This article looks into a syndicator’s credentials for selection and management of a property that indicate to an investor the investment opportunity offered is more likely to succeed than fail.

First, be a capable syndicator

A broker must have credentials to engage in the activities of a syndicator. Credentials include the abilities to:

· select suitable property for the right price, on the right terms, at the right time, and in the right location;

· enter into purchase agreements;

· conduct a due diligence investigation and analysis;

· arrange purchase-assist financing;

· determine the proper vesting for title;

· manage the landlord-tenant relationship;

· preserve the property’s value by repair, maintenance, and replacements; and

· account for income, expenses, and mortgage payments.

The composite of these abilities, properly honed, represents an expertise sufficient to cope with the foreseeable challenges presented by the ownership of income-producing real estate. The broker possessing these qualities demonstrates he is qualified to manage a real estate investment program for himself or a group.

Without a background of education, training, and experience in the acquisition, ownership, and disposition of income property, a broker is not fully qualified to lead a group of unsophisticated investors into the co-ownership of income-producing real estate.

The investor’s point of view

To analyze his risk of loss when investing capital, a prudent investor must begin by judging the capabilities and competence of the syndicator. Since success is dictated by property selection, financing, and management, the greater the syndicator’s credentials, experience, and talents, the less the risk of failure.

To see an investment program through to fruition, the syndicator must have an evident sense of purpose, i.e., a consistency of behavior, determination, and focus. Without a showing of his finely honed competence for buying, owning, and selling real estate over a long period of time, solicited investors will instinctively be put off by a syndicator’s lack of experience. They will sense the existence of an increased risk of losing capital due to the syndicator’s lack of drive, dedication, and experience.

A syndicator must be able to present himself as a manager able to see his way through the difficult stages of an investment and emerge successful at the end of the process, in spite of local economic upheavals that will cyclically beset the property.

Experience selling income properties, either on behalf of an owner or when acting as a principal, is evidence the syndicator understands the challenge of selling property. Operating a property month after month, then selling it during the short window of maximum liquidity for a resale opportunity in a real estate business cycle is a difficult task.

In application, the price paid for a property becomes the initial indicator as to whether a profit will likely be realized on its resale. Further, the terms for payment of that price — the financing — must reflect the local economy’s future stress on rental income and cash flow from the property, all of which affect the ability to retain ownership.

The timing of a purchase is best understood by a syndicator who has gone through at least one full real estate business cycle — from bust to boom and back. This provides a personal grasp of the difference between the concept of historical equilibrium trends in property values and the reality of price movement during a business cycle, with its excessive rise and fall in real estate prices.

Selecting the correct phase of a business cycle — preferably the end of the recessionary phase after a bust — as the time to select and buy property to assure a profit on its resale is an absolute necessity for getting an advantageous price.

However, few buyers are willing or able to acquire property at any price during recessionary lulls in the real estate resale market. Thus, the syndicator, by choice, is a “market maker” of sorts. He prudently goes into the market to buy at a time when few others are willing and able to compete. To do so, he creates a buyer in the form of himself and a limited liablity company (LLC) full of cash investors, none of whom would likely themselves be willing buyers as individuals in or at the end of a recession.

Thus, a syndicator promotes the acquisition of property in a market following the height of foreclosure and real estate owned (REO) action where few sales exist and when speculating buyers are sparse. In timing acquisitions for long-term investment, the syndicator must take advantage of the temporary (cyclical) dearth of buyers in the marketplace at the time sales volume begins to increase (based on fundamentals, not speculator activity) but before prices start to pick up. This is typically a 12-to-18 month window period and occurs long after the current cycle’s recession has been declared as ended.

During a well-developed buyer’s market of greatly reduced sales volume and the second off-loading of properties held by speculators, the syndicator is better able to negotiate a price and terms for its payment that will help insulate against the risk of a loss of invested capital.

By taking advantage of market prices that drop below the equilibrium trend, a built-in profit is realized the instant the period of ownership moves into the recovery phase of the business cycle. Prices then begin to rise, a trajectory pushed upward ever faster by the recovering demand fueled by increasing numbers of “fair weather” investors and the ever-recurring flow of first-time speculators.

