fees. In a specified syndication offering, the sponsor will prepare a specific property information packet that will accompany the legal documents, which is colloquially called a pitch deck.
Semi-Specified Offering Real Estate Syndication
In a semi-specified syndication offering, the sponsor has identified some, but not all, of the commercial properties that will be included in the syndication’s offering. A semi-specified offering requires the sponsor to have at least one property that is under contract as well as an investment strategy that describes the criteria for additional properties (which are typically similar to the one under contract) that the sponsor plans to acquire as part of the same syndication offering. A semi-specified syndication offering allows the sponsor to raise capital to close on the property under contract and continue raising capital to investigate additional properties for acquisition in the future.
In a semi-specified syndication offering, the sponsor will prepare a specific property information packet, colloquially referred to as a pitch deck, with respect to the property that is under contract as well as an investment strategy detailing the type(s) of real estate assets the fund will additionally be investing in. For example, if the business plan discusses investing in multifamily apartment complexes, the syndication will typically not have the right (via the legal documentation, including the PPM and operating agreement) to acquire commercial office buildings or retail strip malls. This ensures the investor knows exactly what types of properties may or may not be acquired by the syndication.
Investors do not have as much control, compared to a specified offering, when investing in semi-specified offerings, but there are benefits. Sponsors can act quickly to acquire additional properties that meet the syndication’s criteria. As opposed to raising money for each individual property, which can be time consuming, the sponsor, with funds in hand, can shorten the contract period and be more competitive in the marketplace when investigating new acquisition targets.
• Most sponsors who conduct semi-specified offerings have a history of investing in real estate (usually the same type of real estate the issuer will be acquiring), and therefore, investors should have increased comfort that the sponsor will make decisions on the investor’s behalf, while staying within the guidelines of the issuer’s strategy.
• Because a semi-specified offering involves more than one property, the investor’s capital is also diversified and the risk is spread out. Although the assets may all be within the same real estate asset class, multiple properties lead to a more diverse use of the funds within that real estate asset class than only investing in one property.
• At least one property will have been identified so investors will be able to analyze the identified property before making a decision to invest in that property, which can help derisk the investor’s money to an extent.
Blind Pool Discretionary Real Estate Funds
Blind pool investments are called real estate funds or blank check funds. Investors in blind pool real estate funds invest their capital into the fund without knowing what specific properties will be acquired by that fund. Blind pool real estate funds can be very large both in terms of the amount of money raised and the number of investors involved. A blind pool real estate fund typically provides the sponsor with broad discretion to make investments, subject to the investment strategy spelled out in the offering documents, such as the private placement memorandum, the fund’s operating agreement and the pitch deck.
A blind pool real estate fund allows a sponsor to raise capital from investors solely on the sponsor’s investment strategy, which should describe the type of properties the sponsor intends to acquire, the geographic area of the properties to be acquired, the exit strategy associated with the properties and other important characteristics associated with the real estate the sponsor will be acquiring. That being said, often times blind pool real estate funds do provide Sponsor’s the broad discretion to deviate from the investment strategy in certain situations. A blind pool real estate fund works best for capital raisers and fund sponsors who have a history and successful track record of investing in the real estate asset class that is described in the investment strategy.
In a real estate blind pool fund, since the fund is raising capital before identifying the specific real estate assets or investments the fund will acquire, the sponsor can use the investor capital that was raised for deposits, due diligence costs and legal fees before closing on the purchase of any property.
Blind pool real estate funds are more also more flexible as they can concentrate on real estate investments that have high yields and can pivot quickly if the market changes. But a blind pool real estate fund is only as good as the sponsor’s ability to source lucrative deals.
Accordingly, in a blind pool real estate fund, deal flow is key. Once the sponsor raises the capital from investors, the sponsor needs to put that money to work as quickly and efficiently as possible in order to generate returns.
