Just how does a real estate syndicator or a fund sponsor think about the exit? How are we going to exit out of this property? What are the mechanisms that we can use? This video is going to go through the five different ways of exiting out, getting your investors back their money.
My name is Tilden Moschetti. I’m a syndication attorney with the Moschetti Syndication Law Group. Let’s go through those five different ways to exit a property and get investors’ money back, having that capital event occur.
The first way is very clear cut; it’s probably what you think of first. Don’t we just sell the asset? Yeah, that’s exactly what you do. You sell the asset. Now, whenever that happens, the asset gets sold. The money’s sitting there. And now what do you do with it? You just follow through what you told them. Look at the operating agreement, look at the PPM, look at everything you’ve told them, and use that like a recipe.
For example, if you’ve got a waterfall structure with a preferred return and it says, “Well, first you give investors the money back, then you give a preferred return of 8%,” just making numbers up here. And then we’ve got a 70/30 split. So 70% goes to the investors and 30% goes to you, the sponsor. You just follow that like a clear-cut example. And then you give everybody an accounting. You’re done at the end of the day. That’s the most common way that happens. I mean, that’s certainly the way that you’re going to plan. It has the possibility of happening because it certainly happens probably in 90% of deals.
Probably the second most common way is called a refinance exit. So if the property value is here, but you’ve also got the loan amount already down here, and so it’s got pre-existing debt, or maybe it doesn’t have debt at all, what the sponsor can do is say, “Okay, I’m gonna go put debt on it, I’m going to put it up here. And so now I can give investors that money.”
So we set the fair market value, let’s say the shareholders own 70% of the asset. And I’m able to get, because it’s such a great asset, a loan-to-value of 75%. You go to the bank, you say, “Give me 75% on the value of the property,” and then you go back to your investors and say, “Look, fair market value of this is here, we have this pool of money from refinancing, here’s the money.” What it essentially is doing is making it so that you, the sponsor, are buying the property at fair market value.
Now, this has some clear advantages. It lowers the risk of the deal going sour, and it lowers the risk of it not trading for exactly what fair market value is. The caveat is you really want to make sure that you’re doing it at fair market value. As soon as you come to the investors with this idea, with this proposition of what you’re going to be doing, shareholders are immediately going to be a little taken aback. They’re going to be asking themselves, “How do I know that I’m really getting fair market value and not getting taken advantage of? They know it better than I do.”
So you need to make sure that the mechanisms are in place. Your syndication attorney should have baked in that possibility if it’s there to make sure that, okay, we’ve got this mechanism. We’ll determine fair market value based on an appraisal by a third party. And then that appraisal will go to the investors so that they can understand it. They can ask questions, they can question it.
Sometimes if we perceive that the trust level might be a little bit less, we might say, “And if there’s a question on fair market value, the shareholders themselves can ask for another appraisal. And if it’s off by more than 5%, then we can do a third appraisal and we take the average,” or whatever that is. So there are mechanisms in order to take care of that answer. That’s a fairly common thing to bake into a real estate syndication, so that those sponsors are able to basically keep that property for themselves.
The third way that happens is called a recapitalization. Through recapitalization, this isn’t actually a pure sale. This is changing the way that whole capital stack happens. So perhaps let’s say that the property was bought for $5 million, it’s worth $5 million, and you’ve decided you want to recapitalize it. So if it was bought all cash, right? So that $5 million worth of value, and you go to the bank, and they were willing to give you a loan-to-value of 50%. So now that’s two and a half million dollars in cash.
You can then go to your investors and say, “Great news, based on the equity, you guys own 75% of the equity, we’re now going to dole out 75% of this loan out to you in order to make sure that everybody has that money.” So that’s money that’s being paid out. It reduces their basis, and basically gets them their money sooner.
Why would you do this? Well, to get their money sooner, it’s going to drive up your IRR like sky high, because now you’ve gotten them a bulk of money up front. You just want to make sure ultimately, at the end of the day, that the fees that you’re going to pay are worth it, right? Because there are still loan fees and appraisal fees and all those things that go into recapitalization. And you want to make sure that your investors are benefiting out of it at the end of the day.
The fourth way is one that I oftentimes get asked about, and it sometimes works, but it sometimes doesn’t. And that way is through what’s called a 1031 exchange. Now, if you’re in real estate, you probably know what a 1031 exchange is. It’s where you take an existing property and you exchange it for a like-kind property, replace the debt, replace the money, things like that. And then you don’t have to pay any gains. So the gains tax never happens, it doesn’t trigger that.
Now, the reason I say it sometimes works and sometimes doesn’t is because as an entity, as an investment entity, it can act just like you as a person. It can do this thing where it’s going into another property. But where we sometimes run into problems is if there are people who want to leave the fund or the syndication, and you want to pay them out. Sometimes we have a problem there. And you really want to talk to a good qualified tax attorney who specializes in 1031 exchanges. They will definitely know about this issue and be able to help make sure that either it’s going to work or it’s not going to work and make sure that it’s all done in the right manner.
The last way is through what’s called merger or acquisition. This is where you take that investment, all that equity that’s in the investment entity itself, and you turn it into something that might be through an upgrade into another REIT. And it might be into a merger into another fund that another fund buys out. And it gives the investors the opportunity to either stay in or an opportunity to exit.
This works sort of like a 1031 exchange, or actually works sort of like an upgrade, but not exactly because the taxes are a little bit different. But it’s an opportunity for your investors to either stay in if they really want to, if they’re attached to that asset or as an ownership, or to move out in general.
That’s not as common, maybe because the kind of portfolios that exist, they’re not being absorbed in that way all the time. It definitely happens on a larger portfolio, where a REIT might be interested in buying out the entire portfolio and willing to go through the legal hurdles of doing an upgrade. Or if it’s a private equity fund or a larger syndicator that wants to incorporate that into its fund.
It can also happen with the sponsor, who also has a separate fund, who wants to absorb that as an opportunity. It can be set up ahead of time, but they’ve got to know it ahead of time. Your investors have to know it because again, it looks like maybe something fishy is going on here. And I’m getting either getting this new thing that I never bargained for in the beginning.
So you want to make sure that your syndication attorney has baked in that possibility into the PPM, into the operating agreement. So it’s there. So at the end of the day, if there’s any question and your investors start asking you why you’re doing it and what basis you can do it, you can point to them and say, “This is why and this is why it’s a good thing.”
My name is Tilden Moschetti. I am a real estate syndication attorney with the Moschetti Syndication Law Group. We specialize in Regulation D rule 506(b) and rule 506(c) offerings for real estate syndicators, real estate investment funds, businesses, really anyone who’s trying to raise money. They want to take investor money and be able to use it in order to make them more money and make the sponsor, you, more money as well. That’s where we help. Give us a call if you’d like to meet and discuss your project and see if there’s a good fit between what you’re looking to do and what we offer.