Edited transcript from the teleseminar, “How to Structure a Real Estate Syndicate”

Originally broadcast on Jan. 10, 2018

 

Listen to the teleseminar

 

 

Kim Lisa Taylor:

Welcome to Syndication Attorneys, PLLC’s free monthly teleseminar. Thank you for coming back after the holidays; hopefully you all survived. We had a very nice holiday, and we’re glad to see everybody that’s joined the call today. We’ve got a pretty good turnout. We want to give you some great content and hopefully this will clear up some of the mysteries of syndication for you. Just want to let everybody know that all of our calls are 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 teleconference is of a general educational nature and should not be construed as legal advice, which may only be sought after establishing an attorney-client relationship and consideration of your specific facts or questions. Our attorney-client relationship does not begin until we have a fee agreement in place signed by all the parties.

So now we’re just going to jump into our topic, “How to Structure a Real Estate Syndicate.” I know that when I was first starting out in multifamily real estate back in 2007, that was a big mystery to me. I went to an RE Mentor training seminar that’s put on by Dave Lindahl, for those of you that don’t know, but that was who I went to at the time. There are a lot of other trainers out there as well, but I do some training for Dave now and that’s the one that I’ve been most associated with in the past.

During that, my husband and I were thinking about buying multifamily, and we thought, “Let’s go; let’s figure out how it works.” So we learned a ton of stuff about how to find deals, do due diligence, how to analyze deals, how to figure out investor returns and returns for ourselves and all that stuff, but we didn’t know how to really structure the deal with investors, and that was still a mystery, and I was an attorney at the time. So don’t feel bad if you don’t know this stuff, because you can be a very well-educated person, but this is just something new you have to learn.

So we said, “Well, what do we do next? How do we further our education? How do we get that information that we need?” When we found out that the RE Mentor was going to be holding a Private Money Boot Camp, so we said, “Well, we have to go. We’ve got to be there.” So we went to that, and during that, we learned a lot more about how to structure a syndicate, and then subsequently I began doing security work myself in my law practice. So in the meantime, I’ve been doing this now for nearly 10 years and have learned a whole lot about structuring real estate syndicates. I can’t share everything I know with you in this 30-, 40-minute call, but I can share enough that you’ll go away feeling like you have a clue, and that’s really the point here.

So if you don’t have our article in front of you … When we sent out the invitation for this teleseminar we also sent you a link to the article. If you don’t have that link handy from the newsletter, you can go to our website at syndicationattorneys.com, and there is a page there called Resources. Under the Resources page is a sub-page called Articles, and I think the second article that’s posted there is “How to Structure a Real Estate Syndicate.” So if you’re near a computer and you can pull that up, again, go to our website at syndicationattorneys.com and go to the Articles page and then pull up the “How to Structure a Real Estate Syndicate” article, because there’s a nice diagram there that’s going to help you see what I’m talking about as we describe how these things are structured.

I’m going to start with the simplest possible structure. There’s a lot of variations on this, but this is probably the structure that we use 80% of the time when someone is buying a specific property. The title holding entity is the first thing you need to create, and that is the entity that’s going to take title to the property. It’s going to be a single-purpose entity. It’s never done anything else; it should be newly formed, doesn’t own any other real estate, it’s just something you’re forming. It’s called a single-purpose entity or a special-purpose entity. Sometimes we abbreviate that SPE, and that is the title holding entity that’s going to take title to that property. It’s also going to be the borrower on any loan that you might get.

If you’re buying multifamily or commercial properties, chances are you’re going to get an institutional loan for 60 percent or 70 percent, or maybe even up to 85 percent or 90 percent of the purchase price of that property. That lender is going to want this single-purpose entity to be the borrower on that loan, and they’re the ones that dictate that it’s an entity that doesn’t have any other assets. So it’s the borrower on the loan, takes title to the property, but the other thing that it does is it sells interests to the investors. So this is where you’re going to be selling securities. This is where you’re going to be creating that investment contract.

So if you’re new to these calls, then you may not have heard of this before, so I’ll just give you the quickest primer. If you are selling something that meets the definition of an investment contract, then you are selling securities and you have to follow securities laws, and that’s why my law firm exists, is to help you be able to do that. But you need to be able to understand that there are rules that apply to what you’re doing when you’re selling an investment contract.

So what is an investment contract? That was defined by the U.S. Supreme Court way back in 1946 as an investment of money in a common enterprise with an expectation of profit based solely on the efforts of the promoter. So that’s the thing that distinguishes investment contracts from joint ventures, is that in the investment contract, you have passive investors who are relying on the promoter, or the person who found the deal and is putting those group of investors together, the syndicator, they’re relying on them to make a profit. In a joint venture, you could have an investment of money in a common enterprise with an expectation of profits but you wouldn’t have that fourth component, because everybody would be actively involved and they would all be participating in making their own profit from that venture. So that is the distinction.

Now, back to how does this relate to our title holding entity. When you’re creating a syndicate, you’re going to assume that what you’re creating is going to be an investment contract and you’re going to draft the documents that are appropriate to selling securities. So why is it an investment contract when you’re just selling interest in an LLC? Because we’re going to set up this title holding entity as a manager-managed entity.

