Many real estate investors will become involved in syndicating larger deals as they grow over the course of their career.
Syndication in real estate is when you pool together funds from several investors in order to purchase properties that are more expensive than any individual investor would be capable of purchasing.
Syndications are often structured as an LLC with a general partner (the company providing the offering) and limited partners (the investors). The general partner operates the asset over the course of the investment and the limited partners are passive members.
In order to structure a syndication, you will need to have a securities attorney involved with drafting legal documentation for your investment opportunity. Two of the most important documents you will need are the private placement memorandum and the operating agreement for the opportunity.
In this article we will give a brief overview of things you should understand about these documents as either a general partner preparing an offering or a passive investor deciding whether or not to invest in someone else’s offering.
The operating agreement is the document that sets the rules in place for your offering. It is the actual contract between the limited and general partners and clearly defines the roles of each party as members of the company.
The private placement memorandum is in some sense the “official” document related to the individual investment, but it cannot function without the operating agreement, which defines how the company providing the offering itself will function. There will be many clauses in these agreements that are typical when setting up an LLC, but this list will go over some of the more important ones:
In the event that some cash outflow is necessary (such as a repair) and cannot be covered by the operating funds, this is the provision that stipulates investors may be called to provide additional cash contributions, with the risk that their shares are diluted if they do not. While you’re obviously searching for deals where you would hope this would never happen, you need to include this. If there is no clause about this, savvy investors will run away because the operator is not prepared for a worst case scenario. The provision itself should also be reasonable and not overly aggressive or penalizing.
The operating agreement will stipulate what reporting is provided to the investors. This is typically done quarterly.
There should be clearly defined rules stating the manager has to distribute cash flow in regular intervals.
You need to include language stating that if the general partner commits fraud, willful misconduct, or mismanagement, they are liable. If this language is not included, that is a red flag that the general partner may be up to no good.
The private placement memorandum is a document you must distribute to your prospective investors when selling shares of your syndication opportunities.
A prospectus is a general term for offering memorandums when selling securities. The private placement memorandum is a specific type of prospectus used in private, unregistered securities.
Rather than registering with the SEC, you can file what is called a Form D rule 506 exemption.
Form D is used to file a notice of an exempt offering of securities with the SEC. This allows you to legally move forward with finding investors for your deal. There are two types of 506 filings:
Your offering may be made available to accredited investors as well as up to 35 sophisticated investors. Sophisticated investors are defined as having a superior knowledge of investing and business. Obviously that’s somewhat vague and open to interpretation, but the general idea is these must be people with some involvement or demonstrable business knowledge. Accredited investors do not have to provide verification. No advertising is allowed and investors can only be people with whom the operator had a pre-existing relationship.
Your offering may only be made available to accredited investors. The operating partner must verify that these investors are accredited through a third party company that specializes in this kind of verification. Advertising of any kind is allowed
Remember that, a single company with more than 500 non-accredited investors or more than 2,000 total investors will be obligated to properly register with the SEC and cannot file a Form D exemption. This is, of course, unnecessary for our purposes. Publicly traded REITs must register with the SEC, but that is the highest pinnacle of size for a real estate organization and will be covered in a separate article.
Your PPM and operating agreement work in tandem to give all the legal disclosures and rules surrounding your offering as well as the structure of the company. Your presentation and thoroughness are important here, as investors will try to judge both you and your offering based on the information you provide. A good investor will try to read between the lines and find out what you aren’t telling them. That’s why a properly prepared PPM and operating agreement should disclose every element of the deal with no stone unturned. Here are some of the things your attorney will need to include when drafting your PPM:
1. Summary: As the name implies, this should be a full overview of the investment
2. Legal Disclosures: These would include your Regulation D 506 filing as well as any other legal disclosures you are obligated to provide to investors for your offering.
