How to Syndicate Multifamily Properties
The word syndication is often used in the real estate business, but keep in mind that it describes only a type of partnership structure. The basic idea of syndication is a group of people coming together to combine efforts towards a profit.
The basic concept of syndicating a real estate deal is that you will be obtaining a loan to purchase the property and that you will use investor money for the down payment. In return for this investment, each investor will own a percentage of the property. The investors will share in the net cash flow plus the proceeds at sale. The annual cash flow plus profit at a sale will create the return on investment (ROI) for the investor. The more cash flow and profit at sale, the higher the ROI.
There are many different structures that you can use when forming a syndicate. The real question is not whether you are syndicating a deal but whether you are creating a security. If your structure creates a security, then your investment must be filed with the Securities and Exchange Commission (SEC) and comply with all SEC laws regarding the issuance of a security.
How do we know if what we are trying to do is a security? We can use what is commonly known as the Howey test. This test comes from a case involving the SEC and a Florida orange farmer. The SEC found that Howey had inadvertently created a security when he sold and then leased back land that produced oranges. The Howey test was created from this case and is a set of four questions/criteria that will establish whether an investment is a security:
- 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.
In simple terms, if someone invests in something and expects a profit from that investment and said profit is created or controlled by someone else (i.e., the syndicator), you have a security.
If the partnership structure you are planning answers yes to these questions, you are creating security. If you are creating a security, you will need to file a private placement memorandum (PPM) with the SEC. This may sound intimidating, but it’s not. An attorney will create the PPM and complete the filing for you as well as show you how to use the document.
General Partners and Limited Partners
For most syndicated real estate deals, investors and partners will fall into two categories: General Partners (GPs) and Limited Partners (LPs). The GP team will consist of you (the syndicator) and your equity partners, or sponsors. In the real estate industry, the word sponsor is typically used to describe an equity partner who joins the team for the purpose of bringing cash liquidity and the net worth to the deal. This is done to satisfy the lending requirements for most loans. If you don’t have personal net worth equal to or greater than the loan amount, you are not likely to qualify for the loan. This is why you would bring in a sponsor to help support your lack of financial capabilities.
Now that you have assembled your equity team (GPs), you will need down payment money. This is where the LPs come in. The LPs are your cash investors who will provide you with down payment money. In the beginning of your real estate career, these investors are likely to be friends and family members. They will invest their cash and receive a predetermined amount of equity in the deal as well as a subsequent amount of profits produced by the asset (i.e., cash flow).
When thinking of the concepts of GP and LP, you can swap the word partner for the word liability. The GPs are generally liable, and the LPs are limited in their liability. The GPs are the ones who will be signing on the mortgage and who will be liable for the loan in a default situation or in the case of any lawsuits. The LPs are risking only the money they have directly invested in the deal. In a default situation, they would lose their cash investment only.
General Structuring
The most commonly used structure when syndicating a deal is a two limited liability company (LLC) approach composed of a manager LLC and an owner/member LLC. The manager LLC consists of GPs and asset managers. The owner LLC is the company that owns the physical asset and is recorded on the deed. The LPs take fractional ownership of this LLC for their cash investment. The manager LLC also takes a fraction of the ownership interests in the owner LLC. I am using the terms manager and owner to describe the situation, but these are not legal terms. They are simply two LLCs that are created to perform these functions. A general description of a syndicated deal will look something like what is presented in this image.
How much should each LLC own? The answer to this question is based on the return on investment (ROI) your investors need to get. ROI is both cash on cash (CoC) return and internal rate of return (IRR). This calculation is part of your initial deal analysis. If you plan to raise money for your deals, then it is arguably the most important aspect of your analysis.
The basic concept is that you must give your investors enough equity and cash flow to produce their needed ROI and to keep enough equity and cash flow for yourself to make the deal worth the effort. A common example of this would be splitting a deal seventy/thirty between the GPs and the LPs. The GP group would own 30 percent of the deal while selling 70 percent to the investors or LPs. The GPs would get 30 percent of the cash flow and profit at sale, and the LPs would get 70 percent of the cash flow and profit at sale. See below.
A seventy/thirty split is just an example. Keep in mind that each deal will be different depending on the strength of the cash flow and appreciation. The more cash flow and appreciation a deal produces, the more equity that you and your GPs can keep while providing the same ROI to the investors. The less cash flow and appreciation, the more equity you will have to sell to the investors to get them the required return.
You will need to calculate the investors’ annualized return by adjusting the amount of equity given. Start your analysis by giving your investors 70 percent of all profits and see what ROI that projects. Now you can increase or decrease the 70 percent number until you get the desired annualized return that would attract investors. For example, if your investors want to see 8 percent cash flow (CoC return) and your calculations at 70 percent ownership to the investors indicate that the deal’s cash flow will produce only a 6 percent return, you will need to increase the investor split to get the 8 percent. In reverse, if the deal produced a 10 percent cash return but your investors needed only 8 percent, then you could keep more than 30 percent.
