Edited transcript from the teleseminar ‘Distribution Waterfalls & How Cash Flows in a Syndicate’

Moderated by Kim Lisa Taylor

Originally broadcast on Aug. 27, 2020

 

Listen to the teleseminar

 

Kim Lisa Taylor:

We’ve got a tremendous number of people on this call today. This is fantastic. Right now, there’s over 100, and there’s more people still joining, but we are going to go ahead and get started, because we’ve got a lot to cover.

So we always start with our disclaimer. Welcome to Syndication Attorneys, PLLC’s free monthly webinar. This is our August 2020 edition. We talk on this webinar about topics of interest to real estate syndicators, with the opportunity for live questions and answers at the end of the call.

I am attorney Kim Lisa Taylor. Joining me on the call today is Susan Rathbone, who’s our administrative assistant, and she’s new to the firm, so this is her first teleseminar.

Before we get started, please note that all of our calls will be recorded and may be used for future promotion, posted on our website, or broadcast in a podcast available to the public. If you don’t wish to have your voice recorded, please schedule a one-on-one consultation instead of asking questions during the live call.

Information discussed during this free webinar is of a general educational nature and should not be construed as legal advice. This is primarily an audio-only conference. I mean, you can see my face there. Hi, everybody. But I have not prepared a slide presentation for this, but the articles are going to be important to your understanding of the topics we’re going to discuss today.

So I think it would be helpful if we look first at “How to Structure a Syndicate,” and we’ve gone through this one before. And I can share my screen. Let me do that.

 

The link to that article is here:

https://syndicationattorneys.com/articles/structure-real-estate-syndicate/

 

Okay. So this is the article that’s on our website also about how to structure a real estate syndicate and you’re seeing a chart showing it in graphic form.

This isn’t always the way that it’s done, but very typically, we will have an investor-level entity that’s going to acquire property and become the borrower on the loan. It’s going to take title. This is the entity that will sell interest to your investors. Then we’ll have a management entity, so that’s a manager-managed LLC or a limited partnership. Usually we’re going to use an LLC unless you’re bringing in members from outside the U.S., in which case we might use a limited partnership for that.

The management entity, in the case of an LLC, would be called the manager, and it, too, would be its own LLC. If we were using a limited partnership, that would be called the general partner. You can see the management entity earns fees from the investor entity.

And then this investor entity typically has a couple of classes of members. Class A is going to be your investor class, and it’s going to own a percentage of interest in the investor LLC.

You’re going to sell off some of the interest in that investor LLC to investors, and then the rest is going to be retained for your management team, and we call that Class B. Class B is where the manager earns its profits. And this is where you’re going to earn the bulk of your money.

Ideally, we like you to separate your management entity from the entities that own the Class B interests, or the people that own the Class B interests. Just for tax purposes, it makes it a little cleaner, because your earnings at the management entity level from the fees are going to be for your active role in management. They’re always going to be taxed at ordinary income rates. The earnings from the Class B interests are going to be taxed at a capital gains rates on sale. So when you earn your share of profits and you’ve sold the property, then at that point, you would be paying capital gains on that.

Ins the management entity, this entity could be structured as a joint venture, where it’s a member-managed LLC, and there’s two to four members in this entity. Sometimes we’ll structure this management entity as a manager-managed LLC, just to satisfy certain lender requirements. They want the guarantors to be the ultimate controllers of the deal, so they would like to see them as the managers of the manager. If only some of the people in management are signing on a loan, then we would structure it that way. But if everybody in management is signing on a loan, then we would do it as member-managed.

And then your Class B is usually going to mirror the same people who are in management, and exactly the same percentage interest as in the management entity, but they could take title individually to their Class B interest, versus having the management entity own the Class B interests. Both are acceptable, but like I said, we like to keep it clean for tax purposes.

And then the Class A can be actually separated into subclasses. So you could have different classes of investors that have different rights, maybe different voting rights, different rights to distributions, and just different terms.

For instance, if you have one class that wants to just receive a return on investment, then they never get a share of equity. So they just get a fixed return, let’s say. Then that could be Class A-1, and they get paid usually as a preferred class. So think of this like preferred and common stock. Your preferred class is going to get paid first, right after the lender, and so they’re always first in line, and maybe even pay them monthly. And then you have the right to buy them out, maybe on a refinance or something like that.

The subsequent classes of Class A … so let’s say you have a Class A-1 who is a fixed-return class, and then you have Class A-2 that is your equity class …. then Class A-2 and Class B would usually split cash in some fashion. You still could have a preferred return for your Class A-2 if you wanted to.

Another reason you might have subclasses in your Class A is because maybe you want to offer some incentive for people to invest more or to invest early. And so you could say Class A-1 are kind of the people that get the first priority because they invested either more than everybody else or they invested earlier than everybody else. Class A-2 is going to be the next tier, and you could have… We’ve done up to three. I think when you get to four, it gets kind of cumbersome.

Anyway, so that’s typically how your structure goes. I just wanted to show that because that’s kind of relevant to our waterfalls. And I’m going to leave that chart on my screen, because I think it’s going to help as we start talking about the cash flow and the waterfalls.

So a very typical waterfall would be that the investor entity generates what’s called distributable cash. The distributable cash is what’s left after you’ve paid off your debt service and all of your property operating expenses, and you’ve withheld whatever you think you need for reserves. So it could be that you know you have some upcoming capital improvements, or you know you’re going to have a big tax bill or something like that. So you’re going to want to keep some money in reserves and just for some working capital. So after you’ve determined all that, then you look at what’s left, and you say, “Okay, this is our distributable cash.”

And then how do we distribute that? Well, when we write documents, we write it so that the management’s fees are paid as an operating expense of the company. So that you would get paid those first before you start making profit distributions to your Class A and your Class B members. So you’d want to catch all of that up, make sure that your management is taken care of. And the reason that we do this is because in a lot of deals, it’s a really long time before the property is going to generate enough distributable cash for Class B to get a share of profits.

