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How to Structure Syndicated Investor Deals: What Kind of Legal Entity Should I Use?

by Michael Blank on January 20, 2014 · 14 comments

  
Structure Syndicated Investor Deals

It’s important to understand the different ways you can structure your syndicated real estate deals, not only so that you can visualize it happening, but also so that you can speak confidently to your potential investors.

In the last article “How to Structure Syndicated Investor Deals: What Investors Are Looking For”, we talked about what investors look for in regards to terms and returns. In this article, we’ll address how to structure a deal from an entity perspective.

To start with, make sure you NEVER buy anything in your own name.

In most cases, you’ll want to use an LLC. The reasons for this are beyond the scope of this article, but I will summarize by saying that it provides the right level of asset protection for you and is the simplest to set up, administer and tax.

I generally set up a separate LLC for each deal. That way, if something bad happens (like a lawsuit), then it might take down the one ship but hopefully not any of your others!

If you’re considering taking on outside investors (a good idea, as we talked about in a previous article), then you have a few options:

Option # 1: Borrow the Money

This is the simplest way to use other people’s money in your real estate deals. The investor gives you cash and gets a promissory note in return. The promissory note is referenced on the deed, which is then recorded. This secures the investor’s interest, and you can’t sell the asset before the investor is paid back. This arrangement is so standard that most title companies can handle this for you without any problem.

This is what I use for my house flips.

I don’t like using this on buy and hold properties because normally you have to make at least interest-only payments. If you couple this with a traditional commercial loan, then the combined debt service leaves little or no cash flow at all. I’m not saying, don’t do it, just make sure the deal works!

Option # 2: Your Investors are Members of your LLC

A typical LLC has two “roles”: it may have one or more “managers”, which is you, as the syndicator, performing the day to day operations. And then there are the “members”, which are your investors.

You are a manager but you will also most certainly be a member. This is because in your deal, you will give yourself at least 20% equity in the building for putting the deal together and managing it. (If I can’t own at least 20% of the deal for syndicating it then it might not be a good deal in the first place!)

The document that governs the roles and responsibilities of the managers and members are described by the LLC’s “operating agreement”.

The operating agreement describes what you, as the manager, can and can’t do without requiring a vote by the members.

You can design your operating agreement (almost) however you want.  You can give your members as much or as little decision-making authority as you want – as long as they agree to it, of course.

For example, you can give yourself (as the manager), nearly all decision-making authority, and the members nearly none. This makes the members “silent” investors.

Just remember that you are also a member, and that in this arrangement, you have an equal vote with the other members. For example, if you own 20% of the building, then you also only get 20% of the vote.

This is fine if your other members are friends and family (and generally unsophisticated) and will normally go along with whatever you recommend.

You can mitigate the risk of being out-voted by giving members basically no decision-making authority at all, leaving you as the manager with most of the authority.

This kind of LLC arrangement is fairly standard, and your attorney will normally charge you around $1,300 to draft an operating agreement that reflects your wishes. Each of your members will also sign the operating agreement to make it a binding contract.

Option # 3: Multiple Classes of Members

This is an advanced version of Option # 2, where, in addition to the manager role, you have two classes of members. The “Class A” members may have preferential treatment with regards to distributions or decision-making over “Class B” members, who may be largely silent and have different returns. This is just an example, the possibilities are endless with this kind of arrangement.

This normally only becomes relevant for larger deals involving more sophisticated investors. Just know it’s out there as an option.

SEC Securities Law Considerations

Anytime you take on investments from anyone else, you are essentially selling securities. As such, you must pay attention to state and federal securities regulations. I’m not going to talk about these here (later perhaps!), I just want to mention that this is an important consideration during this process.

Working with Your Attorney

While all of this sounds complicated, just relax in the knowledge that you are the business person. You’re not the CPA or the attorney, and you don’t need to be. As a syndicator, “you have people for that”. You just need to know enough to manage everybody. Just make sure you’re working with a competent attorney to set up the entity and draft the operating agreement. Your SEC attorney will make sure you comply with securities law requirements. The attorneys will handle the details. And I can assure that you will learn a lot!

Conclusion

It’s important that you know different ways to structure your syndicated real estate deal. First, because it opens you up to the possibilities so that you can visualize how it could be done. Second, you need to be able to explain it your potential investors. And third, you need to be able to tell your attorney what you want.

I’d like to close by saying, don’t let the apparent complexity of all this scare you from getting started today. Remember that you don’t need to know everything up front. Yes, educate yourself. Learn the rest “on the job”.

I hope you found the article useful … let me know what you think.
Photo Credit: See-ming Lee 李思明 SML

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{ 14 comments… read them below or add one }

Adrian Tilley January 20, 2014 at 5:22 pm

So, to answer the question in the title, what kind of entity should I use?

For the record, LLC’s sometimes provide some asset protection depending on the situation, but many times will provide no legal protection whatsoever. I think it’s a common misconception that as long as your property is in an LLC, you’re golden.