An Important Note on Real Estate Funds:
Most investors view a specified real estate syndication offering as less risky than a blind pool real estate fund. Some of the key considerations that investors will evaluate to understand a blind pool real estate fund prior to investing in one include:
1. What is the track record of the sponsor with this type of asset class?
2. Does the sponsor have a track record with prior offerings?
3. What is the investment philosophy or investment strategy of the sponsor?
4. How is the sponsor, manager or general partner compensated and what are the fees?
5. What is the investment term of the blind pool fund?
6. What is the investment period of the blind pool fund?
7. Will funds be reinvested if a property is disposed of during the term of the fund?
8. Are there limits on the deal size of the prospective investments?
9. Are there limits on the amount of leverage the blind pool real estate fund can incur with respect to a real estate asset?
WHICH IS BETTER, AN OPEN ENDED OR CLOSED ENDED REAL ESTATE FUND?
Since capital investments in real estate funds are illiquid, real estate funds have many unique structural issues that must be addressed. An initial consideration is whether to use an open-end or closed-end structure. Both structures will be considered below.
What does an open-ended real estate fund mean?
An open-ended structure often has an infinite lifetime (this may also be referred to as evergreen real estate fund) and is designed to offer investors the possibility to buy and redeem their ownership interest in the fund, enabling them to enter and exit (subject to compliance with securities laws) the fund over a period of time.
The manager manages the redemptions, and the real estate fund grows and shrinks depending on new subscriptions and redemptions by investors. But the ability to enter and exit the fund can be hindered by market circumstances, securities laws and other limitations.
Redemption levels can be capped or frozen to allow the manager to manage redemptions and balance the interests of continuing and exiting investors. Managers can also choose not to accept new subscriptions, for example, if the real estate fund has surplus cash to invest.
An open-ended fund structure does not work for a specified offering or real estate syndication where the sponsor is raising capital for one or more specified real estate assets to be held for a predetermined period of time. An open-ended fund structure, however, works for a real estate fund where the real estate fund buys and sells real estate intermittently (rather than just buying and holding for the long term or a prolonged period of time). Accordingly, there will be periods of time when the capital of the fund is not fully deployed into real estate assets and thus unavailable to fulfill redemption requests.
A fund redemption plan is an important consideration and tool as the sponsor raises capital, but it is extremely important to consider the structure of any redemption plan. In addition, any fund redemption plan should be flexible, providing the fund manager with broad discretion based on the circumstances at the time of a redemption request and the cash reserve needs for the real estate fund.
What does a closed-ended real estate fund mean and why is it the preferred choice?
A closed-ended structure has no ownership interest redemption mechanism. The investor comes in and cannot redeem its ownership interest during the life of the real estate fund. A closed-ended fund structure has a finite lifetime, typically around seven to ten years. The closed-ended fund usually has a defined investment period of two to five years during which the capital is invested in real estate assets. Closed-ended real estate funds may also define a fixed re-capitalization period: if an asset is sold during the period, it will be reinvested, but if an asset is sold after the period ends, the capital will be returned to the investors.
A closed-ended fund is better suited to a true real estate syndicate where the fund is raising capital for one or more specified real estate assets to be held for a predetermined period of time. In such a real estate fund, virtually all of the capital is committed, whether it be for acquisition of property, property rehabilitation, ongoing property expenses or reserves; thus, there is no capital available to fulfill a redemption request.
A Note on the Benefits of Real Estate Syndication and Funds
Investing in real estate syndication has numerous benefits, including cash flow, tax savings and a hedge against inflation. But investing in real estate syndications, specifically, provides additional benefits, which include the following:
1. Sponsor expertise: Investors can benefit from a sponsor’s expertise to source and find lucrative deals and execute complex business plans.
2. Diversification: Unless you are investing in a real estate syndicate with only one asset, investors can achieve diversification through investing in a real estate fund with multiple assets spread across different geographic regions and markets.
