Although there are numerous ways to structure a commercial income-producing property, the following model describes a typical 2 Class syndicate with equity investors and a separate Manager entity.
How to Structure a Real Estate Syndicate
In the above scenario, you will form a separate, title holding entity (the Investor entity) that is also the borrower on any bank loan. If you use an LLC as the investor entity, it will be “manager-managed,” or you could use a Limited Partnership with a general partner (management class) and limited partners (LPs).
The manager or general partner will be a separate entity, usually an LLC that encompasses the members of the management team.
Each entity you form will have an agreement between management and investors (company agreement) that will govern how the company will operate. The company agreement will define management and investor rights and duties and how cash will be distributed to each of the participants.
The Investor entity will have 2 (or more) classes of “Members” (if an LLC) or LPs. We’ll call them Class A (for cash paying Investors) and Class B (the management or “sweat-equity” class). If different Investors get different returns, Class A can be broken into separate sub-classes (A-1, A-2, etc.).
Investors will purchase Class A interests in the investor entity. Class A investors will contribute 100% of the capital contributions necessary to capitalize the company but will only purchase a portion (e.g., 50%-80%) of the ownership interests in the investor entity. The management class will retain the rest of the interests.
Class A may be offered a preferred return (meaning they get paid their returns before Class B gets paid). Preferred returns can be cumulative (accrues even if not currently paid) or noncumulative, usually calculated on an annualized basis, but determined quarterly. For instance, if you offer an 8% cumulative preferred return, Class A members would get paid all of the distributable cash until they have received a 2% return each quarter calculated against their “unreturned capital contributions.”
If the preferred return is “cumulative,” any arrearages would be made up at the next distribution event prior to paying current returns. Or arrearages could be deferred until sale of the property (depending what your Company Agreement says), meaning arrearages are made up from equity on sale, after paying back the Class A capital contributions, but before splitting equity between Class A and Class B.
If the return is “noncumulative,” Class A members gets all of the distributable cash needed to make up their preferred return for the current distribution period, but deficiencies do not accrue.
For voting purposes, Class A’s percentage interests are calculated either as a percentage of the Class A interests or as a percentage of the total interests in the company, depending on what classes are entitled to vote on specific matters as spelled out in the Company Agreement.
Class B includes members of the manager and/or others who provide services to the company. They keep the remaining ownership interests in the company in exchange for a nominal amount (e.g., $1,000 total). Class B should pay for their interests to establish a cost basis for their investment.
Class B members only get a portion of the distributable cash after Class A members receive their annualized preferred returns for the year, although this can be calculated and paid in quarterly increments, if you have said so in your company agreement. As such, Class B returns are subordinate to Class A’s preferred returns. This is important for tax purposes.
The management entity earns fees but not distributions and does not keep an ownership interest or voting rights in the company. If the manager is removed, the manager’s fees are pro-rated between the prior manager and the new manager, but distributions to its members (as Class B interests) remain undisturbed.
In this scenario, it is important that you take a management oversight fee (usually 1% to 2% of the gross receipts for a specified offering, or 1% to 2% of the money raised if a blind pool).
Why use the 2 Class structure?
- To preserve your distributions if the manager is removed. We suggest you take “ownership” interests, because if you are removed or resign as the manager, it will help preserve your right to distributions. We suggest you take the Class B ownership interests in your individual name, a trust or the name of another company you own, etc., to distinguish owners of the Class B interests from the “manager” (or its members), although this is not required. However, it is better from a liability standpoint if the manager doesn’t actually “own” anything.
- To segregate fees from distributions. Since you will pay for your Class B interests, you will establish a cost basis so that earnings on Class B distributions may be taxable at capital gains rates, versus your manager’s fees, which will be taxed at ordinary income rates (meaning you may have to pay self-employment tax on those earnings).
- You can grant Class B interests to other people. Since Class B retains a percentage of the interests, the manager can allocate those interests as it sees fit amongst persons who provide services to the investor entity. This could be useful for people who bring you deals, etc., but to whom you don’t want to give a management role (although people who raise money should be a member of the manager). It might not work for a loan guarantor, as the bank usually wants the loan guarantor to be a member of the manager.
Next, we’ll talk about cash flow in a real estate Syndicate:
The following description describes the cash flow from a commercial income-producing Property in a syndicate comprised of a 2 Class LLC with a separate management entity, with a minimum/maximum offering:
Here is how you will handle investor funds prior to closing on the Property using the above structure as a model:
- All investor funds will be received in your Investor LLC’s bank account (NOT the Manager LLC’s bank account).
- You cannot use any of these funds until you have raised the Minimum Dollar Amount (see your PPM for this definition), and you are getting ready to close on the Property. Note: If you don’t raise the Minimum Dollar Amount, you cannot close on the Property and you must give back investor funds without deduction.
- Investors will wire their funds to the Investor LLC, which will receive and hold all investor funds, including the $1,000 that the Class B Members are contributing for their Class B Interests.
- You will wire only the funds required for closing (per the escrow company’s payment demand) from the Investor LLC to the Property escrow shortly before closing on the Property. Any excess funds will be retained in the Investor LLC bank account.
- Post-closing, the Investor LLC can write checks to the Manager LLC or its members for Acquisition Fees (we call them Organization and Due Diligence Fees, the IRS term), and to reimburse any members of the Manager for their out-of-pocket acquisition expenses (deposits, due diligence fees, legal fees, lender fees, etc.).
How cash will flow during Property operations:
- The Property will have a Property Management account, maintained by the Property Manager, from which Property operating expenses and debt service are paid.
- You will periodically sweep excess cash from the Property Management account to the Investor LLC’s bank account. It is from these funds that you will pay the Manager LLC’s fees. This is where you will also hold operating capital and reserves, including any funds for future capital improvements. Any remaining cash is “Distributable Cash” (see definition in your Operating Agreement or PPM).
- On a quarterly basis, the Manager determines the amount of Distributable Cash to distribute to its Members (Class A and Class B) following the “waterfall” in Section 4 of the Operating Agreement and writes checks directly from the Investor LLC to the Members.
- When the Investor LLC prepares its tax returns, it may send a 1099 to the Manager LLC, as those fees will be taxed at ordinary income rates (as determined by your CPA). The Investor LLC sends K-1 forms to the Members (Class A and Class B), as those earnings are taxable at capital gains rates. Note: This is why you must pay for your Class B Interests as that establishes the cost basis against which your Class B earnings can be taxed.
On sale or refinance of the Property:
Any Distributable Cash generated from a “capital transaction” such as a sale or refinance of the property will be distributed according to the waterfall described in your Company Agreement.