And in the meantime, you have some operating expenses. You have to pay your own bills as a syndicator, you have to take care of yourself, and if you’re not able to do that, then it’s actually a disservice to your investors that you’re not earning any money, yet you’re having to spend all this time taking care of their investment. And now you’ll end up having to go out and get a job or do another deal or something, and that’s not necessarily in these investors’ best interests for you to turn your attention away from their investments. So you want to make sure that you are taken care of. The fees aren’t really where you earn the bulk of the money. This is just kind of keeping you afloat so that you’re not going under and expending your own funds just to do this deal.

So now you’ve got distributable cash. So this is, say, from operation phase of the company. You’ve collected your cash flow from your rental income, and it’s been received by the property manager. So there may be a separate property management account where all of those funds are going.

If you have a property management account that’s separate from your investor entity account, then you’re going to want to keep very tight control of that account. Make sure that you are a signer on that account. Make sure that your property manager is not commingling your funds with other clients’ accounts. A lot of them will want to do that. They’ll just want to lump all of their earnings from all of their clients into one single account. If you have a multifamily property or any kind of a commercial property, you should insist that they have a separate account just for your property.

And then you’re going to want to watch that account carefully, because property managers tend to spend what they see, and so you’re going to want to sweep excess cash out of that account, probably on a monthly basis, and put it into your investor entity account.

The investor entity and the management entity will both have separate bank accounts. So you would sweep the money from the property management company into your investor entity account from the investor entity. That’s where you’re going to make your determination of whether there’s distributable cash. You’re going to pay the management entity its share of the fees.

And now, you can always decide, “We’re going to defer our management fees, like our asset management fee” or something like that until you’ve been able to take care of your investors. That’s a choice that you can make, but we want you to have the right to take your fees first. When we write documents, we actually say that if you are going to voluntarily defer a management fee, that you can actually earn interest on it. Again, that’s something that you could decide to forego for the sake of your investors, but you do have the right to do it.

The next in line would be Class A. So if you have any kind of a preferred return, then you would make your next payment to Class A. And so let’s say, for instance, Class A owns 70 percent of the investor entity. So then you would take 70 percent of that distributable cash, and you would allocate that to Class A. And then you would look at your list of members that make up Class A, and they would each own a percentage of Class A. So then you would allocate that cash.

The 70 percent that you are allocating to Class A would then be further divided pro rata amongst all of your Class A members. So if you had a preferred class… so back to that scenario where you had a Class A-1 and a Class A-2, with Class A-1 being a fixed-return class and Class A-2 being an equity class … then you would first distribute whatever you owed to Class A-1, and then you would take whatever’s left of that, and you would allocate it pro rata amongst Class A-2.

And then after that, there’s usually going to be something for management.

One option is just to do a straight split. If this Class A owned 70 percent, Class B owned 30 percent, you would just take that distributable cash, and you would pay 70 percent to Class A and 30 percent to Class B, and whatever Class A gets, that’s what they get. There’s no preferred return. That is one way to do this.

Another way to do it is to pay a preferred return to Class A. And what that means is, Class A gets 100 percent of the distributable cash that’s left after paying your management fees until they reach some benchmark. Very typically, that’s going to be 7 or 8 percent return on their money. That’s going to be an annualized return. So an investor that puts in $100,000 would get $8,000 a year, but you would determine that on a quarterly basis.

For first quarter, you’d be trying to give them $2,000. If you were short, then you would give them all of the cash that you had, and then you would carry if it’s a cumulative preferred return. That means any deficiencies would carry forward and be made up later. If it’s a non-cumulative return, which is not common, you’d just give them all you had, and then if they were short, they were short, and the next year’s a new year. You start over.

So that’s how you’re going to be doing your quarterly distributions. We never, ever recommend doing monthly distributions for anybody except for maybe your fixed-return class, because you don’t have to do a lot of financials and calculations to determine distributable cash to pay your fixed return. Just know you owe them. You have to pay them anyway. But if you have an equity class, we highly recommend that you only do quarterly distribution so that you have time to do your appropriate evaluation of distributable cash and make sure that you’re not paying out cash to your investors that you should be keeping in reserves.

So we’ve talked about the preferred. So if you had a preferred return, you would pay that to Class A first until they were taken care of, and then whatever’s left would go to the next step in your waterfall.

The next step in your waterfall could be just a straight split between Class A and Class B. So you pay preferred return to Class A. Whatever’s left gets split between Class A and Class B. That’s a very classic way to do this, but it’s not really in your favor to do it that way. It could leave you with having done a big deal and never really making any money out of it, and your investors making all the money. We used to write a lot of deals that way, just doing the straight split after we paid Class A, and I had too many clients come back and say, “We’ll never do a deal like that again, because the investors made all the money, and we made nothing.”

Okay, so the alternative to that is to give Class B some kind of return that could be carried forward. If there wasn’t enough to pay in the early years, then it could be carried forward. That’s called a Class B catchup.

One of the articles that I gave you all is called “Class B Catchups Explained,” and I would encourage you to read that, because it really actually goes through the analysis, and it shows you how much you would make if you just went to a straight split after you pay Class A, or if you had a Class B catchup and put that into your waterfall.

 

The link to that article is here:

https://syndicationattorneys.com/articles/class-b-catchup-distributions-explained/

 

So a waterfall with a Class B catchup would say, “First you pay Class A, then you pay catchup distribution to Class B, and then anything that’s left after that would be split between Class A and Class B, according to the percentage interest each class owns.” So in our 70/30 scenario, then that remaining cash would be split 70/30 between Class A and Class B.

So that’s the operations waterfall. Okay, so there’s another waterfall that you need. So there’s always at least two. Sometimes there’s three waterfalls.