A local track record of achievements

The personal achievements of a syndicator also lend credence to his syndication efforts. Investors sense a greater probability of success in an investment selected and managed by an accomplished individual — one with power — when his credentials include:

· at least three years’ experience as a property manager, operating his own income properties or properties on behalf of others;

· at least three years’ experience as an appraiser or as a broker providing opinions on value;

· creditworthiness sufficient to qualify for loans himself without relying on a co-signer or guarantor;

· cash reserves for emergencies, not for investment;

· accumulated wealth, preferably in the form of equities in real estate;

· community service, such as involvement in civic affairs — social and political;

· longevity as a resident in the community;

· higher education and studies in real estate and business;

· licensing in related trades, such as construction, appraisal, real estate, lending, etc.;

· personal accomplishments of merit; and

· existing income from sources other than up-front fees for the current syndication of property.

Risk avoidance for equity investors

The primary financial purpose for the syndication of a property by a broker is to raise funds from passive investors for the down payment on the purchase of property that the broker will co-own with the investors. Thus, as the syndicator, the broker’s fractional ownership interest in the property is l00% financed by mortgage money from a lender and equity capital provided by investors.

The syndicator’s claim on the property’s income and profits for his fractional ownership interest is junior only to the mortgage financing encumbering the property (as are the investors’ ownership interests) if the syndicator’s percentage of ownership participation is not subordinated to the ownership interests held by the investors, called parity participation.

However, without subordination of the syndicator’s co-ownership interest to those claims on income held by the investors, the dollar value of the investors’ percentage of ownership on closing will be less than the down payment they have funded to acquire the property, a condition called watered stock.

Accordingly, the fractional ownership interests acquired by most syndicators are, as a matter of practice, subordinated and junior to both:

· the mortgage financing (the first claim on the property’s value); and

· the equity financing provided by the cash investors (the second claim on the property’s value).

The syndicator whose fractional ownership interest in an LLC is a Class B subordinated ownership interest (the third claim on value) has financed the acquisition of his ownership interest through mortgage financing (lender) and equity financing (passive investors). This arrangement constitutes “double leverage” and provides 100% financing of his ownership interest.

From the income aspect, the syndicator’s ownership claims dissipate the earning power of the investors’ cash contributions, whether or not his ownership interest is subordinated.

Apart from earnings, the investors’ risk of loss of their investment is analyzed based on the distinction between parity or the subordination of his co-owners’ interests.

For example, investors typically are asked to put up at least 100% of the cash (equity financing) needed to acquire the property. When doing so, they agree to the “watering down” of their share participation in any future increase in the property value. They agree to receive less than 100% of the property’s future increase in value in exchange for distributions of spendable income and net proceeds of refinancing or a sale that has priority to the syndicator’s claims.

Thus, the investors dilute the earning power of their cash by sharing future growth with a non-cash investor, the syndicator, but do not increase their risk of loss or create a moral hazard by doing so.

Further, due to the dilution of the investors’ earning power, the syndicator on a resale of the property receives the first profits resulting from an increase in the property’s value over the price originally paid to acquire the property. The amount of this initial distribution of profits to the syndicator is limited to the dollar value given to his Class B interest. When subordinated to investor claims on profits, distribution to the syndicator from sales proceeds is based solely on an increase in property value.

Depreciation and book value (adjusted cost basis) of the asset only plays a role in tax reporting, not the sharing of spendable income or net proceeds of refinance or resale.

Conversely, the priority return of the investors’ cash contributions is distributed based on the price paid for the property, before considering any increase in the property’s value. Also, any minimum annual yield owed to the cash investors, which may have accumulated unpaid due to deficient spendable income in the past, has priority over any disbursement of sales proceeds to the syndicator.

After the initial pay out of net sales proceeds to Class A and Class B members to return their capital contributions with an annual minimum rate of return, any remaining sales proceeds are typically shared by all members on a pro rata basis — share and share alike. Thus, a Class A member’s participation in the remaining profits is again diluted by the ratio of sharing between Class A and

Class B members.

While Class A members are assured a priority return of their cash and a minimum annual return, to avoid the moral risk created by parity sharing, the syndicator, through his Class B ownership, imposes a dilution of the participation by the Class A members in profits on the sale — the trade-off investors make to enjoy a flow of income and full return of their cash contributions before the syndicator participates as a co-owner.

Funding the purchase

Equity financing provided by cash investors, like mortgage financing, is meant primarily to fund the purchase of property, not to compensate the syndicator for his time and effort spent contracting to acquire the property. Thus, equity financing is not generally considered a primary or major source of funds to compensate the syndicator for his acquisition activities. He receives an ownership participation for these pre-syndication efforts.

