You are looking to buy a midsize apartment building, but like so many others in the same situation, you determine that you do not possess the private capital necessary to finance your venture. You will soon realize that real estate investing is a team sport and that the only way you can fund your dream involves pooling together your assets with other investors in a “syndication.” Real estate syndications are a common feature of multi-property real estate projects. While there is no such thing as a “garden-variety” or standard real estate syndication, it is useful to explore how one might work in today’s market, and the necessary steps of how real estate syndicates are created.
Your journey in launching a real estate syndication begins with a sponsor. The sponsor is the person (or persons) who choreographs the multifamily deal by fielding, combining and carefully presenting the assets of multiple investors like yourself. To the sponsor, their syndication takes on an almost life-like quality, and like a child, the syndication will either (a) remain passive, or (b) command every second of his attention and keep them up at night.
Naturally, creating a real estate syndication is a complex and lengthy process, but it can be broken down into a few stages. The first task facing the sponsor is identifying a great deal. To do this, the sponsor must carefully research their local market and network with many key players including brokers, lenders, investors, property managers, appraisers, attorneys, and accountants. Then, the sponsor must sort through over a hundred deals, underwrite and analyze the financials, make a Data-Driven Commerical Real Estate Multifamily Investment Decision on each property, and submit dozens of offers before one may be accepted. To complete the acquisitions process, the sponsor must draft a letter of intent, negotiate the purchase contract, and then get the seller to sign the draft agreement.
Although the acquisitions process is nearly complete, there are still many vital steps that must be completed before the deal can go into effect. Chief among them is performing research and financing–which includes the following actions. First, the investors must structure the syndicate that they have just created. There are several ways to structure a commercial income-producing property, but all involve careful coordination between investors and managers. Typically, sponsors will create a separate entity that holds the title and acts as both a borrower from the bank and a seller to investors.
The investors then need to decide upon an arrangement with their managers to determine how their entity will operate. This agreement will define the management and investor rights, as well as how liquidity will be distributed among involved parties. After this step is completed, investors and managers must arrange debt and equity financing. This stage in the process is crucial and is called the equity raise. The equity raise involves investors combining their capital to fund a portion of the purchase from the total acquisition cost. Although the sponsor’s duties are primarily completed by this point, they continue to be a critical player throughout the lifespan of the real estate syndication.
Structuring the Deal
While the draft agreement is being produced, the sponsor is working with investors who assess the particulars of the deal to determine how much of their capital they should invest in the project. Because investors have contributed so much of their own capital in the project, they are concerned with these three components of the deal: (1) the credibility of the sponsor and their individual history, which is necessary to ensure that the sponsor is trustworthy and can be expected to uphold their end of the bargain; (2) the expected length of return; (3) the estimated return on their investment, because naturally investors would like to be made keenly aware that their investment is being put to good use.
Under those considerations, sponsors will offer equity investors the lion’s share of the projected profits from the deal. A first-time syndicator might offer the following deal: 80% of the deal to the equity investors; 5% to an experienced and successful co-sponsor; 5% to a loan guarantor who will offer lenders a means to receive money if the principal borrower is deemed to be high risk; and 5% or less to a lender who finances ancillary costs related to the purchase, including the cost of inspection and property surveys, legal fees, and audits. This deal leaves 5% for the sponsor, and although this may not seem fair given that the sponsor is mainly responsible for financing the project, a 5% stake can still be expected to bring high returns on a successful project.
The Equity Raise
Acquiring the capital to fund a multifamily investment can be a daunting task, and it is one that is primarily determined by the available assets from both the lending side and the investing side. Typically, a lender might cover three-quarters of the cost of a multifamily investment project, depending on the type of loan and the size of the project. The investing side has to raise enough capital to cover the rest of the project–so equity investors may be asked to raise enough capital for the remaining 25-30% of the deal. Because of the costs associated with the equity raise, it can take several rounds of funding before enough capital is raised to cover the project entirely, therefore, the standard practice is to get the deal entirely under contract before completing the equity raise.
At this time, experienced sponsors will reach out to investors and gauge their interest in the proposed project. Although it is possible to syndicate a real estate “fund”—that is, to raise capital before signing a purchase agreement—most real estate sponsors have better success by getting investors to sign on to a preexisting deal rather than the other way around.
The Private Placement
Rule 506 of Regulation D puts forth two distinct exemptions from registration for sponsors when they promote, offer and sell securities. Sponsors relying on the Rule 506 exemptions can raise an unlimited amount of money. According to Regulation D, Rule 506 exempts companies from registering their offering of securities with the SEC. The 506(b) exemption is the most common of the two, allows sponsors to receive and collect money from an uncapped number of “accredited investors” and up to 35 “sophisticated investors”—provided that the sponsor has a previous relationship with the investor and does not engage in any solicitation or advertisement of the offering.
Rule 506(b) allows a securities issuer to raise an unlimited amount of money from an uncapped number of Accredited Investors and up to 35 Sophisticated Investors. … The relationship must have been developed prior to selling the securities in question. The expanded 506(c) exemption, more recently, does allow the securities issuer to solicit, advertise and promote the offering, but all those individuals who do invest must be accredited, and the sponsor must independently verify whether each of their investors has accredited status.
Real estate syndicates relying on Rule 506 exemptions can raise an unlimited amount of capital so long as they satisfy certain requirements, After the sponsor determines whether the syndicate meets Regulation D criteria, they should hire a securities attorney who specializes in real estate offerings. An effective securities attorney will help the sponsor navigate the treacherous waters of a real estate syndication by doing the six following things:
- Filing “Form D” certificate of non-registration with the SEC and the state securities agency.
- Forming the entity (LLC) that will own the apartment building.
- Authoring the operating agreement for the new ownership entity.
- Preparing the private placement memorandum — a carefully written, detailed, and cross-checked prospectus for the offering which specifies the structure of the deal, the terms of the equity investments, and the risks associated with similar deals.
- Drafting the subscription agreement—the document with which the investor commits their money to the deal and subsidizes the newly-formed entity and its newly-formed bank accounts.
- Documenting and collecting the investor questionnaires (electronic or hard copy) which prove that each investor is accredited.
The deal is nearly complete after the sponsor and securities attorney obtain their investor commitments. At this point, the sponsor must acquire debt financing, sign off on every inspection and due diligence item, and get the financial and property management teams ready for quick action.