The operations waterfall is what we just went through. The other one is called your disposition waterfall, or capital transaction waterfall.

Capital transaction is what occurs when you have a sale or a refinance of the property. At this point, the sales proceeds are going to pay off any outstanding debt that you have on the property … so your first-position loan … and then whatever closing costs that there are. And then your investor entity should receive directly those sales proceeds. That should not be going through your property manager account at all.

So it’s coming to your investor entity, and from there, then you’re going to think about, “Well, what do I need to withhold?” Because you really have to kind of think, “Do I have all of the outstanding bills from any contractors or vendors, my property manager, utilities, taxes?” Whatever didn’t get paid at the sale. Is there anything outstanding that could crop up that we would still have to pay? And you’re going to want to withhold some reserves for that, because if you distribute all this cash without withholding reserves, then guess who gets to pay that when that bill shows up? It’s going to be very hard to claw back distributions from your members to pay that.

So you’ll withhold some money in reserves for maybe six months, just to make sure everything is taken care of. But in the meantime, you could probably distribute the bulk of that cash. So first, starting with any loans that anybody had made to the company, to this investor entity. The manager might have made some advances or some loans to cover some costs along the way. You’d want to pay those back. You could have borrowed money from a member, or you could have borrowed money from a third party. So those loans should all be taken care of before you start, again, determining distributable cash. You should make up any arrearages and any management fees. So make those up, and make yourself whole. And then at that point, you can declare distributable cash for your Class A and Class B members. So then you would pay back all of the capital contributions of Class A.

Now, let’s say this is the sale that we’re talking about here. Well, at some point along the way, you might have refinanced the property. If you refinanced the property and you get cash back, you’re always going to want to use that cash to pay back capital contributions of your Class A members. And if you are paying a preferred return to your Class A members, then it’s always calculated against the unreturned capital contributions of Class A.

Let’s say you can pay back 50 percent of the capital contributions of Class A. Then, from that point forward, you would only owe them a preferred return on the 50 percent that remains invested in the deal. You might use the cash that you receive from a refinance to cash out that fixed class of members. So you have that fixed-return Class A-1, then you could use that just to pay them off and leave all the capital contributions of your equity investors in the deal. So you’ve got some options there. It just depends on how we’ve written the documents and what we’ve said you’re going to do. But those are options and choices that you can make while we’re drafting the documents, and we can describe them in the documents.

So first, you want to pay back your investors and make them whole. A lot of law firms always write that you make up the preferred returns of your investors first before you pay back their capital. I prefer that you pay back their capital first, because I want you to reduce your liabilities as quickly as possible. You won’t get sued for not making the preferred returns you promised your investors, but you will get sued for not paying back all their money. So if you can pay back all their money and get them whole first, then you make up any arrearages in their preferred returns. If you’re short on the preferred returns, it’s not as critical. I mean, it’s not going to make you look good, but you’re less likely to get sued over it.

So pay back capital first. Then you pay back arrearages in Class A preferred returns. If you just have a straight split after that, then you would just split the rest of the cash. If you have a Class B catchup distribution, this is where it’s going to really make a big difference to you as a syndicator that you would be able to look back in time, all the way to the beginning of the deal, and say, “Hey, I didn’t get my catchup distribution during years one and two of the ownership of the property, so I can make that up now.” And what you’re really trying to do when you have a Class B catchup distribution is, you’re trying to equalize the deal all the way back to the first year of operations as if you’d split all the cash 70/30 from day one. So that’s what your Class B catchup would be … the equivalent to what you would have earned if there would have been enough money from day one to pay you 30 percent of it and to give the investors their preferred return.

So then you would make up your Class B, and then anything left after that would be split between Class A and Class B. There may be another step in your waterfall where you actually have a cap on Class A returns. And in that case, you would say, “Hey, if the investors have gotten all of their money back plus a return of, say, 17 percent” … and you can use average annual return or IRR; either one works … you just establish what that number is in advance and say, “Once they’ve got all their money back, plus they’ve got this, then we will change the split.” So all of a sudden, instead of doing a 70/30 split, maybe everything after that goes to a 50/50 split, or something like that.

So that’s pretty much how that all works. Let me just look quickly at the article about “How Cash Flows in a Syndicate.”

 

The link for this FAQ is here:

https://syndicationattorneys.com/faqs/how-does-cash-flow-in-a-syndicate/

 

So this is just that FAQ that I made available in the chat. It’s really talking about the same thing that we’ve just gone through. So this will be good for you to read later on. But yeah, that’s pretty much how that whole thing works. I hope that was helpful.

If anybody has any questions, we’re happy to take questions. If you want to raise your hand, you can raise your hand, and we’ll go to those questions first. Maybe Susan can help me manage the questions that are in the chat. But I’ll go first to the people who have their hands raised. Dante, I’m going to allow you to unmute. Hey, Dante. What’s your question?

 

Dante:

Hello, how are you?

Kim Lisa Taylor:

Really great. Thanks for joining the call.

 

Dante:

Yes. I finished your book last night, actually. Great book. Good job on that. Just wanted to tell you that.

Had a quick question. So I’ve always been told … obviously you have the investor entity that borrows and holds title to the property, so it’s, say, 123 Main Street LLC. And then if it’s a 70/30 split, you have the 70 percent to the investors, 30 percent to the GP. I was always under the impression that that’s the ownership of the property. In the graph, it shows Class A. It looks like that’s the limited partners, the 70 percent. And then I’m just confused if that 30 percent is the Class B, which is the asset management class, who would get the acquisition fee. But then I see the management entity that I thought was that 30 percent. You don’t mind just touching on that a little bit?

Kim Lisa Taylor:

Yeah. So the Class B and the management entity are one and the same.

Dante:

Okay. That’s what I thought.