If the syndicator is to remain solvent, he needs to be reimbursed for all of his out-of-pocket expenditures related to the purchase of the property. Further, he needs to receive a reasonable fee for the organizational time and effort spent performing syndication activities, such as preparing the investment circular, soliciting investors, and forming the LLC.

Also, the syndicator’s time and effort spent locating the property, entering into a purchase agreement, conducting the due diligence investigation, arranging for the assumption or origination of purchase-assist loans, and opening and closing escrow relates to the acquisition of the property. These real estate-related transactional activities warrant the receipt of consideration (a percentage of ownership) separate from the fee paid to the syndicator for services rendered to form the LLC and organize the investors.

Analyzing the risk of loss

Basic market factors common to all real estate transactions pose risks of loss no matter who owns the property or whether it is a single family residence, income property, or vacant land. Commonly acknowledged risks of ownership, understood by even the most ill-informed investor, include:

· the purchase price;

· the down payment;

· mortgage financing;

· costs of ownership;

· the property’s location;

· occupancy and rent;

· the maintenance of the property; and

· recovery of cash on a resale.

To provide a “comfort zone” sufficient for prospective investors to look further into the attractiveness of a syndicator’s investment program, the syndicator must adequately address each of these market-related risk factors. His analysis of these risks must neutralize an investor’s initial fear of loss common to most individuals who consider a major financial move.

These market risks are the latent economic concerns of any investor. If not addressed by the syndicator, the typical candidate for group investment is probably unable or unwilling to ask questions on his own about real estate. Thus, an investor’s gut reaction toward the investment will remain apprehensive, most likely barring a commitment to contribute as a co-owner.

Justifying the price and down payment

The first marketplace question that comes to the mind of every investor is whether the purchase price to be paid for the property is a proper amount. The syndicator must justify the price as below-market if he is to entice investors to look further into the investment’s profitability on a resale. An appraisal by a credentialed and licensed fee appraiser stating the property’s value at a dollar amount greater than the price the syndicator has agreed to pay for the property is a huge advantage.

Logical explanations as to why a seller will accept a below-market price include:

the lack of a brokerage fee (typically 6%) on the transaction;

a price based on earlier sales at lesser prices; or

a price reduction that was vigorously pursued by the syndicator through offers, counteroffers, and inducements of a substantial down payment or cooperation in meeting the seller’s tax exemption goals.

A direct comparison by the syndicator (or the appraiser) to a recent sale on similar terms of a closely comparable property located in the immediate vicinity of the syndicated property provides evidence of good value in the syndicated property.

Since nearly all of the cash funds contributed by investors are going towards the down payment, an investor’s instinct to avoid being “ripped off” is satisfied. The remainder of the cash funds,  after distributing a small cash amount to the syndicator for LLC organizational efforts and costs, are held as reserve funds. This way the investor reduces his innate concern about creating a moral risk of a loss by a diversion to the syndicator of funds borrowed or contributed to the investment.

The investor, aware of the percentage of ownership the syndicator is receiving, does not want to also pay the syndicator cash to help him acquire that ownership interest when the syndicator’s percentage of ownership already dilutes the earning power of the downpayment cash contributed by the investor.

Also, the greater the amount of the down payment as a percentage of the price, the less the risk of loss on the investment and the greater the amount of spendable income. Further, a mortgage lender originating a loan with a lower loan-to-value ratio offers better rates and payment schedules since the lender can reduce his risk premium in the interest rate.

Recovery of contribution on resale

After a syndicator confirms that the present worth of the property is equal or greater than the investor’s cash savings being transferred to the  real estate investment (and the mortgage amount), the investor needs assurance that the funds will be recovered on a sale of the property. Thus, it must appear to the investor that market trends will support the original cash investment and likely result in an increase in its value over the long term.

Clearly, a syndicator can offer his opinion of value, his expectations about future market trends, movements in property values, and the presence of future buyers willing to purchase the property, as long as he has a reasonable basis for his opinion.

Documentation showing the direction of sales volume and prices of comparable properties during the six-month period preceding the purchase will help demonstrate whether prices are rising, dropping, or flat. Given the constant recurrence of business cycles and their effect on the volatility of real estate sales and prices, the syndicator can rationally demonstrate what he believes will occur regarding an increase or decrease in the future willingness of buyers to buy and the likelihood of a respective rise or fall in prices and rents.

