Episode 73 – The Essential Guide to Structuring Your Real Estate Syndication

Many clients have questions about how to structure their syndication or fund. So I thought we’d do a blast from the past for today’s video to take a look at just what goes into that thought process. It’s a blast from the past because it’s a video I recorded about three years ago when I was working with people who are becoming real estate syndicators and real estate fund managers. But the information in it is absolutely up to date. It’s timely, and I know you’ll find it useful.

We are talking through the core right now, specifically about company foundation. In this segment, we are going through structure. Now, why are we going through structure? Well, structure is obviously kind of like the foundation. It’s what everything is based on. If you structure it right, it makes it much easier to grow and do what you want to do. It also can protect you, as we’ll talk about soon.

First, before we get started, I’m going to use a couple of terms here that we may not have gone through yet. You may not have seen the segments on LLCs versus corporations. We need to go through specifically two terms: member-managed LLCs vs. manager-managed LLCs.

A member-managed LLC basically means you’ve got people who are all part of the same LLC. So this is a property LLC, and each person gets their own vote, and they all have control equal to the amount of shares or membership units that they own in that LLC. This becomes very hard to manage, as you’re basically going to be ceding control to all of your investors in order to get things done. It makes it hard for you to get paid and is kind of defeatist in how you want to do things.

You may use member-managed in one particular context, and that’s the joint venture. We’ll talk through what joint ventures look like. But most of the time, you are not going to do this. Instead, you’re going to do a manager-managed LLC, which basically means that you or your entity have control over the LLC itself. Your investors have only the voting rights that you give them in the operating agreement.

I set that out because I’m going to talk specifically about member-managed or manager-managed in the first way that you could do this. The way you can structure a syndication, and the way a lot of people do (these are people who have not gone through our core, they are not members of the Altitude Syndication Founders Club), is the way that most syndications take place. There’s actually a very big mistake that goes on when you set it up this way, and we’ll talk about why.

Let’s say you have identified a terrific building. You think this is just perfect for investing. It’s going to make you and all of your investors a lot of money. So you go, you put a down payment on it, and then you call up your friends – call up Bob, call up Joe, and maybe three or four other people. They all contribute money into the property as well.

You smartly decided, “Okay, well, I’m going to create an LLC and that’s what’s going to own the property.” So we’re going to call that property LLC. When you were setting this up, one of the decisions you made was whether it was going to be manager-managed or member-managed. Hopefully, most of the time you will choose manager-managed after we had this discussion, because then at least you have some control over the property itself and over your actions.

But here’s the problem with this very simplistic form of structure for syndication. Let’s say there’s Bob over here, and Bob has decided he just doesn’t like you. He thinks you sold him a bill of goods, and he doesn’t like this property. Joe’s totally thrilled with it, and so are your other investors. But for whatever reason, Bob’s gone off his rocker and just doesn’t like it anymore. So now he’s mad.

What’s Bob do? Well, we’re in the United States, and I’m a lawyer, so I always see it this way: he is going to file a lawsuit against you and the property. He’s mad, he wants his money back, he wants all these other things, he wants punitive damages, and he wants to punish you and the property and anyone who has any association with it – you’re all a bunch of jerks.

The problem with the way the structure is set up in this instance is that you now have exposure to this lawsuit. There’s an indemnity clause, no doubt here, but it’s not as effective as you probably would like because ultimately, what is your choice to do? You can’t just bankrupt this property LLC because you’ve got all these other investors out here. If things go horribly, horribly wrong and you just want the whole thing to go away, you can’t even bankrupt that property because now all of these people need their money, and you are also on the hook.

You’ve had control over this property if you’ve set it up as a manager-managed LLC, and so you are acting kind of like a general partner (GP), the one who’s responsible for everything, and you are subject to the claims against the property LLC itself. This is not the way to go, but this is the way that actually most small syndications are put together. This is not the way sophisticated syndications are done.

So how are sophisticated ones done instead? We still got this, we’ve still got you obviously, and we’ve got this terrific looking building here that you know is going to make a ton of money. You’ve got your investors, and this time, this is a whole new one – you’ve learned your lesson. So now Joe’s got Bob’s gone, but now you’ve got Joe and you’ve got Sue, and both of them invest their money into this great property. We’ll call it Property 2 LLC.

But now you’ve learned your lesson. You know that if you were just to put your money and put the deposit in on that property, you know that you’re being exposed. So what do you do instead? You create another entity here that is You Management Inc., and we’ll go through entity choice, but many times this will be a corporation, sometimes it’s an LLC. For this purpose, it doesn’t really matter.

So you contribute your deposit money into You Management Inc., and then through You Management Inc., you make the down payment on the property, start gathering up the investors, and things like that. Now Property 2 LLC pays management fees and other fees to You Management Inc.