Kim Lisa Taylor:

Yeah. So you have what’s called carried interest in your deal. So management class is entitled to carried interest. So Class B could just be the manager LLC. Or it could be separately the members of the manager LLC.

 

Dante:

Okay. So management LLC gets the asset management fee, correct?

Kim Lisa Taylor:

Yes. We always want the management entity to earn the fees so that they can be taxed at ordinary income rates. So if we set it up so that the members of the management entity are the Class B members, then what happens when tax time comes around is that the members of the manager LLC receive a K-1 from the management entity. The individuals who own the Class B interest, they would receive a K-1 from the investor entity.

 

Dante:

The management entity, the investor entity, that would get the acquisition fee at acquisition of the property and disposition fee, correct?

Kim Lisa Taylor:

Yeah, any fees: asset management fee, disposition fee, loan guarantor fees, refinance fees…

 

Dante:

That’s the Class B, correct?

Kim Lisa Taylor:

No. All fees, anything that’s called a fee, goes to the management entity. The Class B only earns a share of profits.

 

Dante:

Okay. So they have an equity stake in the property, then? That 30 percent equity?

Kim Lisa Taylor:

30 percent is what they’re entitled to, as far as a portion of the cash flow and a portion of the equity on sale.

 

Dante:

Okay. And then, just to be clear, so that management entity, not Class A or B, they don’t own any percent of interest. They just get those fees, correct?

Kim Lisa Taylor:

Yes, unless you want to make the management entity be the Class B member, in which case they own 30 percent.

 

Dante:

Which is a little cloudy at a tax purpose, like you said, correct?

Kim Lisa Taylor:

Yeah. I mean, you can talk to your CPA about it. We actually interviewed Thomas Castelli from The Real Estate CPA, and it’s one of our recorded teleseminars that you can get off our website. So you might want to listen to that, because we actually address that question there. And he said you can do it kind of either way. It doesn’t really matter all that much, but it’s a little cleaner if you do separate them.

 

Dante:

Okay. Wonderful. Yeah, that was where my question was at. That makes sense, because again, I was always taught that it was just that 70/30, and all fees go to that 30 percent ownership, which is, like … in our case, it’s Victory Capital Group, and they own that 30 percent. But you’re saying it would be a different entity, so that makes sense.

Kim Lisa Taylor:

I’m just saying that Victory Capital Group’s members could become the individual Class B members.

 

Dante:

Correct. Yep, and I understand that. I always thought it was just the two, with the management entity and then the Class A on the whole of the ownership. Okay.

Kim Lisa Taylor:

And it’s okay to do it that way. Now, just a little more advanced strategy that some of you might want is … let’s say that your management entity is three or four people, but then for Class B, you want to allocate some Class B interest to some other people. Maybe you have key employees, or…

 

Dante:

And just one of those GPs, maybe, right?

Kim Lisa Taylor:

Well, or somebody else that wants to… You have a contractor that you want to reward or something. Then you could also make them a Class B member. Or, let’s say you have a Class A member that’s also going to help you guarantee a loan. Well, you may be able to give them some Class B interest. If you want to have employees become Class B members, you don’t necessarily want to give them a voting right, because what if they leave? And if they’re no longer an employee, you want to be able to control that. So if you have a number of people that you want to make Class B, you could create a separate Class B LLC, and that the manager controls.

 

Dante:

Okay. That makes sense. Thank you. You answered my question wonderfully.

Kim Lisa Taylor:

Very good. Thank you so much.

Okay, Kareem. Can you tell us what your question is?

 

Kareem:

I don’t know why I can’t see my camera.

Kim Lisa Taylor:

That’s okay. Just go ahead and ask your question.

 

Kareem:

Okay. Thank you, Kim. Very clear explanation. I have challenge with some of my investor who have been with me for many years. They want cash flow now, and the deals we are buying today, it doesn’t have the cash flow they want. We used to do Class A, Class B. One group of investor take all the cash. Other group take the tax benefits. Is it still viable as a structure?

Kim Lisa Taylor:

Yeah, you can disproportionately allocate tax benefits and cash flow. You would want to work closely with your CPA on that, just to make sure that we’re not writing anything that they wouldn’t be able to honor because of IRS rules. So as long as we do that in conjunction with your CPA, yes, we can do that. We actually have written into our documents that if there’s any class that can’t get a benefit from, say, the depreciation or something, that that could be allocated amongst the other classes. For instance, if you have self-directed IRA investors, I have been told that they cannot enjoy the depreciation benefits. So in that case, you might want to just allocate that amongst the other members.

I had some other clients that have taken a larger portion of the tax benefits for themselves as syndicators and given a lesser portion to the investors. And then I’ve had some that have had, like you’re suggesting, one class that’s going to get different tax benefits than another class of investors. And if that was your situation, then we’d want to have that Class A-1, Class A-2 structure where you could describe what each class gets.

 

Kareem:

Thank you, Kim.

Kim Lisa Taylor:

You’re welcome. Thank you for the call.

Chris Bennett, I’m going to unmute you. Hi, Chris.

 

Chris Bennett:

Hey, Kim. How are you doing?

Kim Lisa Taylor:

Really good.

 

Chris Bennett:

Good. This has been a great seminar. Really appreciate you sharing. I had a couple questions on return on capital versus return of capital. You mentioned some people will have, at disposition, return on capital first, meaning, like, a preferred return or whatever that split is, and then the return of capital. I’ve seen it done that way before, and some people have argued in favor of that. But the right way to do it would be to return capital first, whatever that contribution was. $50,000 or $1,000, et cetera. And then give a return on capital, the 8 percent pref or whatever the split is. Wouldn’t that be the more sensible way to do things?

Kim Lisa Taylor:

So when you’re talking about from sale, like, some…

 

Chris Bennett:

Yes. At disposition, yeah.