It is necessary to remind investors that inherent in the nature of a successful real estate investment is long-term ownership. To cash out on a resale, they must await a peak in prices during a business cycle — hopefully accompanied by a handsome profit for having acquired the property at the right price.

It takes time to reap the benefits of the monetary inflation inherent in the hedge provided by ownership of real estate and to take additional profits from value increases due to property appreciation brought about by growth in the local population and their wages. These national monetary policies (inflation) and local demographic trends (population) drive up rental income over the period of a business cycle. With rising rents, the value of the property increases by a corresponding percentage if the capitalization rate for setting property values remains the same and operating costs do not rise faster than the rate of inflation.

An investor’s fear of loss is probably best alleviated if the price paid for the property is less than the fair market value by at least the amount of the brokerage fees avoided on the purchase. The logic is that the property, if resold today for its fair market value, was purchased at a price that would generate net sales proceeds sufficient to return all the investors’ funds — after payment of a full brokerage fee.

Purchase-assist mortgage financing

When an investor is solicited by a syndicator to participate in a real estate investment, the investor automatically reflects on what he has come to believe is helpful or harmful in a mortgage. Thus, investors are fairly comfortable talking about interest rates on real estate loans (fixed or variable) and the merits of a future refinance. An investor’s background experience with mortgages aids in

persuading him to subscribe to an investment, as long as the syndicator explains why the rate of interest he has agreed to for purchase-assist financing is good for the investor’s future ownership.

Investors need to be advised on aspects of the purchase-assist financing, including:

· why a loan was arranged with a particular lender;

· what fees, charges, and yield spread premium the syndicator was able to avoid by negotiating the loan directly with the lender at the par rate; and

· that the 2-4% in loan brokerage fees, points, discounts, and yield spreads accompanying most other mortgage originations was avoided.

If the interest rate is above par rates at the time of origination, the spendable income will be less than it would have been had the loan rate been at par — a huge unnecessary shift in wealth to lenders and loan brokers.

When unnecessary loan fees, charges, and yield spread premiums are paid to a mortgage loan broker to negotiate the loan in lieu of direct lender negotiations by the syndicator, the amounts of both the debt underlying the down payment and the cash disbursed to others outside the investment group are greater than they should be. Here, the earning power of the invested cash is diluted and the risk of loss is greater than it needs to be.

The mortgage financing arranged for the purchase is either a fixed rate mortgage (FRM) or an adjustable rate mortgage (ARM). Whichever it is, the rate must be no greater than the current rate charged by lenders in the national secondary mortgage market.

Property values (prices) are inextricably and conversely tied to interest rates on mortgages. As marketplace mortgage rates rise or fall, the market value of all real estate moves in the opposite direction, comparable in effect to rates and pricing in the bond market, but with a delay due to the stickiness of seller pricing.

Further, the type of interest rate (FRM or ARM) selected to help finance the acquisition has an impact on:

· the future worth of a property;

· the amount of spendable income remaining after monthly loan payments; and

· the ability to retain ownership.

A participating investor should be informed that when rates for purchase-assist mortgages and assumed loans increase, the pace of sales slows and the price paid for property declines.

Fixed rate mortgages

As real estate prices trend downward due to a rise in fixed rates on purchase-assist loans, lenders and sellers duel in a trade-off for the dollars paid by the buyer, initially and monthly, to own the property. As interest rates rise, prospective investors acquiring income-producing property insist on an increased rate of return (cap rate) on their cash invested in the property, after payment of operating costs and interest on the mortgage. Cash becomes king.

Operating expenses are difficult for management to reduce and rents are unlikely to be substantially raised on acquisition of a property. Also, older investors will not likely invest in an income-producing property without an annual cash return (from spendable income). Thus, the investors’ annual cash-on-cash return requirements are met from the net operating income (NOI) remaining after payments on the mortgage — spendable income.

When market interest rates increase for new fixed rate loans, a reduction takes place in the amount of mortgage money the property can carry, thus the amount a syndicator can borrow to finance its purchase is also reduced. Mortgage loan amounts are based on the NOI available from a property to service interest and principal payments. The resulting loan amount (lower as interest rates rise), plus the down payment, establishes the maximum price a prudent investor (syndicator) pays for a property, not the price prayed for by the seller as the listing price.

Thus, mortgage lenders, over time, charge higher rates to earn more money while the seller’s property loses value in a compensating amount. The lost property value represents the present worth of the increase in the real rate of interest earned by the lender. Thus, a shift in wealth from the seller to the lender occurs during periods of rising rates — if the seller chooses to sell.