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Kay Khan January 21, 2014 at 10:33 am

How about transferring the property in land trust and making LLC the beneficiary for added protection.

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Ben Leybovich January 21, 2014 at 12:31 pm

Agreed!

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Michael Blank January 21, 2014 at 12:56 pm

I think you’re right, using an LLC (or any legal entity) can give you a false sense of security. It won’t stop someone from suing you personally, for example.

Your comment is also spot on, in that you can structure different legal entities to do what you want to do. LLC’s tend to be the most common. Even though I haven’t done it, your idea about a land trust with the LLC as a beneficiary would probably work also.

Thanks!

Michael

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Greg January 21, 2014 at 5:25 pm

Before you dive into using LLCs everywhere be sure and understand their ramifications. I talked to my father-in-law who has been renting properly for 20 years. He told me you can’t borrow conventionally that way. If you get used you might HAVE to hire a lawyer which can be expensive.

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Luis January 23, 2014 at 12:27 pm

Based on your experience, are there any pros or cons from using an S-corp instead of an LLC for flips and buy & hold investment strategy?

I currently have an S-corp set up (from a previous business) which I plan to recycle to use in my new “real estate investor” business.

I was thinking that recycling the entity, (i.e. changing the business purpose registered with the state), would be a good Idea since I have had the entity for over two years (with registered DUNS number) and banks look at the age of the business as one of the lending criteria.

I also like S-corp because it is easier for the owner to prove active income, (instead of passive loss deductions, generally limited to the amount of passive income gain), based on the salary the owner could pay himself through a W-2 as regular employees do.

I was thinking that this fact is especially good for those that invest part time and will like the benefit of reducing there regular job’s income taxes with any loses from the S-corp.

However, I was not 100% sure if an S-corp (as the Parent) can structure LLC’s (as the child) for each of the deals. Not sure if this will be much benefit.

Please share your thoughts about this…

My Disclosure: all that I am an accountant, this is not qualified legal or accounting advice. I recommend you speak with a knowledgeable professional in your area that haves full understanding of your particular situation.

Thanks

Luis

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Michael Blank January 27, 2014 at 7:44 am

First let me say that I’m not attorney and don’t pretend to be one, so check whatever I may say with your lawyer. I have several restaurants that are all separate LLCs that we elect to be taxed as an S-Corp. I was advised to do this for the same reason you mentioned: you can pay yourself a reasonable salary that you pay payroll taxes on, but you don’t pay payroll taxes on profit distributions. I don’t have any experience with a “pure” S-Corp, and I don’t know to what extent S-Corps can own other LLCs. Thanks!

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Greg January 27, 2014 at 8:06 am

If you intend to finance rental property through 30 year fixed debt instruments (secondary market loans), forget about LLCs. Banks generally won’t talk to you because a loan through an LLC is effectively a non recourse loan. They’ll kindly send you to their commercial loan department if at all. The state you live in might also have annual fees you must pay for your LLC structure. And apparently, in certain areas, you HAVE to to hire a lawyer if you go to court, even for a simple eviction. Need I remind you, lawyers aren’t free.

In a nutshell, LLCs aren’t free and can come with costly impacts so don’t make them a default structure you will get into. DO YOUR HOMEWORK. The exact impact can vary state-by-state, and county-by-county.

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Jorge Caicedo January 29, 2014 at 12:49 pm

What’s the difference between a syndicated investor and a regular private(not hard money) lender?

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Michael Blank January 29, 2014 at 1:11 pm

None! Just another (fancier -;) way to say the same thing!

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Andrew Schena February 26, 2014 at 8:06 am

Mike,

Great article. We use the syndicated structure for most of our flips here in Boston. The largest reason is due to the fact that the acquisition price is so high in the city, and then you have to get a construction loan to do the job! It can be difficult to raise $1M+ to do the entire project, especially when you’re doing multiple projects at once. Of course, until your stable of lenders is deep enough to handle it! But it’s a great way to get your business off and running.

Andrew

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Michael Blank February 26, 2014 at 9:08 am

Thanks Andrew!

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Ehsan March 28, 2014 at 6:52 pm

Great advice, thank you. Following up on this, I spoke with an attorney about this and he said that if the investor/members of the LLC were not “accredited investors” as defined by the IRS, the legal fees could be upwards of 10k, rather than the $1,300 noted by the author. Any thoughts on this from folks who have worked on setting up similar entities? Does the cost sound too high? Should I endeavor to only create an entity funded by accredited investors as a best practice?

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Michael Blank March 31, 2014 at 8:42 am

I’m not an attorney, but my understanding is that under exemption 505 you get to have up to 35 non-accredited investors. Also the $1300 I referenced was for the LLC operating agreement, the PPM etc is extra and is often upwards of $10K (even though my attorney charged me less than that). Hope that helps!

Reply

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