Kim Lisa Taylor:

… from sale or from a refinance, I think it’s more prudent to pay back the capital first. I’ve seen a lot of offering documents written by other attorneys where they always do the arrearages and the preferred returns first, but as I mentioned, I like to reduce your liabilities first. But here’s another thing about that, is that even during your cash flow … well, your ownership period of property when you’re receiving rental income … you could characterize every distribution that you give to your investors as a return of capital.

 

Chris Bennett:

Okay. That was my second question. Yeah, That’s great. Sorry, go ahead.

Kim Lisa Taylor:

Another option would be to … everything they get, their preferred return is considered a return on investment, but everything above that is considered a return of capital. So the pluses of that is, everything that’s a return of capital is not taxable to the investor. So they may like the fact that they would get a return of capital for some period of years, and they would only get taxed when they get a big chunk at the end. They may prefer that. The downside for investors is, they never get that big chunk back, that original $100,000 investment that they can go now and invest in something else.

 

Chris Bennett:

Understood. Okay. So in other words, during the hold period, as you’re doing your distributions quarterly or whatever the time period that distributions are set at, you could say, “Here’s a return, your 8 percent pref,” whatever that number is. “Here’s that, and then here’s, on top of that, a partial return of your original capital as well.” So in other words, you’re distributing both, in a sense, along the way. Is that what you’re saying?

Kim Lisa Taylor:

Yeah, that’s exactly right.

 

Chris Bennett:

Okay, got it. Perfect. Thank you so much. Appreciate it.

Kim Lisa Taylor:

There is another teleseminar I’ll direct you to in our library, on our website. It’s called “60 Years of Investing Wisdom With Sam Freshman.” So that’s something I think every single syndicator should listen to. It’s amazing. Sam is amazing, and he’s agreed to become a guest on our show again, talking about what he sees happening in the current real estate market, because he’s been around, and he’s seen it all.

 

Chris Bennett:

That’s great. Awesome.

Kim Lisa Taylor:

And we’re going to talk to him about his structure a little bit more, but he talked the last time we had him on, about having people … he just pays back principal. I believe he just pays back their principal all along the way. But their goal is to just pay off the properties and keep them for cash flow forever. So they become legacy investments. They don’t do the five- to seven-year fix-and-flip model. They just keep them forever, and he said that some of their investors that they have are the grandkids of the original investors. And they never want to get out of a deal because they’ve been paid back long ago, and they’re just happy to receive mailbox money from that point forward.

 

Chris Bennett:

Mm. That’s wonderful. Okay, I’ll check that out. Thank you, Kim. I appreciate it.

Kim Lisa Taylor:

Yeah, thank you.

All right, let’s see who else we have. We have one more person with their hand up. Oracle , how are you?

 

Oracle:

I am doing great. Good to see your face. I am still putting things together, making sure that we’re all right before we talk again. But loved the webinar today. Wanted to ask you to elaborate on voting rights in the classes, as well as for just even voting within the management entity. What is the best way to look at giving Class A voting rights, or B, or … Where should that really sit in regard to those rights? And then what are they voting on, would you say? What would be the main things that we’ll be voting on?

Kim Lisa Taylor:

Yeah, so this is highly customizable. You can allocate voting rights however you want. What we typically do is, we have certain things that only Class A gets to vote on, and that would be removal of a manager. So in a lot of the offerings we write, we’ll say that Class A members owning 75 percent of the percentage interest of Class A have the right to remove the manager if the manager’s doing a bad job or stealing money or not responding or something like that. So it allows the investors to have an out. We do put that in there, because there are a lot of investors that will not invest in a deal that doesn’t have a way to remove the manager. They’ve just seen too many deals go bad, and they’ve heard the horror stories, and they just want to make sure that there is a way that they could protect themselves if they had to.

And then we have other things that everybody would have to vote on. For instance, if you wanted to have an amendment to the operating agreement that would change the distribution waterfall or the fee structure for the manager, or something like that, that you would really need to get consent of all of the members. If you wanted to sell the property, instead of selling the property, if you wanted to do a 1031 exchange. So all of a sudden, these investors who invested in Property A are now being faced with a choice to go forward into Property B and defer their taxes, or get their cash out and just move on to a new investment.

So in that case, you would have to take a vote of your investors to find out what they want to do, and if you don’t get unanimous consent, you really can’t force people to go into a deal that they didn’t agree to in the first place. So you would buy them out, concurrent with the purchase of the new property, and that would be one thing. So you still have unanimous consent of the members that do stay in the deal. So those are just some typical examples, but most of the decisions are made at the management level, decisions on whether to get a refinance loan and when to sell, whether or not to buy the property. Those kinds of decisions we usually have made at the management level.

 

Oracle:

Thank you very much.

Kim Lisa Taylor:

You’re welcome.

Sandra, hi. I’m going to put you on the hot seat.

 

Sandra:

Hi, Kim. Good morning. I have a question. I am in the residential assisted living business, and we have set up this most recent business venture as two separate businesses, one being the property and the second being the actual residential assisted living business. So on the property side, we have a Class A and a Class B, and then on the business side, my question is centered around the fact that it will be a nonprofit organization. But if we decide to bring in someone that is interested in investing, I imagine that the setup can be completely separate and different, in terms of the percentage split, than the actual property. Typically, if it’s a nonprofit, is there anything that should be taken into consideration, or should we decide to bring in an investor?

Kim Lisa Taylor:

I don’t think you can bring in an investor on a nonprofit, because the reason that an investor would want in that is to be able to get a share of the profits. You could perhaps bring in an investor as a lender to the business.

 

Sandra:

Or a GP? Like, a third GP?

Kim Lisa Taylor:

Yes, but then you’re going to have to work within the nonprofit rules to make sure that you’re paying the management team in a way that’s not going to run afoul of the nonprofit corporation rules. But that’s a little unusual situation. Or you could have both of the entities be for-profit with completely separate investors, but then you’re really doing two separate syndicates. One is a syndicate to invest in the business. The other is a syndicate to invest in the property.