Prospective investors, on the other hand, will experience no short- term benefits from the reduced price and no harm from the increased interest rates they pay. The price paid is the equalizer for the buyer.

Consider the fact that investors cannot lower (and the seller cannot raise) the price paid to the seller for the property once the purchase escrow has closed. Further, the lender funding a fixed-rate loan cannot increase the principal balance or the rate of interest agreed to by the investors. However, the investors can refinance in the future and reduce the rate of interest on their mortgage financing, often dramatically.

On refinancing the original purchase-assist loan in future years at lower rates, the spendable income generated by the investment will increase. The increase will equal the difference between payments on the old loan and payments on the new loan. Thus, a windfall of additional spendable income occurs. Also, the value of the investment is strengthened since the risk of loss inherent in any future decrease in rent or increase in operating costs is reduced by advantageous refinancing. 

Adjustable rate mortgages

An ARM loan used to finance a syndicated property complicates the syndicator’s disclosures when reviewing the adverse effects of ARM mortgage financing. The syndicator needs to demonstrate that the ARM loan was selected because the note rate on the ARM, while variable, will most likely decline in the future.

The ARM note rate is different from and always greater than the initial qualifying or teaser rate. Thus, by taking on an ARM loan the syndicator is gambling that the note rate will drift lower rather than higher. However, it is an unlikely economic scenario that allows rents to rise and cover increasing payment of ARM rates since short-term interest rates are rising at the same time.

An ARM loan is tied to an index of short-term loan rates, not long-term mortgage rates. High, short-term consumer rates are set by the U.S. central bank (federal reserve) to fight inflation. In doing so, the bank causes ARM rates to rise and the domestic economy to slow, placing it in an informal recession — a business slow down. Conversely, a drop in short-term rates allows the economy to pick up (through more employment to increase production of goods and services), which in turn generates more real estate sales (and tenants).

As short-term rates drop, a decline in ARM rates follows, eventually reducing the dollar amount of monthly ARM payments and producing more spendable income (or reducing the negative cash flow).

Also, sales volume increases to re-commence price increases, all triggered by lowering short-term rates to or below inflation rates.

When ARM financing is employed to fund the purchase of property, the ARM will eventually need to be refinanced, replaced with a lower fixed-rate loan for the duration of the group ownership. Any investor who grasps the math of the future buildup in a property’s value and the increase in spendable income over years of ownership under a fixed-rate loan can handle the math of these loan arrangements.

Analysis of operating costs

Operating costs incurred during the ownership of a property are generally not of concern to the typical passive investor in syndication. No formulas, rules of thumb, or guidance exist for syndicate investors to use to make a quick analysis of value — just look at pricing in the real estate investment trust (REIT) market. Further complicating an analysis of operating costs, each property is unique.

Also, expenses for repair, maintenance, and general care of a property vary hugely from property to property due to causes that are better understood by first preparing a structural engineer’s report or a due diligence investigation of the property.

However, if operating costs are temporarily increased to cure deferred maintenance and accumulated obsolescence or amenities, these costs are suddenly a subject of great positive interest to investors. They are a benefit to investors. The end result is increased value due to the one-time event called sweat equity, and more spendable income due to a one-shot increase in rental income.

A temporary increase in costs to cure deferred maintenance on the property, increase or upgrade security for the tenants, or add facilities and amenities to keep and attract a better class of tenants generates increased rents. In addition to reducing the investors’ risk of loss, these activities tend to increase the NOI and thus the spendable income distributions they will receive. Without a change in capitalization rates, the property’s value will increase by the same percentage as the increase in NOI, the sweat equity.

Rents occasionally are below-market and can be raised without significant cost. A reasonable plan for executing any rent increases proposed in the investment circular needs to be prepared and presented to the investors.

A detailed plan is especially necessary if scheduled income is forecast based on rents that are anticipated to be greater than the rents tenants now pay. Some units will be on leases with rents that cannot be altered until expiration of the leases, thus interfering with the timing of the increases.

Others are under rental agreements or expired leases that allow for increases after service of appropriate 30- or 60-day notices.

A timetable on a spreadsheet needs to be prepared and presented to the investors. It should list each unit, when and how much each tenant now pays in rent, and the rent amount he will be required to pay in the future.