3. Access to large investment opportunities: For many individual investors, investing in a real estate fund allows them to own a piece of something much larger than what they could afford on their own or would have access to participate in.
4. Passive investor: Real estate investors in real estate funds are passive investors. The sponsor, manager and its management team are actively involved in the day-to-day operations and management of the fund, while the investor takes a passive, uninvolved role.
5. Attractive returns: Properly managed real estate funds can offer attractive double digit returns to investors, which would be difficult for individual investors to obtain on their own.
6. Capital appreciation: Investors generally experience capital appreciation through the indirect ownership of real estate assets.
WHEN IS A GOOD TIME TO SYNDICATE REAL ESTATE AND WHY SHOULD I SYNDICATE REAL ESTATE?
Real estate entrepreneurs come from many different walks of life. Some worked for a real estate investment company, as a banker, lawyer, real estate broker or in another professional capacity related to real estate. And some are making the leap from a completely unrelated profession.
Most real estate entrepreneurs start out small, fixing and flipping single family residential properties, buying small multifamily units or apartment complexes or buying a few real estate secured notes. Most use their own money initially or get money from family and friends with one investor per deal, typically structured as a private money loan secured against the real estate asset. Over time, as the entrepreneur’s reputation grows, and if they are ambitious or hope to take their business to the next level and make a full-time career out of real estate investing, the model of one investor per deal will eventually no longer work without relationships with unlimited supplies of capital. If the entrepreneur has reached their capacity, the entrepreneur must seek out referrals or new relationships with private money lenders or partners, in order to keep growing the business. Developing these relationships can be time consuming and requires a new level of presentation and commitment on the part of the entrepreneur.
The real estate entrepreneur may reach the point that he or she is not able to close on a deal because there is no capital available to them.
This presents a dilemma if the entrepreneur comes across too many deals that it cannot close because of lack of capital. The solution to this dilemma typically is to syndicate real estate investments.
There are many different reasons someone would syndicate in real estate. The following are some of the primary reasons:
Control – If you are a real estate entrepreneur using a single investor on every deal, the back and forth over terms and underwriting standards can become overwhelming and restricts your ability to expand. Once you have systems and processes and become an experienced real estate deal maker, it becomes easier to quickly identify good deals. Being able to pull the trigger on good deals immediately, without the back and forth that can take place with individual investors, is an enormous advantage and presents an extremely convincing argument to syndicate real estate.
Capital at the ready – In hot real estate markets, competition for real estate assets is high. Speed is often the reason why an entrepreneur beats out the competition. Working under the one passive investor per deal does not lend itself to being able to close deals quickly. While the real estate entrepreneur still must raise capital for the syndication, once the capital is raised, it is available to close on those good deals.
Make more money – While starting a real estate syndication does not always result in the sponsor earning more money, the perception is that it will. The ability for the sponsor to raise more capital with a real estate syndication depends on a number of factors, including the asset strategy, the fees being charged to the syndication and the size and scale of operations.
Grow operations – Starting a real estate syndication will typically allow the sponsor to expand and grow its operations, which can through expanding outside of the sponsor’s current geographic area or through the number of real estate assets or larger projects that the sponsor is able to undertake.
A Note on the Risk Associated with Investing in Real Estate Funds
Just as with any type of investment, there are also risks associated with investing in a real estate fund, including the following:
Lack of control: As a passive investor, the investor is putting trust in the sponsor’s skill and judgement. In most real estate funds, investors have very limited voting rights and virtually no control of day-to-day operations of the real estate fund.
Illiquid investment: A real estate fund investment is an illiquid investment. An ownership interest in a real estate fund is usually subject to significant transfer restrictions by the real estate fund’s governing documents, including the PPM and the operating agreement. In addition, federal and state securities laws also restrict the transfer of an ownership interest in a real estate fund.
Visibility to fund operations: Passive investors will generally only receive reports on a set schedule outlined in the real estate fund’s offering documentation; thus, it can be easy for real estate fund managers to manipulate reports if the manager is unethical.