The manager does not have to be a member; it could be a CPA, it could be anybody, but it’s you. You’re the one who found the deal, did the due diligence, got the thing under contract, and now you’re trying to raise the money to close on it. So that’s going to be you. Probably it’s not going to be you by yourself, because finding a property and doing all that stuff, now adding to that the task of finding investors and managing investors, that’s a pretty big job for one person to do by themselves. So a typical management structure for a syndicate would be another LLC. The manager of that title holding entity could be another LLC, and that could have multiple members, or it could be one person that just has some paid staff who are helping them develop those various syndication tasks.

The document that you’re going to create for the title holding entity, that you need for this title holding entity, is an operating agreement. If your title holding entity is a limited liability company, your other option for a title holding entity is to form a limited partnership. That was a lot more common back in the ’70s and ’80s. Currently, limited liability companies are more commonly used for real estate offerings than limited partnerships, but if you are going to be bringing in investors from outside the country, you may want to consider a limited partnership for your structure.

In a manager-managed LLC that you’re going to use for the title holding entity, you’re going to have a manager and you’re going to have members. If you are setting it up as a limited partnership, you would have a general partner who takes the same role as that manager and limited partners. All right. So I think we’ve covered what the title holding entity does, what it needs, and why it’s a security.

Now let’s talk about the management entity. So who is this manager? Well, if this manager has multiple members, then it too is going to be a limited liability company. Even if it was a single-member LLC, we always suggest to our clients that you want to have an LLC for that. Ideally, you should have at least one other member. Why? Why do you need to have more than one member in an LLC for a management entity? Well, one, single-member limited liability companies do not offer a lot of liability protection for you. There’s a lot of case law around the country where these can be pierced, the corporate veil can be pierced, and it’s very easy for someone to argue that “Hey, there’s only one member. This person is just using this LLC to try to protect themselves and they shouldn’t be allowed to do that. I should be able to go after their other assets, just because they’re using it as their alter ego.” That’s the legal term of art that gets applied when someone tries to pierce the corporate veil.

So ideally you want to have a second member in your LLC even if they own just a minor component, but the other reason you want to have another member is what if something happens to the sole member? Then if there is no member in an LLC, then by law, then that LLC would dissolve and now you could have a syndicate that has no manager. So if you had a second member in there and something happened to one of the members, then it wouldn’t matter.

The LLC would continue as long as it still had a single member, and the syndicate, the title holding entity, would not be affected and the investors would not be harmed, because presumably, that other member of that LLC, maybe they don’t have the same experience or knowledge that you have about how to operate that syndicate, but they should know enough to be able to hire the right people to help them do it or to follow the operating agreement for that title holding entity and get the members to elect a new manager so that they are not harmed. So we always need to be thinking about what is best for the investors here.

The other reason that you want to have an LLC for the manager is in case there’s dissension among the members of the management team. If there are, then that management entity is going to have its own operating agreement that’s going to describe what to do. What to do if people drop out, disappear, stop talking to each other, just can’t do it anymore, they’re not actively involved, maybe they got sick, maybe something happened. You’ve got to have a way to be able to remove a member that is not performing or is causing a problem for the management team without having to engage the members and having them vote.

So if you, for instance, formed your title holding entity and just named individuals as the managers, and if all of a sudden one of them didn’t want to do it anymore or couldn’t, you’d actually have to go out to the members and get their consent to be able to remove that person as the manager, and now that starts to make your investors a little bit nervous. They don’t know what’s going on, they don’t like being involved in politics at your company level. So you want to keep all of that stuff contained within its own management entity.

Now how might that management entity be structured? It could be structured as member-managed. In a member-managed LLC, all of the members are presumed to be managing members. So they’re all presumed to have an active role, and all of them have the right to bind the company, to act independently on behalf of the company. Alternatively, it could be manager-managed, just like your title holding entity.

So if you have a management entity, the reason you might want to appoint a manager within a management entity is if you have, say, three or four members, but only one or two of them are going to be the loan guarantor. The lender is going to ideally like to see the people who are loan guarantors have the ultimate authority over what’s happening with that property. So they would like to see those loan guarantors be managers of the manager, and then the other people that are performing sweat equity functions for that management entity could just be the other members of the manager.

We talked a little bit now about the title holding entity and how it’s structured, we’ve talked about the management entity and how it’s structured, let’s talk about who the members are going to be in the title holding entity. We like to structure our syndicates so that they have two classes of members. They can have more, but at a minimum, we like to see two. Class A is going to be your cash-paying investors, and that would include members of the manager who are actually paying cash to buy interest in the company. If the management team is contributing cash, then they would buy Class A interests, or Class A units. That’s what you buy in an LLC, they’re interests or units. If someone from the management team was contributing cash, they would buy Class A units right alongside all of the other investors, all the passive investors. All right. So who’s Class B then?

Class B are typically … it could be the management entity itself, or you could break it down further and allow that to be members of the management entity, so that they are getting distributions individually from the title holding entity for contributing sweat equity to the deal. There’s some other names for what we call these Class B interests. We can call them carve-outs, management carve-outs, or you might have heard the term carried interest, so that’s where the manager would carry their interest is in their Class B interests.

So what’s the difference in how the members and the managers get paid? The manager in the syndicates that we typically structure, the management entity, that LLC that’s going to serve as the manager, is typically going to earn fees. So these are things that would be taxed, ordinary income rates for actively managing this syndicate. So the management entity earns fees. What’s the difference? What does Class B get? Well, Class B gets their share of distributable cash. So what is distributable cash? It is the cash that’s left over after you pay the property operating expenses, management fees, so that would be property management fees as well as your syndicate management, your asset management fees, to the syndicator.

