Why 506(c) Structures in Syndications Are Becoming More Prevalent
We have been involved in the syndication of multifamily real estate since 2017. Back then the prevailing legal structure was the 506(b) structure. Today, things are changing. It is important for LP investors to know what these changes are and adapt accordingly.
The 506(b) structure allows for the General Partner, or GP, to invite other investors into their deal with whom they have what the SEC determines as a substantial relationship. These are therefore private deals and not allowed to be publicly advertised. Investors or Limited Partners need to qualify as accredited investors but are not required to do this through a 3rd party. In a 506(b) structure, the investors fill out a questionnaire within the subscription documents stating their qualifications as accredited investors.
For limited partners investing in 506(b) deals this is convenient as it doesn't require the extra step of paying a 3rd party for verification or going through their CPA to get a letter of verification.
I'm noticing that today however the landscape is changing. This change is not one that many limited partner investors like. The change I'm noticing is that the 506(c) structure is becoming more prevalent.
The reasons for this, I believe, are two-fold. 1) It has become easier to obtain 3rd party verifications with the growth of online companies who operate in this space, and 2) as the multifamily syndication industry has grown over the past 5 years, the 506(c) structure scales better for the sponsor.
Sponsors under 506(c) are not required to have "a substantial relationship" with every investor (although I would argue it's still a good practice to get to know your investors and their investment goals). With the third-party verification process, sponsors can more easily scale their fundraising and break out of the limitations of their own personal networks. They also have the ability to publicly advertise.
What does this mean for investors?
When an investor sees a 506(c) structure, they should understand a couple of things. 1)This opportunity "may" be publicly advertised and so the capital raise likely will occur faster than a typical 506(b) deal. Investors should get in their soft commits early and begin their diligence process. Also, investors should be reaching out to their CPA or 3rd party verification service if they want to proceed with investing in the deal. The online services cost around $59-$69 for a letter that expires in 3 months (true at the time of writing this article).
Many investors are unhappy with this change as it does require sharing personal information with a third party that was not previously required under the 506(b) structure. However, the top 3 companies that provide verification services have robust security in place to protect customers and their data (I'm not sharing those companies here because Bigger Pockets has a policy against advertising such services in these articles).
In brief, 506(c) is more prevalent in multifamily syndications and I think we'll be seeing a lot more of them. For investors, it is best to get prepared and start looking at verification services they trust. I like to work with my CPA personally for these letters as they are free and also last longer than 3 months.