Syndication is the act of bringing together in co-ownership a group of investors to fund the purchase, operations, and eventual resale of an income-producing property. Syndicated co-ownership is most effectively accomplished when structured as a limited liability company (LLC).
The real estate broker who negotiates the acquisition of the property and organizes the group is known as the syndicator or manager. The broker also performs property management services during the group’s ownership of the property, and handles the resale of the property.
When a broker decides to solicit investors and form an LLC to acquire and operate an income-producing property, they need to consider the following steps:
- Research available rental properties, then select one and investigate its physical condition, operating income and expense data, environmental and natural hazards of its location, title conditions, personal security and economic risks. [See first tuesday Form 185, 279, 304, 314, 321, 324 and 352]
- Contract to purchase the property and open escrow naming the syndicator, not an entity (LLC), as the buyer. Prior to closing and after the LLC has been formed, assign the right to buy the property to the LLC. [See first tuesday Form 159, 161, 161-1 and 401]
- Prepare the investment circular (IC), subscription agreement, LLC-1 (Articles of Organization) and LLC operating agreement along with their exhibits and addenda. Name the syndicator as manager of the LLC. Deliver copies of the IC to prospective investors to solicit them to become members and fund the LLC to acquire the property. [See first tuesday Form 371 and 372]
- Enter into a property management agreement to employ the syndicator to manage the day-to-day operations of the property. [See first tuesday Form 590]
- Close the purchase escrow, funding the purchase price and related acquisition costs from cash contributions received from the investor-members of the LLC and any mortgage financing. Take possession of the property and send copies of all closing documents to each member of the LLC.
- Operate the property on behalf of the LLC during the LLC’s ownership of the property and distribute earnings to the members.
For syndication purposes, real estate is initially separated into five basic categories:
- existing residential and nonresidential income-producing properties, called existing rental property;
- yet-to-be-built construction and subdivision projects;
- pre-builder developable land to hold for profit on resale;
- agricultural land; and
- remotely located land with no present economic use.
An existing income-producing property is the most prudent category of property for real estate investment groups to acquire and operate for income and profit. The benefits derived from the co-ownership of existing income-producing rental property include:
- an initial capital investment without the expectation of future additional contributions;
- minimal involvement by each individual investor;
- equity buildup due to amortization of the mortgage principal through monthly payments made from rental income;
- spendable income from operations distributed periodically;
- an increase in value resulting from consumer price inflation and asset appreciation; and
- tax benefits provided by depreciation deductions for annual capital recovery from rental income, and reinvestment on a sale of the property.
The other four categories of real estate investment properties do not offer these advantages.
Group investments in construction projects and agricultural or business opportunities contain additional inherent risks of loss for investors, classified as corporate securities risks. These “quasi-real estate” investment programs require the expertise of the manager in an ongoing business-related service or trade operated on a parcel of real estate. The manager, or others, promise to create value for the co-owners after acquisition of an interest in real estate through development, managing resale of inventory or the husbandry and sale of crops before a return on (or of) the investment can be expected.
However, the co-ownership and operation of an existing rental property, identified and brought to the attention of the investor before their release of funds to the syndicator, does not contain corporate securities risks. The investors in a rental property receive, through the LLC, a beneficial ownership interest in land and existing improvements with no further improvements or other value-adding changes promised by the syndicator. The asset they acquire as a group provides them with full present value for their contributions at the time of closing — the moment their funds are first placed at risk of loss.
Further, rental property acquired with a down payment sufficient in size to give rise to spendable income can be held without the foreseeable need of additional capital contributions. The risk that co-investors might default on future periodic advances needed to maintain ownership is mostly eliminated by buying a “net cash flow” property.
To control a property for purchase without an unconditional commitment to buy, the syndicator has a variety of contract situations to choose from, including:
- a purchase agreement with boilerplate contingency provisions;
- an option to purchase the property; or
- escrow instructions with contingencies, without first entering into an underlying purchase agreement or option to purchase.
A contingency provision in a purchase agreement identifies a condition that needs to be satisfied or waived by the syndicator for the agreement to become enforceable by the seller. If the condition is not satisfied, the syndicator may cancel the agreement and avoid any obligation to purchase the property.
