Real estate syndications are a powerful way to pool resources for substantial property investments. Within this domain, a highly regarded method is the two-class syndicate model, which involves two key groups: the equity investors and the management entity.

This structure streamlines operations by assigning specific roles and responsibilities to each group, thereby enhancing efficiency.

Whether you’re a seasoned investor or new to real estate syndication, understanding this structure can provide a solid foundation for your investment ventures. It offers a well-organized framework that can help you achieve your financial and operational goals, making your journey into real estate syndication both manageable and rewarding.

Introduction to the Two-Class Syndicate Model

In a two-class syndicate, there is a structured division between those providing capital and those managing the investment: Equity investors contribute the necessary funds for the investment and enjoy benefits like potential returns and profit sharing. Meanwhile, the management entity takes charge of day-to-day operations and strategic decision-making.

For this setup, an Investor Entity is formed to hold the title and act as the borrower for any bank loans while selling interests to Investors. Lenders in some scenarios, particularly where loan balances exceed $10 million, may require a separate single-purpose entity distinct from the Investor Entity. However, the title-holding entity in such cases will still be entirely owned by the Investor Entity.

When a Limited Liability Company (LLC) is used as the Investor Entity, it is structured as “manager-managed” and features a Manager with the passive Investors as members. A Limited Partnership could also serve the same purpose, with a general partner (GP) serving as the management class and limited partners (LPs) as the passive investor class. For this discussion, we’ll focus on LLC, the most commonly employed structure among syndicators today.

The Investor Entity requires a Company Agreement between the management and the investors. This outlines their rights and duties, governs the operation of the company, and details the cash distribution method. With this clear separation, each party can focus on the roles they do best, resulting in a more organized and effective investment approach.

A division of roles allows each party to leverage their strengths, enhancing both operational efficiency and financial returns. Understanding these dynamics is crucial for anyone interested in this investment strategy.

The Member / Investor Component

To organize and streamline roles and responsibilities, the two-class syndicate structure within a manager-managed LLC comprises two types of members: Class A (cash-paying investors) and Class B (management or “sweat-equity” class).

Class A Members

These are the equity investors who contribute 100% of the capital in exchange for 50%-80% of the Investor Entity’s ownership interests. They can be divided into subclasses, e.g., A-1, A-2, and so on, each receiving distributions based on the percentage of their ownership interests.

Class A has limited involvement in daily operations but receives preferred returns on their investments before Class B members, calculated annually but determined quarterly. Such returns come in any of two forms:

Cumulative

The Waterfall section in the Company Agreement details this preferred return, which accrues even if no cash is available to pay it until the next distribution event. Arrearages could also be deferred until a capital transaction, such as refinancing or sale of the property. In this case, they are paid after capital contributions are refunded but before distributions are made to Class B or equity is split between Class A and Class B.

Noncumulative

For noncumulative returns, Class A Members receive all of the distributable cash needed to fulfill their preferred return for the current distribution period, but deficiencies do not accrue.

Class B Members

This is the service class comprising members of the Manager and other service providers. They hold the remaining ownership interests in the company in exchange for a nominal amount ($100 or $1,000 in total) on top of their non-capital contributions to the Investor Entity.

Class B Members receive their share of the distributable cash during operations after Class A Members have received their annualized preferred returns. In the same manner, during a capital transaction, they get distributions when Class A’s capital contributions have been refunded and any arrearages have been paid.

Thus, Class B returns are subordinate to those of Class A’s, a distinction crucial for tax purposes. If Class A and Class B are on par, Class B could face a taxable event in the first year for its portion of the ownership interests. Instead, Class B Members can establish a cost basis for their investment by paying for their interests. Doing so will potentially allow distributions to be taxed at capital gains rates rather than ordinary income rates, which include self-employment tax.

Duties of the Management Entity

The Management Entity in a two-class syndicate is essential for the smooth operation and growth of the investment. Their responsibilities cover a wide array of tasks, including managing the day-to-day operations of the property, handling tenant relations, and ensuring property maintenance. They are also in charge of financial oversight, such as budgeting, managing expenses, and distributing returns to investors.

Another critical role of the Management Entity is ensuring compliance with all relevant regulations and legal requirements to safeguard the investment from potential legal issues. They must also develop and implement strategic plans for property improvement and value enhancement.

As Manager, this entity is usually organized as a separate LLC and includes the management team as members. They don’t hold ownership interests or voting rights but earn Acquisition, Organization and Due Diligence, Asset Management, Refinance, and Disposition Fees.

Benefits of the Two-Class Structure

This model offers several advantages for real estate syndications. One is preserving the distributions for the management class if the Manager is removed.

Additionally, Two-Class separates fees from distributions. Hence, earnings on Class B distributions can be taxed at capital gains rates rather than ordinary income rates that include self-employment tax.

And since Class B retains a percentage of the interests, the Manager can allocate it among the Investor Entity’s service provider. This flexibility is beneficial for those involved in deal finding, fundraising, and guaranteeing loans on its behalf.

Final Thoughts

The two-class syndicate model is a well-structured method for organizing real estate syndicates, clearly distinguishing between the roles of equity investors and the management entity. By leveraging a manager-managed LLC, it allows for a clear division of labor, ensuring that both parties can focus on their areas of expertise.

This distinct separation not only enhances operational efficiency but also mitigates risks, making it easier to manage large-scale investments. Equity investors can concentrate on financial returns, trusting that the management entity is handling the day-to-day operations and strategic decisions.

Such alignment of roles also fosters a collaborative environment where each party has a vested interest in the overall success of the investment. Through this kind of specialization, the two-class model can lead to improved decision-making and accountability. As a result, financial outcomes are improved.

Incorporating the two-class structure into your real estate syndication ventures can provide a robust framework supporting financial and operational goals. As you navigate the complexities of your project, keep this model in mind to streamline your operations and maximize your returns.
Need expert and specialized securities legal counsel when structuring your real estate syndicate? Shams Merchant is the leading real estate private equity and syndication lawyer, representing clients in award-winning real estate projects across the country. Shams specializes structuring and forming real estate syndications, fund, and private placements for commercial property investments and development and has been featured in publications like Law360, the Austin Business Journal, BisNow, and The Real Deal. He is a sough-out securities and commercial real estate lawyer by industry publications and news outlets across the country.