Distributions based on priority returns

Consider a syndicator who, on entering into a purchase agreement and confirming the property’s suitability, places a dollar value of $100,000 on the assignment of his purchase rights to the LLC.

The valuation of a syndicator’s assignment often represents roughly 6% of the present fair market value of the property, a brokerage fee in any other sale of the property. If he were to sell his contract right to purchase the property to another buyer, that buyer should be willing to pay $100,000 for the syndicator’s position, in addition to paying the price the seller has agreed to in the purchase agreement.

The price paid under the purchase agreement calls for a down payment of $250,000, approximately 17% of the purchase price. The syndicator intends to fund the down payment by raising $60,000 from each of five investors, a total of $300,000 in cash. The $50,000 in surplus cash will provide funds for a $10,000 fee to be paid to the syndicator as compensation for organizing the investment group and $40,000 to be held by the LLC as cash reserves and additional working capital.

The syndicator will not be paid cash for assigning his contract rights under the purchase agreement to acquire the property. Instead, he will receive a $100,000 Class B interest in the LLC as a co-owner with the cash investors (class A members).

Thus, the combined amount of all capital contributions ($400,000), comprising the cash raised from the investors ($300,000) and the value set for the assignment of the syndicator’s purchase rights ($100,000), becomes 100% of the capital contributions. Each co-owner’s percentage share of earnings from rents and sale of the property is initially set as the percentage their contribution represents of the total dollar amount of all forms of contributions made by all co-owners, class A and class B.

Thus, the investors will collectively hold a 75% co-ownership interest in the LLC as class A members for their $300,000 cash investment. The syndicator will hold a 25% co-ownership interest as a class B member for his contribution of his right to buy the property.

However, cash investors do not typically consider the syndicator’s contribution of his purchase rights as equivalent to their hard-earned (after-tax) cash contributions. Investors consider a syndicator’s efforts as promotional, illiquid, and untaxed since his interest has not been reduced to cash by a resale of the property.

Unless restrictions and limitations are imposed on the syndicator’s share, all members will share earnings from spendable income and the proceeds of a sale (or refinance) equally, a parity distribution of funds.

Parity (equality) among all co-owners places the cash investors and the syndicator on equal footing. Thus, the investors’ funds are in eminent danger of a partial loss if the property does not resell for a price exceeding 10% more than the price the group paid for the property.

When sharing spendable income and sale proceeds, priority for the claim of cash investors as Class A members over the syndicator’s claims as a Class B member must be a condition of the sharing arrangements. If not, it is unlikely the syndicator will attract investors since they may doubt the likelihood their cash investment will be returned.

Front-end earnings for the syndicator’s sake

Arguably, a syndicator’s assignment of his contract right to purchase the property has a present cash value equal to the dollar amount of the membership interest he will receive in exchange. Typically, the valuation of the syndicator’s ownership interest is either:

· equal to a cash commission a listing broker would have received on a sale of the property; or

· the difference between the reasonable fair market value of the property and the lesser price paid for the property.

In either case, why should the syndicator’s percentage share ownership be on a subordinated basis to the cash investors, and not on a “share and share alike” arrangement for distributions of all earnings?

The answer lies in moral risk: instinctively, investors hold feelings that the syndicator’s participation on a parity basis (or worse yet a full commission as their agent) leaves the syndicator with significantly reduced incentives to properly structure the acquisition and manage the property than had he not received cash up front. Instead, he should receive a fully subordinated share of earnings.

If the syndicator receives an ownership interest with a participation in earnings equal to the cash investors’ earnings, he has less motivation to:

· make the best selection of property and acquire it on the most advantageous financial terms;

· pay constant attention to the management of the property and tenants; and

· pick the right time to sell the property at the maximum market value.

To shift the risk of loss posed by the potential failure of the syndicator’s motivation, the syndicator’s interest must be subordinated to eliminate the equal treatment of parity distributions. When subordinated, the syndicator first shoulders the risk of loss if the property does not live up to his cash flow expectations.

Also, the value he claims his Class B membership is worth will not be achieved on a resale if the property does not increase in value. When the syndicator acts to protect the value of his Class B interest in the investment, his own self-interest automatically provides protection for the financial interests of the investors in the property as well.

However, the investors’ payment of a cash fee to the syndicator in a small amount on acquisition of the property is appropriate. It is fair to assume a syndicator who does not “sell the property” to the group he forms, but seeks investors to “join with him” to jointly own the property, has an operating overhead and personal expenses.