Contingency provisions addressing conditions requiring the syndicator’s approval (or cancellation of the purchase agreement) need to include, among others:
- the condition of the property improvements;
- rental income and operating expenses;
- financing arrangements;
- title information; and
- environmental and natural hazards due to the property’s location. [See first tuesday Forms 279 and 159 §11]
Further, a prudent syndicator includes a contingency provision in an addendum to the purchase agreement allowing them to cancel and avoid buying the property if they are unable to fully subscribe an LLC investment program to fund the acquisition of the property. [See first tuesday Form 376]
Occasionally, negotiations with a seller, either oral or through the use of a Letter of Intent (LOI), do not evolve into a signed purchase agreement, but often result in a non-binding meeting of the minds. Here, escrow instructions are entered into in lieu of first entering into an option or purchase agreement. However, instructions need to include contingency provisions necessary to protect the syndicator by allowing cancellation if conditions are not met.
As the initial buyer, the syndicator needs to also include in all purchase agreements entered into a vesting provision allowing them to assign their rights under the purchase agreement to the LLC. The right to assign requires the seller’s cooperation to deed the property directly into the LLC vesting. [See first tuesday Form 159 §10.6]
Initially, the syndicator enters into a purchase agreement only if it does not commit them to the unconditional purchase of the property. Only after the syndicator has fully investigated the property and is satisfied with the condition of the improvements and nature of operating income and expenses, etc., will they be willing to unconditionally commit to the purchase of the property.
For permission to conduct a due diligence review, syndicators often use a non-binding LOI. An LOI is used by the syndicator, before making an offer to purchase a property, to request the seller provide information necessary for the syndicator to complete their due diligence investigation and determine the property’s suitability for syndication. However, an LOI provides no contractual control over the property or the price to be paid (or demands for further property information) if the syndicator decides to buy on completion of their property evaluation. [See first tuesday Form 185]
After a purchase agreement or escrow is entered into with the seller, the syndicator prepares an IC based on their research into property conditions. The IC is distributed to investors to solicit their membership subscription and contribution of funds for the purchase and joint ownership of the property. [See first tuesday Form 371]
After entering into a purchase agreement to acquire property for syndication, the time period for closing escrow is best scheduled to be 120 days or more. A typical 120-day timetable of events, following the syndicator’s entry into a purchase agreement, option or escrow to acquire an existing income-producing property, is comprised of the following periods of activity:
- First 30 days: The completion of a due diligence investigation of the property and clearance of contingencies regarding the suitability of the property.
- Next 15 days: The completion of the IC with its exhibits, LLC-1 and LLC operating agreement.
- Next 45 days: The solicitation of investors and full subscription of membership in the LLC.
- Remaining 30 days: Extra time, if needed, to fund and close escrow.
If the LLC is not fully subscribed within 45 days after the IC is first presented to investors, it becomes increasingly unlikely the LLC will ever be fully subscribed. Without investors, the syndicator will not be able to close the purchase escrow and acquire the property.
Taxwise, escrow is opened in the name of the syndicator for the same personal tax reason the syndicator makes the offer to purchase in their name: to establish their ownership of property rights created by entering into an agreement to purchase real estate in their name. Before closing, the syndicator will file an LLC-1 with the California Secretary of State and assign their purchase rights in escrow, a tax-free transfer, to the newly formed LLC. [26 United States Code §721]
To accomplish the assignment of the syndicator’s purchase rights to buy the property and the funding by the solicited investors, the syndicator needs to consider opening two separate escrows.
The first escrow is the purchase escrow, in which the syndicator is initially named as the buyer. Prior to closing this purchase escrow, the syndicator’s right to purchase the property is assigned to the LLC. In exchange, the syndicator takes a Class B membership interest with a percentage of co-ownership in the LLC equivalent to the dollar value the syndicator places on their contribution of the assignment. [See first tuesday Form 370]
Thus, the purchase escrow is opened by the syndicator as the buyer individually, but closed by the LLC as the substitute buyer by assignment. Title to the real estate is vested in the LLC on closing.
However, neither the LLC nor the members deposit funds into the purchase escrow until escrow is ready to close and calls for funding. The deposit of investor funds is the function of a second escrow, known as a funding escrow. The sole purpose of the funding escrow is to keep the funds contributed by the LLC members separate from the purchase escrow until the purchase escrow can be closed.
At the time for closing the purchase escrow, escrow is instructed to transfer the funds deposited in the funding escrow to the purchase escrow. The transfer will be made when the purchase escrow can close and vest title to the property in the LLC.
The use of two escrows allows for the unrestricted return of the investors’ contributions in the event any complications interfere with the closing of the purchase escrow. The funds deposited in the funding escrow are at liberty to be returned to investors without the consent of the seller in the purchase escrow.