 

Sandra:

Okay. Got it. All right. Thank you.

Kim Lisa Taylor:

Okay, let’s see. William Brancucci. I’m going to put you on hot seat. Hey, Bill! Bill, are you there?

 

William Brancucci:

I’m here.

Kim Lisa Taylor:

Okay. Cool. Hi.

 

William Brancucci:

How are you?

Kim Lisa Taylor:

I’m very good.

 

William Brancucci:

I wanted to talk about the catchup versus no-catchup clause in a lot of waterfalls, unless you already covered that. But I have another question aside from waterfalls, also I’d like to ask you.

Kim Lisa Taylor:

Yeah. Ask away.

 

William Brancucci:

So do you want to go to the waterfall one first?

Kim Lisa Taylor:

Sure.

 

William Brancucci:

Are you seeing a lot of waterfalls with a catchup provision so that they get to … let’s say it’s a 70/30 split. The GP can catch up to the … after the pref is paid, they can catch up to bring the ratio in parity to 70/30?

Kim Lisa Taylor:

Yeah, that’s the way that we typically write the Class B catchups.

 

William Brancucci:

Are you seeing a lot of that? Is that the way it’s changing, or is it switching to no catchup, and just the split only above the pref rate?

Kim Lisa Taylor:

Of course, I see most of our deals, and I always recommend the Class B catchup if you can do it. If you have investors that are resistant to that, for whatever reason, then you may not be able to do it. But if you’re dealing with a lot of investors that want to ensure that their syndicators are well taken care of so they can stay in business, then that might not be for you. But if you’re starting to deal with Wall Street investors or placement agents, investment banks, or things like that, they’re not going to want you to have a catchup.

 

William Brancucci:

The other question I had was, I’ve run into, in a couple of markets, groups that will buy the workforce housing as a nonprofit, and I wasn’t exactly sure of their structure, but it looks like they didn’t have to pay property taxes, or they got a huge, huge discount. It gave them a major advantage in bidding against us or anyone else, because the NOI for them is much higher. Even on the same revenues, their NOI was much higher than the NOI that I would get or a regular for-profit operator. So I was just curious if that’s a common thing. Are they actually exempt from property taxes? What’s their advantage?

Kim Lisa Taylor:

Well, there’s probably an advantage and a disadvantage. On a nonprofit, then there’s going to be some IRS tax advantages, but you’re going to be restricted to making money from your salaries. So you’re going to really just have management salaries. You’re not going to be able to get a share of any profits, because there’s not going to be any profits. So you’re going to have to up your management and your administration costs … making enough money to have a decent salary. In a nonprofit, think of it really more like you’re just creating a job for yourself, versus creating a legacy, long-term profit share that might help build wealth for you.

 

William Brancucci:

Thank you.

Kim Lisa Taylor:

Mm-hmm (affirmative). Anything else?

 

William Brancucci:

An endless list of questions, but that’s all for today.

Kim Lisa Taylor:

All right. Thanks, Bill. So Bill is one of our long-standing clients. He’s someone that you guys might want to get to know, because he started out, I think, buying $4 million and $5 million deals, and now they’re buying $35 million deals and higher. I think theirs is a very successful model that a lot of other clients could emulate. But Bill Brancucci is one of our clients. Bill, why don’t you give everybody your website, if they want to learn more about your company?

 

William Brancucci:

Sure. Our website is citadelamerica.com. So Citadel, C-I-T-A-D-E-L America dot com is our website.

Kim Lisa Taylor:

Very good. All right. Thanks for joining the call today, Bill.

 

William Brancucci:

Thanks, Kim.

Kim Lisa Taylor:

Okay. We have a couple more questions here, and then I’ll get to whatever’s in the chat. We’ve got a few more minutes. So I have Michael Foley. Michael, I’m going to put you on hot seat. Hey, Michael.

 

Michael Foley:

Kim, hi.

Kim Lisa Taylor:

Hi.

 

Michael Foley:

Question. What are you seeing in the way of prefs to investors, and what are you seeing as kind of all the fees? Have they changed in 2020? What’s the latest on prefs and fees these days on your deals you’re doing?

Kim Lisa Taylor:

Yeah, I’ve been doing this since 2008, and I really haven’t seen that much of a change in the fees. So the acquisition fees are usually 1 to 4 percent of the purchase price, maybe even up to 5 percent. The smaller the deal, the higher the acquisition fee. The larger the deal, the smaller the acquisition fee. Asset management fees are usually always 1 to 2 percent of the gross collected income. Refinance fees are usually 1 to 2 percent of the loan amount, and disposition fees are usually 1 to 3 percent of the sale price. So those are pretty standard oversight fees.

If you’re having to do, like, major repositioning, or if it’s a development deal or something like that, usually in the range of 5 to 10 percent of the hard costs. So whatever you’re paying out to third parties, you’d write yourself a check for that percentage to your management team. Sometimes those fees are going to the property manager if they’re the ones that are managing that process. So the fees and fee structures have largely stayed the same, as near as I can tell. If you are starting to deal with Wall Street investors or investment banks or something like that, you may want to load your asset management fees a little bit higher, because they’re going to squeeze you on your share of profits. Wall Street terms are usually 2 percent acquisition fee, 2 percent asset management fee, and 20 percent of profits. And no catchups, and a lot of them won’t even let the management class take any earnings until the investors have all their money back, plus their preferred returns and anything else you’d promised them.