Distributable cash is excess cash flow that the property generates after paying expenses, after paying management fees, and paying debt service. So you’re going to pay your loan payment. So then the manager of that syndicate would look at that money that’s left and say “All right, how much of this do we need to keep for capital improvements, how much of it do we need to keep in reserves, and how much of it is available to distribute to the members?” The manager has the sole authority to determine what is distributable cash that can be shared with the members. So that’s where the term distributable cash comes from.

These members, these two classes of members, Class A, is typically going to get paid their share of distributable cash first, and then Class B is going to get paid their share of distributable cash. So how is that all determined, who gets what and what order do we pay it in? Well, that’s all spelled out in the operating agreement for the title holding entity. There’s always going to be a section in the operating agreement that is called a distribution section or something like that, and in it is something that we call a waterfall.

The waterfall is spelled out for each phase of how the company is going to be operating. How do you dole out that distributable cash? You typically have a section that describes what do we do with excess cash flow from operations. So operations is during the time that your property is actually producing income and generating excess cash flow. Any cash that’s derived from that would be distributed out to the members according to the waterfall, and the waterfall might have something like this. First of all, it could just be a straight split. So it just says, “Hey, whatever money we get, we’re going to split it 70/30, with the 70 percent of it going to the Class A, and 30 percent of it going to Class B.” That’s the simplest form.

More typical is to have a preferred return for Class A. What that means is you may still be splitting cash 70/30, but you’re going to split it in such a way that you’re going to first make sure that the Class A members get a specified preferred return, or sometimes that’s called a hurdle rate. That’s something where you have to reach a certain benchmark before you would be able to distribute cash to Class B. So the waterfall might sound something like whatever distributable cash there is will be distributed in the following manner, first to Class A, the greater of 70 percent of the distributable cash or an 8 percent preferred return. Then after that we would give something to Class B, which we call a catch-up. So Class B would get their equivalent of a 70/30 split, and then after that, you would split whatever other cash there was 70/30.

If you want to know more about that, there is an article on that section of our website that I mentioned before called “How to Split Money with Investors,” so you might want to read that. It talks a little bit more in-depth about how that’s done.

All right, let’s talk about what a waterfall would look like from a capital transaction. Capital transactions are a re-finance or sale of the property, something that generates cash. So at that point, you’re going to have a separate waterfall that says here’s what we do with the proceeds from a capital transaction. First thing you’re going to do is you’re going to pay back capital to Class A, so whatever cash they contributed is called their capital contributions. You’re going to repay those.

If it’s from a re-fi, maybe you only pay part of it back. But if it’s from a sale, you’re going to give all the money to Class A until they receive their cash back. Then whatever’s left after that is next going to go to any arrearages, so in preferred returns to Class A members. If you had a preferred return, you’d establish a preferred return for your Class A members. Let’s say in years one and two of operations you weren’t able to pay that 8 percent preferred return, but we had said in the documents that that’s a cumulative preferred return. So if you can’t pay it all in the first year, you’re going to have to make it up later; this is where you would make that up is on the occurrence of a capital transaction.

Now you could make it up from later operations if there was enough cash flow to do it, but we usually leave that up to the manager so they can decide if they’re going to make up arrearages either from subsequent cash flow or are they going to wait until there’s a capital transaction. So you make up arrearages in the preferred returns to Class A members. Then if we have that catch-up for Class B, then you would make up any arrearages in Class B’s return. So basically what you’re doing at that point is you’re equalizing everybody across the board from the beginning of the company so that it’s a 70/30 split the whole way through.

And then beyond that, if there’s still distributable cash left from that capital transaction, then you would go and split that cash. You could just split it according to your percentage interest, so in our example we gave 70 percent to the Class A members, 30 percent to Class B members, so that split would just be 70/30. But you could actually add something to that where once the investors have achieved a certain hurdle rate, so once their return on investment has achieved a certain benchmark, maybe it’s 17 percent, maybe it’s 20 percent, annualized over the entire duration that you’ve owned that property, then at that point you might change the split.

Maybe it’s no longer a 70/30 split, maybe now it goes to 50/50, because what you’ve done is you’re rewarding the manager for making this a really great deal for the investors and getting them up to a really nice return. And then once they get to that return, then the manager gets a little bit better bonus so it keeps their interest aligned with the Class A members. So that’s pretty much how you would structure a very simple real estate syndication. So it’s not that hard.

We have a title holding entity, it has Class A, Class B members, and it has a manager, we have a management entity that’s either managed by its members or managed by a manager. The Class A members in the title holding entity are the cash-paying investors and they’re entitled to certain returns and voting rights associated with their interests in the company. Class B members are contributing sweat equity and they also are entitled to certain voting rights and cash distributions based on their portion of the ownership of the property. And then we distribute cash according to a waterfall, and there’s usually going to be a separate waterfall, one for operations and one for capital transactions.