A real estate broker in the business of creating investment groups to acquire property in which he takes an ownership position will soon be out of cash reserves unless he generates cash income during his first three or four years syndicating properties. Services rendered in organizational efforts to form a group are separate from the efforts involved locating property, negotiating the purchase contract, and arranging to close escrow. Thus, the syndicator logically merits a cash fee for the organizational services rendered to the LLC and investors prior to closing.

Distribution during ownership

The payment of management fees to a syndicator for managing the leasing, ongoing care and maintenance of the property, and rendering the services commonly expected by tenants is a diversion of a portion of the rental income to the syndicator. However, it is a necessary and proper one, comparable to the payment of other operating expenses. A third-party broker with expertise in property management would otherwise be employed to manage the operations of the property, and a fee would be paid.

In order for the syndicator who manages the property to legitimize the amount of his fee, he must show it is fair and reasonable. Justification is needed since he has literally hired himself to manage his property and will receive a fee for doing so.

Further, the payment of a management fee before a return is distributed to investors has economic justification. The cost of supplies, labor, and management are paid from income (rents) as expenses of ownership before funds remain for disbursement to the co-owners as spendable income (a return of capital, dividends, etc.).

As further justification, the syndicator receiving a management fee does not receive any portion of the spendable income until the co-owners have first received a minimum annual rate of return on their invested capital. Only if distributable funds then remain can the syndicator share as a subordinated co-owner.

Typically, the minimum rate for the investor’s annual yield is cumulative. If spendable income is not available for disbursement in the full amount of the minimum annual rate of return on investment, the unpaid amount accumulates. The unpaid accumulation will receive priority disbursement in later years when funds from any source become available for distribution.

After spendable income has been disbursed at the minimum rate of return to both the priority (class A) and subordinated (class B) co-owners, any spendable income then remaining is distributed on a parity basis between all co-owners, class A and B, without concern for priorities.

Occasionally, a ceiling rate of return is set for total annual participation in the spendable income by cash investors (Class A members). When a ceiling exists on earnings that limits their annual return from rents, the balance of spendable income is distributed to the syndicator under his Class B membership (not as a management fee).

The nature of the cash investors’ class A participation is similar to the ownership of cumulative preferred stock issued by a corporate entity. The investors receive an annual rate of return. Any remaining earnings go to the common stockholders, represented here by the syndicator’s subordinated class B ownership interest. Further, the syndicator’s rights are often coupled with buy-out provisions containing options to acquire the member’s interests or the property.

When the equity in a property is cashed out, in part or entirely, by a refinance or sale of the property, the net proceeds represent a return of capital to the co-owners. Funds from a refinance or sale are not operating income generated from rents. Again, any fees paid to a syndicator acting as a loan broker in arranging a refinance or further encumbrancing of the property, or negotiating the sale as a broker, is a proper diversion of proceeds that initially belong to all co-owners.

As always, a fee received by the syndicator must be justified as both necessary and reasonable in amount. Here, the nature of the brokerage services provided must be shown as necessary in the operation of the property, and that the amount of the fee is competitive and comparable to fees charged by brokers who provide the same service in the local market.

The net proceeds from a refinance or a sale, being a return of capital, are first disbursed to the cash investors as a priority. The cash investors receive an amount equal to their original cash investment, plus a minimum annual rate of return, less any amounts previously disbursed to them from any source, such as spendable income or the net proceeds of a prior refinance or sale of a portion of the property.

Any proceeds then remaining from the financing or sale of the property after the priority distributions to the cash investors are next disbursed to the syndicator. He receives:

· the dollar amount set as the value of his Class B co-ownership interest that he received in exchange for the assignment of his purchase rights; plus

· his minimum annual rate of return; less

· any amounts disbursed to him as a co-owner (not for service as a manager) from spendable income and net proceeds of a prior refinance or sale of a portion of the property.

After all priority and subordinated co-owners have received a return of their original investment and the minimum annual floor rate of return on that investment, the remaining net proceeds are distributed to all co-owners on a parity basis, usually based on their percentage of ownership.

However, members may agree to a different ratio for sharing the remaining funds between Class A and Class B members, for example, 50% to Class A members and 50% to Class B members.

Occasionally, the parity claims of the investors are limited to their original investment and a maximum annual rate of return from all sources. Thus, the syndicator receives all sales proceeds remaining in excess of this maximum-ceiling annual rate of return for the cash investors.