Anatomy of a Multifamily Real Estate Syndication
Two articles ago, I explained why “the best investment on Earth is earth.” Last month, I showed you why apartment complexes are the best of all real estate investments. But if you want to buy a midsize apartment building, unless you’ve got $10 million or so in cash sitting in your bank — in which case you should stop reading this right now and get back to doing whatever you want, all the time — you’ll soon come to realize that real estate investing is a team sport. In fact, since most people don’t have $10 million in free capital lying around, most apartment deals are purchased by investors pooling their money together in what is commonly known as a “syndication.” And while there is no “standard” or “garden-variety” real estate syndication, here’s how one might work in today’s market.
- The sponsor
The person (or persons) who puts the multifamily deal together — the individual who figuratively herds approximately 10,000 cats into a small brown box and drags that spitting, hissing box to a closing table at a title company — is the syndicator or the sponsor. The apartment deal is his baby, and much like a baby, it will alternate between (a) sitting there not doing anything interesting, and (b) commanding every second of his attention and keeping him awake all night.
The first, and perhaps most difficult, task facing the multifamily sponsor is finding a great deal. All the sponsor has to do to find a deal is learn and understand her local market, network with brokers, lenders, investors, property managers, appraisers, attorneys, accountants, mail carriers, fire fighters… Then, after she looks about 100 different deals, analyzes the financials on 20, and makes offers on four or five, she might get one offer accepted. Then she has to draft the letter of intent, negotiate the purchase contract, and get the seller to sign on the line that is dotted. Nothing to it.
Once the contract is signed, of course, it’s a piece of cake — all that’s left, really, is structuring the deal, arranging the debt and equity financing, performing all the due diligence, reviewing all the conveyance and financing documents, and doing whatever else needs to be done to get the deal closed. One small part of this process — but in many ways the most crucial part — is the equity raise — the pooling of investors’ capital to fund the equity portion of the purchase, generally 25-30%, or more, of the total acquisition cost.
- Structuring the deal
The investors that are interested in our sponsor’s apartment project will understandably be primarily concerned with (1) the sponsor’s trustworthiness and experience, (2) how soon they will get their capital back, (3) their projected return on investment, and (4) whether the sponsor is going to take their money to Vegas and put it on Red 22. Not necessarily in that order.
For all these reasons, most sponsors will offer the equity investors the lion’s share of the projected profits from the deal. A first-time syndicator might offer 80 percent of the deal to the equity investors, five percent to an experienced and successful co-sponsor, five percent to a loan guarantor who meets the lender’s requirements for net worth and liquidity, and five percent to a short-term lender who advances the funds for due diligence items such as inspection costs, environmental studies, financial audits, legal fees and so on. (If you’re doing the math, that just leaves 5 points on the table for the sponsor himself — but as Sir Isaac Newton once said, “five percent of something is better than one hundred percent of nothing.” 1
- The equity raise
Most lenders will not loan more than 70-75 percent of the project cost on a multifamily investment, which means the sponsor will need to raise the other 25-30% of the deal from equity investors. Although it is certainly possible to syndicate a real estate “fund,” — that is, to raise capital before an apartment deal is under contract — most real estate sponsors, especially those without a long track record of other deals, will get a deal under contract first, then raise the equity. One experienced syndicator put it to me this way: “It’s easier to sell an actual building than just the idea of a building.” That being said, a smart sponsor will reach out to potential investors well in advance of the signing of the purchase contract, simply to gauge the investors’ interest in the types of properties the syndicator is looking for.
- Securities laws
In reaching out to investors, or potential investors, however, the sponsor can get herself into real trouble if she is not careful. The Securities and Exchange Commission, formed in 1933 after investor speculation and panic caused the stock market crash of 1929 and the Great Depression, regulates the “issuance of securities,” which includes just about any offer to sell a piece of a business venture, whether it be stocks, bonds, fractional oil and gas royalties, options — or a participatory interest in a multifamily real estate investment. Essentially, the SEC — and corresponding state agencies, like the Texas State Securities Board — attempt to protect investors through the capital formation process by controlling and regulating the issuance of securities. This control and regulation process, however, is so rigorous and onerous that most real estate sponsors will want to raise capital under a registration exemption — that is, to interact with and collect money from their investors in a way that allows them to avoid the expense and red tape of SEC registration.
- The private placement
The vast majority of all real estate syndications fall under one of two registration exemptions allowed by the SEC under Rule 506 of Regulation D. The 506(b) exemption, by far the most common of the two, allows a sponsor to collect money from an unlimited number of “accredited investors” and up to 35 “sophisticated investors” — so long as the sponsor has a previous relationship with the investor and does not engage in any solicitation or advertisement of the offering. The recently expanded 506(c) exemption does allow solicitation and advertisement of the offering, but all those who ultimately invest must be accredited, and the sponsor must independently verify the accredited status of each of his investors. Under either of these exemptions, the sponsor is free to raise an unlimited amount of capital. Actually, “free” is a misnomer in that situation, because there are still enough rules and regulations that apply to an unregistered offering to choke — well, to choke something that chokes on rules and regulations, whatever that is.
If the real estate deal falls under one of the Reg D exemptions and the securities are therefore not registered publicly with the SEC, the equity offering will be referred to as a “private placement.” At this point in the dealmaking process, the sponsor, if she has not already done so, should hire a top-notch securities lawyer. Why? you ask? Easy — because before sailing west across the Atlantic Ocean for the New World, Cortez hired a securities attorney to tell him where the sea dragons were. 2
A securities attorney who is worth his salt will help the sponsor navigate the treacherous waters of a real estate syndication by doing all of the following:
- filing the “Form D” certificate of non-registration with the SEC and the state securities agency
- forming the entity that will own the apartment building
- drafting the operating agreement for the new ownership entity
- drafting the private placement memorandum – a highly detailed prospectus of the offering, specifying the structure of the deal, the terms of the equity investments, and the risks associated with similar deals
- drafting the subscription agreement – the document upon which the rubber meets the road, we put the pedal to the metal, someone blurts out some other awful cliche, and the investor commits her money to the deal and writes a big fat check to the newly-formed entity and its newly-formed bank accounts
- drafting and collecting the investor questionnaire or other proof of accredited status from the accredited investors
Once the sponsor and the securities attorney have put together all the documents and obtained all the investor commitments, the deal is almost done. All the sponsor has left to do is to get the debt financing into place, sign off on all the inspections and due diligence items, get her property and financial management teams at the ready, and handle any number of last-minute tricks, traps, and snares on the way to closing. Once the deal is closed, the sponsor can kick back, light a cigar, and drink a celebratory beverage of her choice — now that she owns an apartment complex, she’s on Easy Street. 3
1. It may have actually been Archimedes who said that.↩
2. This statement might not be 100% historically accurate.↩
3. Nothing could be further from the truth.↩
Please do not rely on this article as legal advice. We can tell you what the law is, but until we know the facts of your given situation, we cannot provide legal guidance. This website is for informational purposes and not for the purposes of providing legal advice. Information about our real estate practice can be found here.