So that’s pretty much how it goes. I think at this point, we’re going to go ahead and open up the call to anyone who would like to ask a question. Please feel free, you’ll need to press star six in order to ask a question. So star six. While we’re waiting, in case anybody drops off during the Q&A time, I do want to give out our contact information. Our website is syndicationattorneys.com, and the best way to actually contact us is to go to our website and schedule an appointment. There’s a button on the top of the page, I think every page of the website, where you can just click the button and you can schedule an appointment. It actually takes you directly to my calendar, and that will get you directly to us.

Alternatively, if you look on the contact page, then there is information there where you can either contact Charlene Standridge, our law clerk, and she will help get you all the information you need or get you on my calendar, or you can even contact me directly. So that’s pretty much the best way to contact us is through the website, or if some of you may already have our contact information, feel free to use that as well.

 

Charlene Standridge:

Kim?

 

Kim Lisa Taylor:

So I think we’re ready for some questions. Yes, Charlene?

 

Charlene Standridge:

I just want to say the website is down right now and we’ve got our people working on it. Evidently a lot of people went on it, it got heavy traffic, so for some reason it is down and we’re working on getting it back up. So just be patient, we’ll get it back up just as quickly as possible.

 

Kim Lisa Taylor:

Charlene, do you want to give out your phone number and your email address in case somebody wants to contact you directly then?

 

Charlene Standridge:

Sure. My email address is Charlene@syndicationattorneys.com, and my phone number is 904-414-6690. So feel free to give me a call and I’ll be happy to either get you on Kim’s calendar or answer any questions you might have.

 

Kim Lisa Taylor:

Okay. Great. Thank you. All right. We’re going to go to live questions now. Hi. Please state your name and your question.

 

Omar:

Yes. Hi, Kim. This is Omar Ruiz. Great information here, by the way. One thing that I didn’t understand well, you mentioned that if you’re working with foreign investors that it may be better to set up a limited partnership instead of an LLC. I didn’t quite understand what the reasoning was on that. What’s the advantage?

 

Kim Lisa Taylor:

Foreign investors are a little bit tricky, and it’s usually driven by tax laws, by U.S. tax laws. So the tax laws between different countries are governed by usually a tax treaty between the U.S. and that other country. We have tax treaties with some countries that we’re friendly with, there’s some countries that we don’t have tax treaties with, but because of those tax treaties we have to do some alternative structures occasionally in order to make sure that those investors don’t get double-taxed, having to pay some kind of a tax here in the U.S. and then also having to pay a tax in their own country.

An example of that is Canada. If you have any Canadian investors, the tax treaty between the U.S. and Canada was written before LLCs existed, so it doesn’t have any provisions for LLCs. But it does say that if an investor from Canada invests in the U.S. in a limited partnership or a corporation, that whatever tax they have to pay in the U.S. will be credited against whatever tax they would owe in Canada so they’re not double-taxed. But since it didn’t contemplate LLCs, those aren’t incorporated in that, so if they invested here in an LLC, a Canadian investor invested directly, then they would pay tax in the U.S. and then they would also pay tax in Canada. So that’s just an example of why you might do it that way.

But dealing with foreign investors can get pretty complex, because sometimes we would actually form an entity in an offshore jurisdiction that has a tax treaty with their country because the U.S. doesn’t have a tax treaty with their country, and then we would look for a jurisdiction to form that entity where the U.S. does have a tax treaty, so it can get just a little bit convoluted. And whenever we are doing those kinds of structuring, we engage an international tax advisor to help us structure it correctly so that those investors are getting the best tax advantage they can get.

 

Omar:

I see. So the crux of the matter is that there’s just these foreign countries that don’t recognize the LLC business structure.

 

Kim Lisa Taylor:

That’s right. That’s exactly right. Okay?

 

Omar:

Okay. Thank you.

 

Kim Lisa Taylor:

I’m going to go on to the next question. Thank you. Okay. Next caller?

 

Luke:

Hi, Kim. This is Luke. I recently purchased an apartment complex. I own it myself. Would the rules for syndication be any different if you did it after you purchased the property versus … I think this all assumes that you’re doing it before you purchase the property, right?

 

Kim Lisa Taylor:

You can do it after the property is purchased. It doesn’t have to be existing property, you can use syndication to develop properties, you can use it for properties that you already own. It’s really just a matter of … in your case, you already have an entity that has title to your property, right?

 

Luke:

Correct.

 

Kim Lisa Taylor:

Okay. And do you have a bank loan?

 

Luke:

Yes. I do have a loan.

 

Kim Lisa Taylor:

So whatever loan you have on that, as long as that loan is in place, you’re not going to be able to change the title holding entity. So you would probably want to sell off a portion of the ownership interest in that title holding entity.

 

Luke:

Great. Would you still be required to go through all the syndication procedures and all the legal aspects of it just the same way?

 

Kim Lisa Taylor:

Yes. It doesn’t matter if you already own the property or if you’re buying something brand new, the securities laws apply whenever you’re raising money from passive investors. So raising money from passive investors in a way that they’re considered investment contracts then those fall within the definition of securities, so now you have to follow securities laws. And that just means you either have to register your offering by going public, getting pre-approval, before you can actually raise the money, or you can qualify for an exemption.

So that’s where securities attorneys like me come in, where we can help you figure out what exemption’s going to be the best one for you to follow based on your circumstances, where your property is located, where your investors are located, what kind of financial qualifications they have, whether or not you need to advertise. Once we know the answers to those questions, then we can help guide you into the right exemptions and help you follow those rules. That’s going to usually require providing some kind of a disclosure document that describes the risks of the investment to your investors, making sure they have all the material facts so they can make informed consent before they invest, and then doing some filings with the SEC and states’ securities agencies to let them know that you’re claiming that exemption. All right?