Alternatively, investors may deposit funds directly into the purchase escrow for the benefit of the LLC if the escrow used will provide for a unilateral return of those funds to the investors in the event the escrow does not close as scheduled.
Escrow may receive funds directly from each investor under a “receipt of third-party deposit” arrangement, stating the conditions for use or return of the funds. The investors are third parties, the seller and the LLC (by assignment from the syndicator) being the contracting principals.
Another arrangement allows the syndicator to hold the investors’ funds is an interest-bearing bank account in the name of the LLC. The account will hold the investors’ funds from the time they are received until they need to be transferred to the purchase escrow at closing.
Typically, a syndicator is not also a cash investor, though they may be.
The dollar value given the Class B membership share the syndicator receives in the LLC for their assignment of property purchase rights is set by the syndicator. The amount set is based on the dollar value the syndicator places on their contract right to purchase the property. In exchange for the assignment of the purchase rights to the LLC, the syndicator receives the set dollar amount of Class B subordinated interest in the LLC. This setting of the dollar sum value of the Class B contribution is a prerequisite to establishing the syndicator’s percentage share of membership.
The cash investors — one of whom could be the syndicator if they also chose to contribute cash — hold Class A memberships. As cash contributors, Class A investors receive a priority distribution of earnings initially limited to an annual percentage return as called for in the LLC operating agreement, and sourced as:
- spendable income from property operations; and
- net proceeds from the refinance or resale of the property. [See first tuesday Form 372]
The spendable income the syndicator receives as their Class B subordinated distribution is the same annual percentage return on the dollar amount of their contribution as the Class A investors receive on theirs.
Any spendable income remaining after initial distributions is next distributed among all the members on a pro rata basis, based on the percentage share they hold in the LLC. This secondary distribution is without concern for priorities or subordination, called a parity distribution.
However, a different ratio of sharing between classes is occasionally established by the syndicator for these parity distributions. For example, the spendable income remaining after priority distributions might be distributed 50% to Class A members and 50% to Class B members.
When the syndicator’s percentage share of excess spendable income is larger than their pro rata ownership, the syndicator has greater incentive to increase the spendable income generated by the operations of the property. This self interest in maximizing spendable income in turn increases the property’s value due to management increasing rental income or reducing operating costs, or both.
Over time, and due to inflationary increases in rents and thus spendable income, these alternative percentages for sharing can shift great future wealth to the syndicator.
Through the syndication of income-producing property, the broker will correspondingly build net worth and receive additional flows of income from fees for management services and distributions of spendable income.
For brokers, syndication is a source of mixed income:
- part of their income will come from the wealth in ownership of fractional interests in real estate; and
- part of their income will come from fees for brokerage services rendered during the co-ownership and on resale.
The broker negotiating the purchase of property and soliciting investors experiences an indirect benefit for holding a CalBRE license granting the right to conduct business as a broker.
In application, the purchase and ownership of real estate by any group of investors involves both the elements of an investment and a common enterprise. Thus, the syndicator’s formation of a group for an investment in real estate has the potential for creating a corporate securities risk.
However, to create a federally defined security when syndicating real estate ownership, the investment program needs to contain a third and critically distinctive element. 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 a promise to perform, by the syndicator or someone else, through future property selection, physical development or other change of use for the real estate acquired, to be completed before the investment goal can be attained.
Conversely, a syndicator’s formation of an investment group to purchase and operate an existing income-producing real estate project, or hold land for profit solely from resale, does not involve a securities risk. Here, the expectation of a return on the investment is based on and limited to the performance of the pre-selected property in the marketplace. Thus, the investment is subject to only the economic conditions and risks that affect the ownership of any parcel of real estate.
An investment group formed to develop real estate or undertake an ongoing resale-marketing program, regardless of the entity or form of vesting chosen for the group, contains securities risks.
Other management activities that occur after closing and create a securities risk include:
- obtaining government approval or permits for zoning or a higher and better use of the property;
- making further improvements or significant capital alterations to the property; or
- operating a business or farming operation that requires expenditures for inventory, production or sales.
Thus, for a security to exist, the syndicator must undertake an ongoing investment activity that continuously places the investor’s capital at risk of loss until the promised value-adding activity is completed. The securities risk is imported into the group investment plan by the management of money, whether obtained from the investors or borrowed funds, to improve the property, create the crop or obtain agency approvals for a new use to fulfill the purpose of the group investment.