New fund managers: New real estate fund managers do not typically understand the business side of managing a fund, which is very different than managing the real estate operation.
WHAT TO BE READY FOR WHEN STARTING A REAL ESTATE SYNDICATION OR FUND?
Given the time, expense and commitment involved in starting and managing a real estate fund, being thoroughly prepared before jumping in cannot be overstated. Before sponsors or fund managers embark on the journey, there are a host of issues that must be addressed, vetted and decided. Below, highlighted are some of the more important issues that should be considered in advance of launching a real estate syndication or fund.
1. Make certain you have the appropriate staff in place (or the ability to quickly ramp up) to manage the increased workload on the accounting, reporting and investor relations pieces. Some investors will be hands off, but other investors will want to call your office and discuss various aspects of the real estate fund. With that in mind, it is crucial to have someone handling the investor relations as a full-time role.
2. The level of scrutiny you will be under will increase tenfold. Not only will your offering documents be scrutinized but the background and experience of the sponsor’s management team will also be scrutinized. Not to mention, you will be subject to securities regulations and you will need to ensure by working with a real estate securities attorney that you are in compliance with all applicable regulations.
3. Sponsors or fund managers that invest in their own capital into their syndications or funds will experience an easier time selling the syndication to investors than those who do not invest in their own syndication or fund. Investors like to see that sponsors have skin in the game as well.
4. You may be great at selecting and managing real estate investments, but starting a syndication is also about being a custodian of investor capital and according to the law, a fiduciary.
5. If your investment strategy is multi-family real estate assets, do not buy an industrial park. Stick to your outlined investment strategy. And also sponsors should be aware of diverting too far from their investment strategy or thesis outlined in their fund documents such as the PPM and operating agreement.
6. You need to demonstrate the ability to see the entire process through, from raising the capital, to acquiring the asset, managing the asset and liquidating the asset. Investors are entrusting their hard earned capital to you, and if you are unable to demonstrate your staying power, investors are not likely to invest their capital in your fund in the future.
7. Transparency throughout the life of the real estate fund is key. Investors do not like bad news, but investors prefer to know and understand the bad news up front, as opposed to having the bad news hidden from them.
8. Communicate with your investors on a consistent basis. If you say you will issue a report to investors on a quarterly basis, make sure you issue a report to investors on a quarterly basis. Consistency is important to investors. This is also important when issuing tax reports like K-1s. Make it a goal to issue K-1s on time prior to expiration of the tax deadline so investors can those reports to their accountants with enough time.
Real estate syndications and have funds have been around for almost a century now. One of the greatest benefits of real estate syndication and real estate fundraising is that it allows individual investors to participate in larger, and more stable, multi-million dollar or even multi-billion dollar transactions that they otherwise would not have access to or qualify for.
Because real estate syndications involve the sale of securities and are, thus, regulated by federal and state securities laws, sponsors and fund managers should always consult with experienced real estate securities counsel and/or a real estate fund attorney before making any offer or sale of an interest in a limited partnership or limited liability company in connection with any real estate syndication or fund.
About the Author
Shams Merchant is a real estate securities attorney and one of the country’s leading real estate syndication and fund attorneys representing syndicators, sponsors, real estate investors, fund managers and private equity firms nationwide in all 50 states. Shams is known as the “go-to” attorney for structuring Regulation D, 506c and 506b real estate investment funds and syndications. He is regarded as an expert in real estate securities and is a junior partner at the largest real estate private equity law firm in the country. An expert in commercial real estate, Shams also represents clients in the purchase, sale, leasing and financing of apartment buildings, office towers, shopping centers, student housing, industrial warehouses, mixed-use developments, self-storage, affordable housing, and various other commercial properties.
Contact Information
Shams@mwfirm.com | (832) 451-2594 | Schedule Meeting