 

Luke:

Great. Thank you.

 

Kim Lisa Taylor:

You’re welcome. We’re going to go on to the next caller. Hi.

 

Bruce:

Hi Counselor. Good afternoon. How are you? This is Bruce from Southern California. How are you, Kim?

 

Kim Lisa Taylor:

I’m good. Hi Bruce.

 

Bruce: Okay. My question is I’m an associate that’s involved in putting together a lot of deals, whether they be movie deals, real estate deals, obviously we’re specifically talking about real estate. So he indicated to me that he had a buyer from Dubai that was interested in a hotel. Right now, this buyer’s in the process of building a seven-star hotel-casino in Dubai, supposedly has unlimited funds. I don’t know if a syndication is going to be appropriate on this deal. I’m having problems reaching my associate at present. I reached out to some folks real estate-wise who were real estate brokers and/or agents. Now that particular individual let me know that there’s a property in Southern California that meets his basic criteria, but my question to you is simply this:

When a property is listed, the broker represents the owner of the property. This is a very well-known property here in Southern California, so there are a couple of things involved. My question to you is simply this. Obviously, if it’s a cash deal, this is a non-issue. But I want to have Plan B and Plan C in effect, meaning that if this particular person from Dubai falls through, I want to be able to put together a syndication, a group of investors. It’s going to be a very, very, very substantial big deal, I would say at least a half a billion dollars, if not more. So time is of the essence even though it’s a large transaction. It’s a pretty well-known property here and I don’t want to lose it, so I don’t know how to proceed. What do you suggest?

 

Kim Lisa Taylor:

Well, I can tell you just in general what I tell people when they have whale investors. And some of you may have heard this mantra before, but when I think of whale investors, these are big fish that are coming in and they’re going to bring in the whole deal or take down the whole deal. It instantly brings to mind for me “Moby Dick,” because if you think about it … if you’ve watched the movie or read the book, Moby Dick left a pretty big wake of destruction in his path. And whale investors often do the same thing. So I can tell you that 80 percent of the time that clients have come to me with a single investor, they have not materialized.

Either they have materialized in the beginning and disappeared toward the end, or disappeared really close to closing and just said, “Oh yeah, by the way, something else came up, I’m not going to do it.” Or, toward the end of the deal or during the course of the deal, they start negotiating terms that no longer make this deal worth it for the client or the syndicator to do the deal, because they own you. At that point, they own you, you work for them, you’re basically an employee, they call the shots … if you don’t like it, too bad; they walk away. In the meantime, you’ve put up all the cash, you’ve put out the time, you’ve put up the risk, and they have nothing invested in the deal.

So my advice to anybody that comes to me and says they have a whale investor is that’s too bad. Keep raising money. Do a syndicate. So do a syndicate. I think this is a very specific question, so you would need to schedule an appointment and we could talk a little bit more about what your syndication options look like. But my advice to you would be to set up your syndicate and start raising money from other sources, and then if this person does materialize, you might still use them, but now they don’t have quite as much power over you if you’ve already raised the money from some other sources, because you don’t need them as much, or maybe you don’t need them at all, and you can decide whether you want to accept their terms.

 

Bruce:

Sure. But the downside to that, obviously, if the property, although it’s a real big transaction, it’s being represented by a broker who represents the owner of the building, time of the essence is going to exist, potentially, and by the time all these intricacies of the syndication itself are to be worked out, you might lose the property.

 

Kim Lisa Taylor:

That’s always an issue. So if you have sources like that, don’t depend on a single source. If you need a big investor to come in and take down part of the deal, try to find several sources so that you’ve got them back up, so if this one doesn’t pan out and if they’re not calling you back, they’re not being timely in their responses, then just move on.

 

Bruce:

Do you have a database of potential investors as well?

 

Kim Lisa Taylor:

No. We don’t help you raise the money. We’re going to give you the documents and the knowledge, and we will introduce you to some potential resources that can help you raise some money, but we don’t help you raise the money. We’re a law firm. We’ll give you what you need so that you can go out and do it. Okay? Thanks a lot. Thanks, Bruce.

 

Bruce:

Thank you.

 

Kim Lisa Taylor:

Okay. Next question?

 

Michael:

Hi, Kim. This is Michael. Thanks for your time today. I had a question regarding private equity fund, as far as the management fee. Is a one percent to two percent management fee, is that per year on the funds raised, the AUM, or is that a one-time thing?

 

Kim Lisa Taylor:

You can calculate an asset management fee in multiple ways. If you’re doing a blind pool fund, it might be calculated based on the amount of money that you’ve raised. If you’re doing it based on a specific property that you’re buying, you’re typically going to calculate the asset management fee off the gross income that the property receives.

 

Michael:

Okay. Yeah. Well, that’s on a one-off deal, right? On a deal-by-deal basis for you, the latter part?

 

Kim Lisa Taylor:

You still could do it that way in a blind pool, you’d just have to model it out and see which way makes sense. If you have 10 properties and you’re getting one percent to two percent of the gross collected income on a monthly basis, maybe that’s not bad. Maybe that’s even better than what you would get if you just took an asset management fee based on the amount of the money invested.