If Sue suddenly decides that she’s mad at you, she can sue the property, she can sue You Management Inc., and she can sue you personally. So what have you gotten out of this? Well, because you’ve done it through this company, as long as there isn’t fraud, you’re actually not liable, and the court’s not going to really recognize that as a lawsuit that’s meritorious. It may be meritorious against You Management Inc. or Property 2 LLC, but at least you’re protected, and now all of your other assets are protected as well.

This is the normal way to do it. You’re happy, you and your investors are happy. This is the most common structure that you’re going to do. This is a management company managing the LLC itself, the property LLC.

This isn’t the only structure. One other structure that’s a little more advanced is basically you have – you’re still here – and now you’ve identified not only one really amazing building, we’ve actually identified two really amazing buildings. And you think that there’s this other building out there as well that would be amazing. You don’t know exactly what it is, but you’re going to find it, and it’s going to be a perfect investment for your investors.

So what do you do here in this case? These are all different properties. So let’s leave this Property A LLC, Property B LLC, and after you find it, it will be Property C LLC. Now, you still have your management company. But how do you do this? Your investors who are here have a choice. Here’s Joe, here’s Sue. They could put money into You Management, but then again, we’re not shielded against them.

So we actually build another LLC or corporation here, and this we could call Investment LLC. Your investors go there, Investment LLC buys and manages these properties. Investment LLC is managed by you and pays fees that way.

So now what you’ve done basically is you’ve built out a structure where one entity that’s easy to manage can manage multiple properties, all protected and shielded, can manage its investors, and be able to treat investors efficiently. The amount of money is all treated based on however you design to do it. But typically, it would be they’re all – you know, if Joe puts in 50% and Sue puts in 50%, they each have 50% ownership in all three of those buildings.

Now, you may be asking, “Well, why are we doing the extra work of having these other LLCs here?” A great example of this exact situation is the Ghost Ship. I encourage you to look it up on Wikipedia; there’s a really good description of it there, and then there are some links within that to different news articles.

What happened in the Ghost Ship – so the Ghost Ship was an office building in Oakland, California. Some of the tenants decided to convert it to live-in lofts and a dance hall of sorts. There was a fire that broke out. Now, the Ghost Ship was owned by a trust, which was owned by one person. But the trust didn’t only own the Ghost Ship; it owned something like 13 other buildings. So all the value of all of that was owned by the trust, which ultimately was owned by this one person.

Ghost Ship fire breaks out, 20 people died, families sue against the trust, who’s the owner of the building. And now, because there’s one entity that’s being sued, all of these other buildings are suddenly vulnerable to losing everything.

If they were done in this manner, in the manner that we’re talking about here – let’s say there was a major slip and fall on Property A that’s somebody’s fault, lying on the ground. That was really bad, and they lost their leg or something, and Property A isn’t very big. So they would file a lawsuit against Property A, and they may try to get to Investment LLC, but they’re probably not going to have that chance to get further up the line unless there’s been a case of fraud or something like that.

So Property A LLC, they file a lawsuit. And if it just doesn’t become worth it anymore, Property A goes bankrupt. But Property B and Property C still exist, and Joe and Sue still own their 50% portion. So they’ve been protected for that. That’s why we separate each building – each building has its own LLC.

The last way that you may encounter putting together a syndication would be something like this: You have identified a terrific building, an apartment building that’s worth – that’s on the market for $2 million. This is a great opportunity for you. You decide that you want to buy this because you see how much upside there is, but it’s going to take a lot of work.

So you put your money in. You don’t have any development experiences. So rather than seeking investors for this property, you seek a different kind of investor – you seek a joint venture. Say you know somebody who owns the company Development Inc., and they are a developer and are terrific at rehabbing apartment buildings. It’s owned by two people, like two brothers. And they own that.

So you have now contributed $2 million into this building, and they are contributing, say, their time and materials into improving it into what it is. And then when it comes time for receiving money, it goes according to however your joint venture agreement has been written. So your joint venture agreement is kind of the umbrella that covers all of this, talks about what your duties are and what the responsibilities are and how everybody gets paid.

So let’s just recap for a minute. This way of doing things here, where you’ve got everybody investing into the same LLC, including you, is just not going to work. It doesn’t protect you from litigation. This is the most common way to do things. This is the way you’re probably going to set up your first several syndications. It may be the only way you use to set up syndications because it just works great.

You can also have different investments and still have you as the management. So this is Property 3 LLC, which has its own investors. And this may be how you structure your entire fund. Or maybe you decide you want to become more like a fund and do it this way and have people invest into your investment fund. Whichever way works for you, this is the basics on how you do it.

So this is the structure to keep in mind. Now I encourage you to actually draw out what structure you think is going to fit your needs the most. Is it something like this where you’re going to go property by property? Or is it something like this where you’re going to have a pool of funds, a pool of money in order to buy several properties at once? Most of you will probably be doing this, but some of you may be doing pools as well.

I hope that was helpful. Draw out your diagrams, and we’ll see you in the next segment. I hope that was helpful for you. My name is Tilden Moschetti. I am a syndication attorney with the Moschetti Syndication Law Group.