How to Structure a Real Estate Syndication
I’ve written several articles on the topic of real estate syndication and why it’s such a powerful tool for small businesses and real estate investors. If you need more context on the basics of syndication, you can find that here.
This article will instead focus on the various legal, payout, and compensation structures used in syndicated financing ventures. We'll also explore how those structures impact general and limited partners and address things to consider when using different partnership and payout configurations.
Legal Considerations for Syndicated Financing
Remember that syndication is a broad term. Black’s Law Dictionary defines a syndicate as, "A group organized for a common purpose; esp., an association formed to promote a common interest [or] carry out a particular business transaction."
But in layman’s terms, a real estate syndication is nothing more than a group of people pooling their resources to acquire a piece of real estate or finance a project.
Before you embark down the path either as a general or limited partner, several legal issues must be considered. But none of this is meant to be legal advice or counsel. You should consult with licensed securities and estate planning/asset protection attorneys before engaging in a real estate syndication.
What legal entity structure will you use?
The first question you need to answer is how you will structure the arrangement? Most real estate syndications are either formed as a limited partnership (LP) or a limited liability company (LLC).
There are merits and drawbacks to each entity structure. LLCs are inexpensive to establish and maintain, offer flexibility for taxation purposes, and limit the liability of individual members. LPs establish a general partner (GP) responsible for everything associated with the investment and limited partners, who are not liable for the entities' debts/liabilities and whose risk is limited to their capital contribution.
It's crucial to qualify whether investors will have a genuinely passive investing role in your syndication. Limited partnerships offer investors no control or active participation in the management of the entity. So, if an investor wants to participate in the project in addition to their capital contribution, a limited partnership may not be the ideal legal structure.
Asset protection is another important consideration, both from the GP and limited partner perspective. General partners in an LP can be personally liable for all of the entity's debts. It's common for the general partner or partnership team to form an LLC as the GP to help reduce exposure.
This isn’t meant to be a comprehensive list. But it's critical to understand there are several legal structures available that offer different strategic outcomes.
Are you offering a security?
The concept of “offering a security” is often confusing because most think of a security in terms of a company’s stock. But the Supreme Court takes a much more liberal attitude when defining what constitutes a security, stating, “[a]n investment contract for the purposes of the Securities Act means a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
The Howey Test is a quick assessment that can help you determine whether a transaction qualifies as an investment contract. Four qualifying statements must be met:
- It is an investment of money
- There is an expectation of profits from the investment
- The investment of money is in a common enterprise
- Any profit comes from the efforts of a promoter or third party
Although you should still engage with an attorney, this assessment offers a “sanity check” to ensure that you are adequately protecting yourself and your limited partners as a sponsor.
Will you be engaging with non-accredited investors?
As a general partner, you're accountable to a different set of guidelines based on the types of investors you're courting for a specific project.
Without delving too deeply into securities law, understand that the SEC delineates between accredited and non-accredited investors. As the name would suggest, accredited investors, are assumed by regulators to be of a certain sophistication and maintain a certain threshold of earnings or net worth. Non-accredited investors don’t meet those requirements.
Engaging with non-accredited vs. accredited investors will even govern what type of SEC registration exemption you can file – further dictating how you must manage the project/offering.
General partners need to be adequately informed before engaging in a real estate syndication. And more importantly, limited partners should feel comfortable that the GP is experienced and has the requisite legal counsel to properly navigate regulatory requirements.
Ultimately sponsors and investors engage in syndicated financing deals with the intent of making money. But as we’ll discuss later, typical payout and compensation structures are heavily weighted towards passive investors.
So, GPs will often work fees into the project to help better compensate themselves for their efforts and expertise – real estate acquisitions are hard to source, and it takes time to underwrite, acquire, and manage the property.
What do these fees look like? There are several to examine:
- Raise fee/acquisition fee: Some real estate syndicators may charge a "raise" fee (based on the total amount fundraised), while others may instead charge an acquisition fee (based on the real estate purchase price). This is typically between 1-5% depending on the size of the deal.
- Asset management fee: The management fee is commonly a predetermined percentage of the total investment fundraise, usually 1-3%. This is meant to compensate the general partner for the management of investors, the property, and legal/tax requirements.
- Promote fee: Also known as the sponsor promote or carried interest, this is meant to further compensate a GP if the deal returns above a predetermined threshold.
- Refinance fee: Similar to an acquisition, refinancing a property requires coordination, due diligence, and substantial time investment on the part of the GP. Its standard sponsors will charge a 1-2% refinance fee in return.
- Disposition fee: A syndicator may charge a disposition fee for their marketing and sales efforts when a property sells.
Ownership and Compensation Structures
Several types of compensation structures dictate the ownership percentages and claims to cash flow each party has throughout the project. Compensation is negotiable between the sponsor and investors, but every deal requires a different approach, and creative collaboration between the investment team often yields the most rewarding results.
These aren’t steadfast rules, but below is a detailed look at several different types of syndicated financing compensation structures:
A straight split is the simplest compensation structure where all cash flows and capital gains are split based on the entity’s ownership percentages.
Most real estate syndications have an ownership structure between 50/50 (LP/GP) and 90/10 (LP/GP). A sponsor that brings more experience and expertise to a transaction can often negotiate a more significant ownership share.
For example, assume a real estate acquisition with a straight split of 75/25 (LP/GP) generates $100,000 cash flow. The sponsor is paid $25,000, while the investors receive the remaining $75,000, split evenly based on their pro-rata capital contribution.
The straight split percentage also applies to any capital gains, either through a refinance or at the sale of the property, earned throughout the project.
A preferred return requires that investors receive a certain return on their initial capital contribution before the GP earns any share. Real estate syndications that pay a preferred return will commonly pay between 6-8%.
Once the preferred return threshold has been met, any excess compensation can revert to a predetermined payout structure (i.e., 70/30 or 80/20 (LP/GP)).
Preferred return requirements can be challenging to accommodate in some deals. Ground-up development projects or deals with a major value-add component may take several years to stabilize before supporting a preferred return in addition to debt service.
A distribution waterfall is another form of real estate syndication structure that dictates how capital is distributed during a project. It allows for the uneven payment of distributions and delineates a pecking order amongst partners.
Waterfall structures can be customized, but they traditionally follow a set of sequential tiers:
- Return of capital (ROC): The return of capital prescribes that the initial capital contribution of all limited partners is returned before a sponsor receives any dividends.
- Preferred return: The preferred return percentage is distributed to investors after initial capital contributions have been paid
- GP catch-up: The general partner will receive a significant portion of the proceeds during the catch-up tier until they've received a certain percentage of profits
- Carried interest: A predetermined percentage allocation between the investors and sponsor after the previous waterfall tiers have been met.
Why Structure Matters to a Real Estate Syndication
The obvious answer is because it dictates how each party gets paid throughout the life of the project. And on the surface, that’s correct.
But more importantly, the structure guides the alignment between a general partners’ motivations of the motivations of their limited partners.
If you think about a typical Wall Street fund, the fund manager is usually compensated based on total assets under management (AUM). They may receive a small bonus based on the portfolio's returns, but their commission is primarily tied to how many people (assets) they can accumulate under their management.
Anytime there is a principal-agent relationship in business, it's vital to ensure that each party is motivated to row in the same direction - incentives need to be aligned. A real estate syndicator should be cautious when including too many fees into a transaction. Investors want to see a general partner get paid when a deal is successful, rather than just when they sign a transaction up.
Avoiding any hidden compensation is also important. Not only does it keep a GP out of trouble with the SEC, but it also serves to build trust between them and their limited partners.