 

Michael:

And if you did it off the money invested that would be a yearly?

 

Kim Lisa Taylor:

But you’d usually take it incrementally, monthly or quarterly.

 

Michael:

Right. Okay. And as far as a developer fee or acquisition fee on a blind pool or private equity fund, how does that work? Does that even exist? Is that common?

 

Kim Lisa Taylor:

Sure. You can build in an acquisition fee that’s a certain percentage of the purchase price for each of the assets, or a certain percentage of the investment amount, according to the assets that the fund invests it. Sure. You can do that.

 

Michael:

So you just pull out an acquisition fee, one, two, three percent, whatever it may be … from the pool?

 

Kim Lisa Taylor:

Yeah. Usually based on the asset value. Well, it could be based on the amount of money that you’re investing, or it could be based on the purchase price of the asset. There’s any manner of ways that you can calculate it. If you’re putting up all the money for somebody’s deal, you probably do it on the asset value. If you’re only putting up part of the money, then maybe you’re just going to do it on the money that your fund invests.

 

Michael:

So if we control the, just for round numbers, $5 million fund, we could take a 2% acquisition fee off that total raised amount right out of the gate and nothing else after that, once deals are acquired, aside from a management fee? Is that typical? I’m sure there’s a million ways to structure it.

 

Kim Lisa Taylor:

I don’t know. Again, management fees are kind of a la carte. There is an article on our website, once it gets back up, that talks about earning money in a syndication and the different types of fees that you might be able to collect, and you’re going to pick and choose some of those which make sense for your particular situation, and what you think is going to make sense for your investors too.

 

Michael:

Yeah. Right. I understand how it works on a deal-by-deal basis, I’m just trying to understand how on a fund, how it would work.  Like an acquisition fee. Do it take it once the $5 million is raised and that’s it, you have nothing else to the hold term of the fund?

 

Kim Lisa Taylor:

We’re always going to… Realize this, though. Your fees are just a small portion of how … they’re the smallest portion of how a syndicator earns money, because the fees are what you earn for actively managing the deal and you want to keep that number as small as possible because that’s where you’re going to get the biggest tax hit. You’re going to get the tax hit when there are income rates on that money, so you’re going to pay the extra 15 percent self-employment tax, but if you take more of that as your carve-out, your Class B carve-out, then we actually ask our Class B members to pay something for their Class B interests, a nominal amount, $1,000, something like that, so you can establish a cost basis and then you may be able to get capital gains tax rates on the distributions you receive as a Class B member, so that’s going to be a more favorable tax rate.

So you really shouldn’t be living for fees so much as just taking … The fees are your walking-around money. That’s keeping you from starving, because it could be a long time before you’re generating distributable cash. So you’ve got to have something to keep you going in the meantime, but it shouldn’t be enough that you don’t have to worry about the distributions, because you really want to be focused on the distributions, because 1), that’s going to be a better tax rate; 2), you’re going to potentially earn a lot more money, and 3), that keeps your interest aligned with your investors because you’re not just walking around with your fees and happy enough. You’re like, “Hey, I need to get to those distributions so I’m going to work really hard to make this one profitable.”

 

Michael:

Okay. Thank you.

 

Kim Lisa Taylor:

Thank you. All right. Next question.

 

Mike:

Hi, Kim. It’s Mike Butler. How are you? From Philadelphia.

 

Kim Lisa Taylor:

Hi, Mike. I’m great.

 

Mike:

Good. You kind of answered my original question earlier, but I do have an advertising 506(c) question, if that’s okay to ask at this time.

 

Kim Lisa Taylor:

Sure. Absolutely.

 

Mike:

It’s a general question. In a 506(c) offering, can you include the returns in the advertisement in terms of percentage or what have you? Or is that something you still can’t do?

 

Kim Lisa Taylor:

No. You can advertise anything you want, and that’s the whole beauty of the 506(c), is that as long as your ads are truthful and not misleading, if you want to make sure that whatever return you’re giving them perhaps you’re qualifying that, is it an annualized return, is it a return that you might realize after property’s sold. We’d want to make sure that that’s accurately stated so that nobody could claim it was a misrepresentation or misleading, but you’re allowed to advertise anything about the deal that’s truthful. And you can advertise it any way you want. I would use the example you could drop flyers from a plane. It probably wouldn’t be a very effective way to do it unless you were dropping it on just country clubs around the country or something.

 

Mike:

All right. That’s a good idea. Okay. Of course, obviously, so that really should correspond within the operating agreement in terms of what our projected returns are going to be.

 

Kim Lisa Taylor:

Oh, absolutely. You can’t bait and switch. Don’t bait and switch. And then you also want to have a securities attorney review those ads, because there’s some certain disclaimers that you should have on those. And the other thing about a 506(c) is that the rules say that you can advertise your offering, but that means that you have to have one. So you’ve got to have an offering, so you can’t just go about willy nilly advertising, “Hey, we offer 10 percent returns,” and then when you get around to drafting your documents you’re saying “Oh geez, they’re really, on this deal, only going to be 8 percent, and oh, by the way, we want to include some unaccredited investors in our deal so we’re going to do 506(b)s now.” So there’s where people get into trouble.