3. General Partner(s): The general partners and their responsibilities in the investment must be properly defined.
4. Property: A complete description of the property or properties involved in the offering.
5. Duration: The length or anticipated length of the investment
6. Allocations and Distributions: Extremely important to investors, this section must explain in thorough detail how all cash is distributed to the investors. Make sure this is clearly defined with no grey areas, as they will inevitably come up as a problem if you leave anything too vague.
5. Terms: Here you will find anticipated returns and minimum investment amounts, as well as any other terms or conditions you’ve set for your offering.
6. Risks: Do not shy away from disclosing every imaginable risk with your deal. When drafting a PPM, of the utmost priority is making sure you are abiding by the law, and you are obligated to disclose all risks, but it’s more than just that.
Proper investors understand that investments include risk and will be skeptical if you try to paint a picture of rainbows and butterflies with no risk whatsoever. On the contrary, you’ll find that when you have good offerings and you’re extremely transparent about the risks, you’ll endear yourself to your investors.
7. General Partner’s Fees or Compensation: Your compensation as the general partner needs to be clearly spelled out and investors will be looking out for this. Include any syndication fees you may be charging for acting as the operating partner of the offering.
8. Transferability: You must decide whether your investors will have the option to sell their shares prior to the investment term.
9. Storage of Funds: You must disclose where funds will be stored to your investors.
This is up to the individual investor and the answer can vary based on your experience level. It typically takes a little under a month for an attorney to properly prepare a PPM.
If you are operating under a tight timeframe, it may be tempting to have your attorney begin drafting a PPM immediately upon an accepted LOI. The risk here is that drafting a PPM can be expensive, costing up to $10,000 or more depending on the complexity of the deal.
Please remember that securities law is extremely complex and it is in your best interest to seek out a dedicated securities attorney, even if that might be a bit more expensive than a jack-of-all-trades attorney with less experience dealing in securities.
Once you have a generic PPM drafted, you can re-use it for future deals by swapping out the sections that are specific to the individual deal. That way you can conduct your due diligence thoroughly and delay having your attorney finalize the deal specific content until you have fully vetted the property.
Many real estate investors will become involved in syndicating larger deals as they grow over the course of their career.
Syndication in real estate is when you pool together funds from several investors in order to purchase properties that are more expensive than any individual investor would be capable of purchasing.
Syndications are often structured as an LLC with a general partner (the company providing the offering) and limited partners (the investors). The general partner operates the asset over the course of the investment and the limited partners are passive members.
In order to structure a syndication, you will need to have a securities attorney involved with drafting legal documentation for your investment opportunity. Two of the most important documents you will need are the private placement memorandum and the operating agreement for the opportunity.
In this article we will give a brief overview of things you should understand about these documents as either a general partner preparing an offering or a passive investor deciding whether or not to invest in someone else’s offering.
The operating agreement is the document that sets the rules in place for your offering. It is the actual contract between the limited and general partners and clearly defines the roles of each party as members of the company.
The private placement memorandum is in some sense the “official” document related to the individual investment, but it cannot function without the operating agreement, which defines how the company providing the offering itself will function. There will be many clauses in these agreements that are typical when setting up an LLC, but this list will go over some of the more important ones:
In the event that some cash outflow is necessary (such as a repair) and cannot be covered by the operating funds, this is the provision that stipulates investors may be called to provide additional cash contributions, with the risk that their shares are diluted if they do not. While you’re obviously searching for deals where you would hope this would never happen, you need to include this. If there is no clause about this, savvy investors will run away because the operator is not prepared for a worst case scenario. The provision itself should also be reasonable and not overly aggressive or penalizing.
The operating agreement will stipulate what reporting is provided to the investors. This is typically done quarterly.
There should be clearly defined rules stating the manager has to distribute cash flow in regular intervals.
You need to include language stating that if the general partner commits fraud, willful misconduct, or mismanagement, they are liable. If this language is not included, that is a red flag that the general partner may be up to no good.
The private placement memorandum is a document you must distribute to your prospective investors when selling shares of your syndication opportunities.