So you just have to be careful when you’re dealing in that world. Perhaps you’re dealing with bigger deals, so 20 percent is okay, but you just have to be aware that they’re going to be pretty rigid in what they will allow you to do. Same as if you’re going to be using a broker-dealer to sell your interests. They’re going to be following that same model. And one of the reasons they’re going to follow that model is because they’re going to want a piece of your back-end profits, and so you’re not going to be able to take 30 percent, because you’re going to have to give them 10 percent and maybe keep 20 percent for yourself, or something like that. So just be aware of that.

As far as preferred returns, 8 has been kind of the sweet spot for most of the bulk of the time that I’ve been doing this. We’ve seen some people start to offer 7. I’ve talked, at one point, to a very large syndicator who has billions of dollars of assets under management, and I asked them what are their preferred returns, you know, schedules look like. And they said, “We do 5 or 6 percent in the first two to three years until we refinance, and then we jump to 8.” Which I think makes a lot of sense, because it’s those early years of the pref that are going to kill you, because that’s where you’re going to give the investors all the money, and you’re not going to get anything. And it’s hard, because that’s the period of time that you’re also doing the bulk of your work on that property to get that property up to shape so that you can increase the income. So you’ve got to just be aware of that. But having a staggered preferred return, I think, makes a lot of good economic sense, and it won’t break you.

 

Michael Foley:

Yeah, I know. I like that idea, especially a deal where two or three years down the road, it’s going to look a lot different than it does now.

Kim Lisa Taylor:

That’s right.

 

Michael Foley:

Is there a good resource? I have investors ask me, “Hey, if we wanted to invest 50, what would our potential return look like, versus if we put in 100?” Like, some type of Excel spreadsheet or resource for helping investors figure out their potential returns?

Kim Lisa Taylor:

You know, I’ve never seen anything like that specifically. All the models that I’ve seen are geared towards syndicators. You could certainly share with them your underwriting template.

 

Michael Foley:

Yeah, I think I might do that, rather than try to come up with something with scratch. Just curious.

Kim Lisa Taylor:

No, that’s a good idea. I think probably a lot of investors would like that, and it might not be that hard just to come up with a simple model where they could plug it in and figure it out.

 

Michael Foley:

Good. Well, that’s what I can work on this afternoon. Thanks, Kim.

Kim Lisa Taylor:

Okay, great.

Let’s see. I’ve got Eddie. Eddie, I’m going to put you on hot seat. Hey, Eddie.

 

Eddie:

Hello. Hi. So I got a question for you. I deal with foreign investors. I’m trying to set up a structure to help them invest in U.S. easier. So the structure is basically an offshore company dealing with a debt or no structure to the investors/lenders. And then that money will be transferred into a local LLC, an offshore one, or local LLC within their jurisdiction. And then that funding will be transferring to the U.S. LLC as a blocker, and then the blocker will invest in the syndication. So do you see any problem in that type of structure, dealing with foreign investors?

Kim Lisa Taylor:

No, that’s typically why you do the blocker, is … there’s a couple of reasons. One is that you don’t want them to have any adverse tax consequences in the U.S., where they would actually have to start paying U.S. taxes. But the second one is, you have to be careful when you’re dealing with foreign investors that you don’t inadvertently expose all of their worldwide income to U.S. taxation. So if you could use those blocker companies to kind of separate them from the U.S. so that they’re not the direct investor in the U.S., that the other company is, then that would help alleviate some of those issues. It also helps prevent them from having to get their own U.S. tax identification number and file their own U.S. tax returns.

 

Eddie:

Okay. Do you see any problem in the debt structure that is outside the U.S.? Instead of they are directly investing into an LLC that would purchase the asset, do you see any debt structure as a problem?

Kim Lisa Taylor:

That’s going to be a tax question, so that would be something that you’d want to explore with your international tax advisors.

 

Eddie:

Okay. Sounds good. Thank you so much.

Kim Lisa Taylor:

Okay, we have James. James, I’m going to make you our next guest. James, ask your question.

 

James:

Hi. I had a question about a PPM that I was recently reading, and it was adding something for Class B, Class A that I had never seen before. And I wanted to get your take on it, see if it’s a red flag. Wasn’t quite sure how to interpret it. To give context, Class A had commitments, and they’ve called in about 40 percent of those commitments for the fund. Class B has to fund fully to 100 percent of their commitment right off the bat. And they have a weird thing saying that after you fund your 100 percent of your commitment, you also have to pay cash to the company for any previous preferred returns or management fees that had already been accumulated since the start of the fund. So essentially, you’ve put in your capital contribution, and then you’d also have to pay extra on top of that, which doesn’t count toward your capital contribution. Does that make sense?

Kim Lisa Taylor:

From an investor perspective, surely it doesn’t, but from the fund perspective, what they’r- trying to do is called truing up, where you’re truing your late-coming investors so that they can come in on par with your early investors so that from that point forward, all returns are created equal, and you don’t have to keep pro-rating between early and late and figuring all that out. So yes, that is a truing up provision that’s commonly used where you would actually pay something extra for coming in late that would then put you on par with those early investors. If you’re paying arrearages in fees, those would go to the manager. Sometimes you’re even paying arrearages on preferred returns that would get allocated to those prior investors.

 

James:

Okay. So it’s truing up?

Kim Lisa Taylor:

It’s called truing up. Yes.

 

James:

Okay. So that makes sense. Basically to get everybody kind of on equal footing, and then it’s easier on the sponsor side for bookkeeping, keeping track?

Kim Lisa Taylor:

Yeah, and it also makes it seem fairer to the early investors, because let’s say the fund has been in operation for two or three years, and you’re coming in in year four, and then they’re starting to liquidate properties in years five and six. Then you would be perceived as having received a windfall, because you would get the benefit when they sell of all of the equity that was generated during those early years when you weren’t part of the deal. And so that’s why they want you to true up, so that now it’s like, “Okay, no, we did make everybody on whole, as if they’d come in all at the same time so that there’s no question when the equity share is distributed that it’s fair.”