Preferred Return (Equity)
This method for calculating an equity split with investors in a syndicated deal works well when prices are low compared with the income they produce (high cap rate), but when prices are high compared with the income (low cap rate), the same method becomes hard to accomplish. The reason for this is because the high prices will not allow you to give only 70 percent. To get the required returns to your investors, you may need to give 80 to 95 percent of the deal to get the ROI high enough. This would leave little equity or cash flow for you. The solution is to give a preferred return on the invested capital. A preferred return, or “pref”, means that you will be giving the investors 100 percent of all profits (cash flow and profit at sale) until they receive a predetermined ROI.
This ROI is called the hurdle rate. For example, if you decide to give an 8 percent preferred return on an investment, you would be giving the LPs 100 percent of all profits until they hurdle the 8 percent. Any profit above the 8 percent preferred return will be split between the LPs and the GPs.
Most investors will like the idea of a preferred return. It shows them that you are confident enough in the deal to put their profits before yours. Also using a pref will allow you to analyze deals from a different angle. Remember that ultimately your investors will be most sensitive to the annualized return. By giving the investors 100 percent of the cash flow (preferred return) up to the hurdle rate, you can keep more of the equity in exchange. The annualized return is calculated by adding cash flow and profit from the sale.
Using a preferred return, you will not likely receive much of the cash flow, but you will get a greater cut of the equity split. Use the investments total internal rate of return (IRR) to determine the amount of equity you will need to sell to the investors, but using a preferred return, you will be able to sell less equity and still produce the same ROI.
Giving away most of the cash flow in exchange for more equity may seem like a bad idea, but I assure you that it is not. When prices are relatively low compared with the income they produce, you can get good cash flow, and the straight split model that I mentioned first will work fine. When the market gets heated and prices rise, you will find that the cash flow will decrease.
Using a preferred return is a way to get your investors the ROI they need, even though cash flow is lower at that time. It’s better to get no cash flow and a lot of equity than to do no deal at all because prices have risen. Decide what will work best for you every time you analyze a new deal.
Why Syndicate a Deal?
Probably because you have to. Most syndications are born from a need for net worth, experience, liquidity, or all three. The net worth of the borrowers being equal to the loan amount is a standard requirement for most lenders. They may want to see that you have some cash available as well, and they may require that you have experience in owning the type of asset you are trying to buy.
I remember walking out of one the first multifamily real estate seminars that I ever attended. I was feeling ten feet tall and ready to conquer the apartment industry single-handedly. The speaker was highly motivating, but I found out later that he did not tell us the entire story about getting started in real estate. I remember hearing a lot of phrases, such as “It’s easier than you think,” “You can retire after one deal,” and so forth. What I was not told about was that I needed to get a loan to buy an apartment building.
I followed the instructions I received in the seminar and found several large apartment complexes that looked like good deals as far as the cash flow numbers were concerned. I took the best one, printed out the realtor’s offering memorandum, and walked straight into the first commercial lender’s office I could find.
“With what net worth, what cash, and what experience?” were the questions the lender asked that ended our laughably short conversation, right before he asked me to leave his office and stop wasting his time. I walked into his office ten feet tall and came out ten inches tall. That experience was brutal, but in retrospect, the guy was totally right.
I did waste that lender’s time that day because I was not truly informed about what it takes to get a loan. I could blame the seminar guru for that, but what good would that do? I took responsibility for the situation by creating value for partners and sellers, getting them to join me on the deals.
Why Create a Security?
The reason that you would want to allow your investment to become a fully registered security with a PPM is to limit the control of your LPs. The last of the four criteria of the Howey test covers this point: Any profit comes from the efforts of a promoter or third party. Limiting the control or voting rights of an investor is a surefire way to create a security.
In the average syndicated deal, you may have as few as two or three investors or dozens in larger commercial deals. What if you had eighteen LP investors in a deal and all eighteen had the ability to control the day-to-day decisions pertaining to the operations of the investment? Eighteen people to help you decide on every detail or daily decisions. Eighteen people to help choose the paint color or the type of carpet your management company will buy. Can you imagine?
This is why you will want to create a security and file a PPM with the SEC. If you plan to have only a few close partners in a deal, then it may make more sense to create a joint venture structure where all partners have voting rights and no partner is passive in their role in the company. If you plan to raise money from investors you have less of a relationship with, or if it will take more than a few people to get the down payment money together, you may want to consider the security route.
Lastly, I will reiterate the need for you to obtain legal and financial counsel before engaging in any syndication of real estate or partnership formation. Never “cut and paste” documents from the internet in order to save money. The mistakes you are likely to make will cost you much more than anything you would save in legal and accounting fees.
For more information like this check out my blog at www.realestateraw.com and join my Facebook group Real Estate Raw for Multifamily Investors.
Best of luck!
Bill Ham