If you’re going to do a 506(c) and you’re going to do an advertisement campaign for it, you need to have your documents in hand and then you can start advertising. And the typical way that you’re going to advertise that is to set up a website, and we have clients that have fun-specific websites, it’s just for that fund, just for that deal. So set up your website. But you’ve got to have some kind of a marketing plan in place where how you’re going to reach out to investors and you’re doing it in a systematic way that’s going to not only generate investors for this deal, but it’s going to generate people that you can develop relationships with for long-term, and they might invest with you for years.

 

Mike:

Okay. Thanks. That’s actually very helpful, and actually kind of segues into … If you don’t mind, if I could reach out to you via email after the call. I do have something that maybe you’d be willing to review. I’d like to get a second opinion, if that’s okay. Can I do that? Is that the best way, to email?

 

Kim Lisa Taylor:

Yeah. Just reach out to us and let us know what you need and we can talk about how we might be able to help you.

 

Mike:

Okay. Great. Thanks, Kim. I appreciate the time.

 

Kim Lisa Taylor:

Thanks, Mike. Okay. We’ll go on to the next question.

 

Unidentified Caller:

Hey, Kim. Love you, love the show. Love everything that you do for us, adding a lot of value, that’s for certain. Speaking of securities law, I understand the benefit of syndication, especially to the manager, but as far as doing a different structure, like maybe adding on debt partners, say, for example, a 12 percent return interest-only with a five-year balloon payment, something like that. Have you seen or structured things like that, and why don’t more people use that structure than the typical syndication? It seems like there could be more retained earnings to the manager going that route, and maybe a safer place for the investors.

 

Kim Lisa Taylor:

Well, there’s a couple of reasons that people don’t always go that route. Number one, it depends what you’re buying. If you’re buying properties for all cash, there’s no problem. Or if you’re creating a fund so that you can loan money out to people, become a hard money lender, you could do that kind of a structure. If you’re buying single-family properties, you don’t have any lenders involved, that could be okay. If you’re buying properties and only have hard money lenders involved, they might not care if you have subordinate debt. But if you’re buying commercial properties where you’re getting an institutional loan, there’s going to be a prohibition in those loan documents from any subordinate debt, so they’re not going to allow you to have any promissory note.

So what happens in that case then is that you still going to form an LLC and you’re going to create a separate class of investors and say this class is going to have these rights. They don’t have any voting rights, they aren’t really members of the company, but they get the rights to preferred cash, so the first cash that comes in after paying property expenses, management fees, and that service goes to this preferred Class and they get a fixed return. Then once you’ve paid back their capital contributions plus any preferred return that would be for the period of time you had their money, then at that point you would be able to sever them from the company. So that’s one way that can be done.

But if you’re talking about two debt partners where you have a promissory note, then that creates a different legal relationship between the borrower and the lender. The borrower-lender relationship is actually an adversarial relationship legally. They’re not your partner, they’re not your buddy, they’re not your friend, you’re only going to give them information they need to know, and the only information you’re required to give them. You’re not going to tell them if you lost your job or if 40 percent of your tenants moved out unless it starts affecting your ability to make those payments. So as long as you’re making the payments, they aren’t going to know, unless they have the requirement that you have to give them periodic updates, which is not common with like a Fannie Mae, Freddie Mac lender, but some of the private equity fund lenders do have those requirements.

 

Unidentified Caller:

So if you stick with more of a promissory note, therefore the bank themselves won’t necessarily look for that subordinate debt, that might just work.

 

Kim Lisa Taylor:

So if you’re using a promissory note behind an institutional loan guaranteed by Fannie Mae or Freddie Mac or some sort of CMBS loans, they’re going to want to know the source of that money, and they’re going to want to see the agreement that you have with those investors, and they’re going to ensure that that is not considered subordinate debt. So that’s why everybody structures just the syndicates as an LLC or limited partnership where they actually have members or limited partners, because that is acceptable to the lenders.

 

Unidentified Caller:

Gotcha. And then would that fall underneath all the different securities as far as a nonaccredited, accredited, and so on, so forth?

 

Kim Lisa Taylor:

Yeah. As soon as you are creating those investment contracts, having passive investors in your deal, now you’re falling under the definition of securities and you have to follow all the securities rules, choose an exemption, and do all those disclosures and filings and things.

 

Unidentified Caller:

Got it. Thanks a lot, Kim. I appreciate that.

 

Kim Lisa Taylor:

You’re welcome. All right. Thank you. We have one more caller, and then we’re going to wrap up. Hi.

 

Chris:

Hi, Kim. It’s Chris calling from La Jolla, California. How you doing?

 

Kim Lisa Taylor:

Good.

 

Chris:

The question I have is we’re looking at structuring a syndicate under a 506(c) exemption, and the thought occurred to us at some point maybe moving over to or transitioning to an A+ registration. My first question, do you folks handle that? Does your law firm handle A+ consulting and formations?

 

Kim Lisa Taylor:

Yeah. We can help you with that.

 

Chris:

Okay. And loaded question, of course, but what kind of ballpark figure are we talking about, A to Z, for the formation of an A+ filing?

 

Kim Lisa Taylor:

As far as what the legal fees are?

 

Chris:

Yeah.

 

Kim Lisa Taylor:

Typical legal fees are going to be $40,000 to $50,000 to set that up, but you should also be looking at having a marketing budget that’s probably commensurate with that, because you’re going to have to have a marketing plan in place in order to reach out to the kind of investors that you want to invest with you.

