Question: Do members of a real estate syndicate need to be accredited investors?
Answer: Sometimes, yes.
The short answer is: the syndicate only needs to be made up of accredited investors when the syndicate produces a security risk. To understand when this occurs, a brief overview of syndication and securities law is needed.
Syndicators of real estate
Syndication is the activity of a syndicator bringing together a group of investors to fund the purchase of a property in a form of co-ownership, such as:
- a limited liability company (LLC);
- tenants in common (TIC);
- a limited partnership; or
- a general partnership.
This property is usually an income-producing property, like a commercial or multi-family project. Unlike a real estate investment trust (REIT), syndicators oversee property management during ownership and participate in the resale of the property.
The syndicator is a broker who manages and oversees the acquisition of the income-producing property. This individual has an agency duty to:
- conduct a due diligence investigation into the property; and
- inform each prospective investor of all aspects of the property and the investment program so they can make informed decisions on whether or not to contribute funds for its acquisition. [See RPI Form 185]
The syndicator names themselves as the manager of the LLC, finds investors and assigns membership to the LLC by preparing:
- an investment circular (IC);
- a subscription agreement;
- the LLC-1 (Articles of Organization); and
- the LLC operating agreement. [See RPI Form 371; 372]
Investors have the right to terminate the syndicator by a vote of the co-owners. The investors purchased the property — not the management. [Fargo Partners v. Dain Corp. (8th Cir. 1976) 540 F2d 912]
Avoid security risks
To avoid inadvertent creation of a security, syndicators need to have knowledge about state and federal securities law.
Broadly, a security is an asset sold with the promise of future financial return. In the case of real estate syndication, to be a security, the investment program sold to the group of investors needs to provide for a return of the original investment based on the promise of:
- future property selection;
- physical development; or
- other change of use for the real estate acquired to be completed before the investment goal is attained.
A securities risk is not produced when the syndicate’s purpose is to purchase and operate an existing income-producing real estate project, or hold land for profit solely from resale.
Further, syndicators do not need to be concerned with securities law when their program meets the requirements of the 35-or-less interrelationship rule for nonpublic offering of a security. This rule applies when:
- the investors do not number more than 35 (spouses counting as one investor);
- all investors have a meaningful, pre-existing business or personal relationship with the syndicator;
- the investors will not resell or distribute the interests they acquire;
- the solicitation of investors does not involved public advertising; and
- the syndicator files a notice of the transactions falling under the exemption with the California Commissioner of Corporations. [Calif. Corporations Code 25102]
Unlicensed syndicators turn to attorneys for advice on forming real estate syndicates, and they are (incorrectly) told they need to locate accredited investors. However, licensed brokers acting as syndicators are aware of the difference between securities and non-securities in real estate investment and thus have no need to obtain accredited investors.
The Securities Act of 1933 requires any offer to sell securities to be registered with the Securities Exchange Commission (SEC).
Registering securities with the SEC can be costly and time consuming. Therefore, syndicators dealing with securities may seek out certain types of investors that allow them to skip the registration process. One such exemption allows a company to sell its un-registered securities to accredited investors. [17 Code of Federal Regulations §230.501]
An accredited investor is a person who has advanced knowledge of financial products and markets, and thus requires less regulatory hand holding than most mom-and-pop investors.
An accredited investor is a natural person who:
- has earned income of at least $200,000 — or a joint income of at least $300,000 if married — in each of the prior two years, and expects to make at least as much in the current year; or
- has a net worth exceeding $1 million, excluding the value of the person’s primary residence. [17 CFR 230.501(a)(5); (6)]
Before the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, a person’s primary residence was counted toward net worth to qualify as an accredited investor. When an investor previously qualified and no longer does due to the primary residence rule, their purchase rights of investments invested in when they previously qualified as accredited investors are grandfathered in. [17 CFR §230.501(a)(5)(ii)]
Accredited investors can also be entities, including:
- savings and loan associations;
- insurance companies;
- investment companies;
- employee benefit plans;
- partnerships; and
- nonprofits. [17 CFR §230.501(a)]
For more information on real estate syndicates, see Forming Real Estate Syndicates, available through the first tuesday Realtipedia.