 

James:

Okay. Thank you. I appreciate that.

Kim Lisa Taylor:

Thank you. Let’s see. And we’ve got one more question. Dante, do you still have a question, or did we already…

 

Dante:

Yeah, just one quick one. You may have answered this already. I was taking notes earlier when you answered my first question. Through the K-1 documents, what tax benefits — and this may be a CPA question — would be passed to the GPs or the LPs through the end of the year?

Kim Lisa Taylor:

We may disproportionately allocate the depreciation or any benefits that you could get that could potentially be disproportionately allocated. And part of that is due to the fact that your management team is the people that are going to be signing on the loans. So there’s some IRS rules, at-risk rules, that the IRS looks at, so you’d want to work with your CPA, just to make sure that what you’re doing is not going to be prohibited.

 

Dante:

Okay, very good. Thank you.

Kim Lisa Taylor:

You’re welcome. Okay. Susan, do we have any other questions in the chat?

Susan Rathbone:

There are questions in the Q&A at the bottom, Kim. There are eight questions.

Kim Lisa Taylor:

Okay, so if anyone needs to drop off, we know this can be a little long, but we’re happy that you were all here. Let me just say that you can contact us, of course, at syndicationattorneys.com. You can schedule a free appointment there. We have many programs that we can help you with. If you’re not ready to syndicate, we have a syndication retainer that will give you access to our weekly syndication masterminds. And also, we’ll give you a free investor marketing plan template and an investor relations blueprint, and we’ll give you a discount off your first syndication with us that is either equal to or greater than the amount that you spent on that pre-syndication retainer, so that is a good way to just get on board with us and to have access to us. It also gives you up to three hours of one-on-one legal consultation. It’s $1,000. My normal hourly rates are $595 an hour, so it’s a pretty big discount.

But when you are ready to syndicate, we offer lump sums. We would have a free initial consultation with you. We would talk about what you’re doing. From that, we would be able to decide what kind of offering you need to do and what kind of documents would be required, and then we’d be able to give you a lump-sum quote. And once we have you engaged as a client, then we hope to keep you as a very long-term client. We have many long-term clients that have been with us for eight, nine years, and we would love to have some more. So if you haven’t been to our website, do go and check out the library. There’s a lot of great free information there.

We are also starting to offer something else that’s new. We have affiliated with an investor marketing platform and an accounting firm so that we can bundle fees … you actually get a discount on our fees as well as theirs for using that bundled product, so it doesn’t cost you very much more than it would to just hire us independently, but you’re going to get annual, or get at least your first year of your investor management platform and your accounting fees included. So that’s something that, for somebody who likes that all-in-one product, that’s something that we’re going to be starting to offer very soon, and we can tell you more about that if you want. If you want to know about the investor marketing platform, it is on our website at syndicationattorneys.com. There’s a tab called Investor Platform. Go ahead and check that out. You can do a demo there, and we’re happy to talk to anybody about any of these products at any time. Just schedule an appointment at our website.

So, Susan, why don’t you go ahead and read off the questions?

Susan Rathbone:

Okay. I believe you’ve already answered Dante and Kareem. We have Leann Zane: “What’s the standard preferred returns and management fees these days? Is it, like, 8 percent preferred and 20/20 still?”

Kim Lisa Taylor:

So yeah, I think we’ve covered that, but yeah, I’m still seeing a lot of 7 and 8 percent preferred returns.

Susan Rathbone:

Okay. “What are the different types of management activities worth? Like, is property management worth 1 percent and a deal sourcing, et cetera, worth something?”

Kim Lisa Taylor:

So you have to distinguish between asset management and property management. So property managers manage tenants, toilets, and trash. If you’re going to do property management, you need to have a separate company that does property management that gets property management insurance, because property managers get sued all the time. So you want to separate that and segregate it from your investor entities. You don’t want your investor entities to get sued.

So asset management is what you do as a manager of an investor entity. We talked about the structure with the manager-managed LLC. Then the manager itself being its own LLC, so that manager LLC is the asset manager. And the asset manager’s job is to oversee the property manager, so you’re going to get weekly reports from them, and you’re going to troubleshoot with them when there’s issues. But you’re also going to be overseeing your investor LLC and managing the taxing and determining distributable cash and making distributions. So you’re really safeguarding the investment as an asset manager for the investors. That’s your job there.

So property management fees are going to be determined by the local market and by the size of the property. Because if you have single-family properties or very small plexes, you might be paying up to 10 percent of the gross collected income. If you have large properties, you could be paying maybe even 4 or 5 percent. So then your asset management fees are going to be separate and distinct from that, and that’s going to be usually 1 to 2 percent of the gross collected income. And you would pay yourself that, and you could even pay yourself that monthly, that you would pay to your management team. That answer the question?

Susan Rathbone:

I think so. There’s one last question by Cecille Stell: “Is it good to use a syndication for fix-and-flip?”

Kim Lisa Taylor:

Yeah. We have clients that do that. You want to do it for an individual fix-and-flip, you’d do it more in a fund, and then you would have to decide: Are you trying to match individual investors with individual properties, or are you trying to just build a fund where that fund is going to go out and do as many fix-and-flips as it can? And that’s something we would talk about during an initial consultation and try to help you figure out what makes the most sense.

Is that it?

Susan Rathbone:

That was all I saw.

Kim Lisa Taylor:

Very good. Well, this has been a really great call. I hope it’s really been helpful for everybody. Our goal is to give you guys enough education that you’re confident to go out and do syndications and to raise money and to grow your businesses to the size that you want to grow them to. And we’re happy to be part of that, and we’re just really delighted that you all decided to join us today, and we hope to have you all as clients soon. So we’ll go ahead and sign off for now. We will make this recording available, and we do post them all on our website, so we will have it available for you soon, and we’ll let you know when it’s up there. All right. Thank you so much.

print