 

Chris:

Okay. And I guess the big advantage of an A+ would be your ability for jumbo solicitation and to reach out to both accredited and non-accredited investors. Correct? Is there any other advantage to going through all the red tape and everything with an A+ filing other than that?

 

Kim Lisa Taylor:

No. And the typical progression that I’m seeing is that most people who start out as syndicators are going to start out doing 506(b) offerings. So the first thing they’re going to do is tap into their existing network of family, friends, and acquaintances and get them educated about what they’re doing. They’re going to bring those people into their deals. Typically, some of those people are going to be unaccredited, so they’re going to be doing that based on previous relationships versus advertising under Reg D, Rule 506(b). Once they’ve tapped out those resources and they’ve got all of their unaccredited people invested, then at that point they might consider going to a 506(c), because two things have happened.

In the interim, they’ve developed a sufficient track record that strangers will take them seriously, and two, now they’ve got some traction in the marketplace. They’ve got something to show for what they’ve done, but they also know how to talk to investors and they’ve got some means to be able to advertise and to set up an actual marketing program. So that’s when people are going to go into the 506(c) realm and advertise.

The only reason that you would go then from 506(c) to Reg A+ is if you’re not finding enough verified accredited people who will invest with you, which is what’s required for the 506(c) exemption, and you now want to be able to advertise to the general public without regard for whether people are sophisticated or anything like that. Anybody with a few thousand dollars can make the investment. You don’t have to worry as much about their qualifications.

So that creates its own set of complications, because now you’re dealing perhaps with people who aren’t as financially savvy to maybe a little bit more nervous investors, a lot more babysitting and hand-holding. So you’ve just got to think of it that way. And you’ve got the added regulatory burdens of your periodic reporting and audits and things like that.

 

Chris:

Right. So obviously a lot more red tape with a Reg A+ filing with the only advantage being, really, that you can solicit to non-accredited investors, along with accredited investors.

 

Kim Lisa Taylor:

Yeah. And I was just reading some statistics, some SEC statistics recently, and what’s interesting is that 506(b) is still far and away the preferred method of raising capital. 506(c) is starting to gain traction, but that’s still a small percentage of the marketplace. So what was really amazing to me about the statistics I was reading is that over the last few years there was 15,000 Reg D filings, and most of them were 506, and 1,500 public company filings, so that has dropped off dramatically, and in the last two years the amount of money raised in private offerings has surpassed, for the first time, the amount of money raised in public offerings.

 

Chris:

Wow. Under a 506(b), that’s just basically the old syndication regs, right? General solicitation is prohibited and all the rest of it, right?

 

Kim Lisa Taylor:

That’s right.

 

Chris:

35 shareholders, et cetera. All right.

 

Kim Lisa Taylor:

Well, it actually is up to 35 unaccredited plus an unlimited number of accredited investors.

 

Chris:

Oh, okay. So under a 506(b) structure, you can generally solicit accredited investors?

 

Kim Lisa Taylor:

No. You still can’t generally solicit. It’s still based on pre-existing relationships.

 

Chris:

Okay. So that’s prohibited under a 506(b). But under a 506(c), it’s okay.

 

Kim Lisa Taylor:

What is interesting is that even giant hedge funds are still using 506(b)s. Now, is it for some reason they’ve shied away from the 506(c)s, and that could be … I don’t know why, but they don’t jump on that bandwagon which is good for you, because then it leaves all of those accredited investors.

 

Chris:

That assumes, I guess, that you have a substantial database of accredited investors in place or something.

 

Kim Lisa Taylor:

One of the strategies you might consider is using a 506(c) to increase your database, but then do a 506(b) offering. But along the way, while you’re doing that advertising, chances are you’re going to meet some people that aren’t verified accredited investors and then maybe the next offering you do is for 506(b) investors so that you can include those people that you’ve taken the time to develop relationships with.

 

Chris:

One last question, if it’s okay.

 

Kim Lisa Taylor:

Oh sure.

 

Chris:

It’s a quicky. With regard to blind pools under a 506(c), are there any prohibitions … I’m not talking an REIT, but can you assemble a blind pool offering under a 506(c) offering only to accredited investors without … are there any SEC regulations that would prohibit that? Track record aside, let’s say that you had the track record where there’d be a trust level there with investors, but can we go out under a 506(c) and assemble a fund that’s not specified for a particular property, a blind pool fund?

 

Kim Lisa Taylor:

Absolutely.

 

Chris:

Okay. Well, that’s it. Thank you very much. Great stuff.

 

Kim Lisa Taylor:

Well, thank you. All right. Hey everybody, thank you so much for taking time out of your busy day. Appreciate that you all get on these calls. I love your questions, these are great questions. I can tell that people … I hope people are starting to get a feel for what syndication’s all about and that it’s not insurmountable and if you’ve been thinking about doing it and you haven’t pulled the trigger, then maybe 2018 is the time you should get ready and get going.

Please do visit our website, there’s a lot of information on it. I’m sorry that I sent everybody there and it crashed, but I promise it will be up later. Avail yourself of that information. The previously recorded calls from our other teleseminars are on that as well and you can listen to those. And if you have any questions, please schedule an appointment, reach out to Charlene, reach out to me, we’re more than happy to talk to you. All right. Have a great day everybody.

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