A prospectus is a general term for offering memorandums when selling securities. The private placement memorandum is a specific type of prospectus used in private, unregistered securities.
Rather than registering with the SEC, you can file what is called a Form D rule 506 exemption.
Form D is used to file a notice of an exempt offering of securities with the SEC. This allows you to legally move forward with finding investors for your deal. There are two types of 506 filings:
Your offering may be made available to accredited investors as well as up to 35 sophisticated investors. Sophisticated investors are defined as having a superior knowledge of investing and business. Obviously that’s somewhat vague and open to interpretation, but the general idea is these must be people with some involvement or demonstrable business knowledge. Accredited investors do not have to provide verification. No advertising is allowed and investors can only be people with whom the operator had a pre-existing relationship.
Your offering may only be made available to accredited investors. The operating partner must verify that these investors are accredited through a third party company that specializes in this kind of verification. Advertising of any kind is allowed
Remember that, a single company with more than 500 non-accredited investors or more than 2,000 total investors will be obligated to properly register with the SEC and cannot file a Form D exemption. This is, of course, unnecessary for our purposes. Publicly traded REITs must register with the SEC, but that is the highest pinnacle of size for a real estate organization and will be covered in a separate article.
Your PPM and operating agreement work in tandem to give all the legal disclosures and rules surrounding your offering as well as the structure of the company. Your presentation and thoroughness are important here, as investors will try to judge both you and your offering based on the information you provide. A good investor will try to read between the lines and find out what you aren’t telling them. That’s why a properly prepared PPM and operating agreement should disclose every element of the deal with no stone unturned. Here are some of the things your attorney will need to include when drafting your PPM:
1. Summary: As the name implies, this should be a full overview of the investment
2. Legal Disclosures: These would include your Regulation D 506 filing as well as any other legal disclosures you are obligated to provide to investors for your offering.
3. General Partner(s): The general partners and their responsibilities in the investment must be properly defined.
4. Property: A complete description of the property or properties involved in the offering.
5. Duration: The length or anticipated length of the investment
6. Allocations and Distributions: Extremely important to investors, this section must explain in thorough detail how all cash is distributed to the investors. Make sure this is clearly defined with no grey areas, as they will inevitably come up as a problem if you leave anything too vague.
5. Terms: Here you will find anticipated returns and minimum investment amounts, as well as any other terms or conditions you’ve set for your offering.
6. Risks: Do not shy away from disclosing every imaginable risk with your deal. When drafting a PPM, of the utmost priority is making sure you are abiding by the law, and you are obligated to disclose all risks, but it’s more than just that.
Proper investors understand that investments include risk and will be skeptical if you try to paint a picture of rainbows and butterflies with no risk whatsoever. On the contrary, you’ll find that when you have good offerings and you’re extremely transparent about the risks, you’ll endear yourself to your investors.
7. General Partner’s Fees or Compensation: Your compensation as the general partner needs to be clearly spelled out and investors will be looking out for this. Include any syndication fees you may be charging for acting as the operating partner of the offering.
8. Transferability: You must decide whether your investors will have the option to sell their shares prior to the investment term.
9. Storage of Funds: You must disclose where funds will be stored to your investors.
This is up to the individual investor and the answer can vary based on your experience level. It typically takes a little under a month for an attorney to properly prepare a PPM.
If you are operating under a tight timeframe, it may be tempting to have your attorney begin drafting a PPM immediately upon an accepted LOI. The risk here is that drafting a PPM can be expensive, costing up to $10,000 or more depending on the complexity of the deal.
Please remember that securities law is extremely complex and it is in your best interest to seek out a dedicated securities attorney, even if that might be a bit more expensive than a jack-of-all-trades attorney with less experience dealing in securities.
Once you have a generic PPM drafted, you can re-use it for future deals by swapping out the sections that are specific to the individual deal. That way you can conduct your due diligence thoroughly and delay having your attorney finalize the deal specific content until you have fully vetted the property.
