Introduction to Real Estate Syndication

Real estate syndication refers to the process of pooling investor capital to purchase real estate. Real estate syndications afford investors a passive investment experience with limited liability protection. Real estate syndications are typically structured utilizing a limited liability entity, such as a limited partnership or limited liability company that acts as the investment vehicle. The real estate syndication’s “sponsor” or “manager” is typically comprised of developers and/or knowledgeable real estate professionals who are responsible for structuring the deal, outlining the investment strategy, conducing due diligence, and managing the day-to-day operations. Notably, real estate syndications involve securities offerings and are subject to regulations enforced by securities authorities such as the Securities and Exchange Commission (the “SEC”) in the United States, as well as state securities regulators.

Yes. Generally, real estate syndications almost always involve the offer/sale of “securities,” as that term is defined under the Securities Act of 1933, as amended (the “Securities Act”). As such, sponsors undertaking a new real estate syndication must either register the securities with the SEC, or, as is more common, rely on an exemption from registration under the Securities Act (such as Regulation D, Regulation S, Regulation A, or Regulation Crowdfunding). In addition, depending on the scope of activities performed by the real estate syndication vehicle’s sponsor, the sponsor may also be subject to the Securities Exchange Act of 1934, as amended (the “Exchange Act”), the Investment Company Act of 1940, as amended (the “ICA”), and the Investment Adviser’s Act of 1940, as amended (the “Adviser’s Act”).

Yes; one of the most important conditions to the applicability of Regulation D as an exemption from registration under the Securities Act is the “bad actor disqualification” provisions of Regulation D, Rule 506(d). Notably, the “bad actor disqualification” provisions of Regulation D, Rule 506(d) are substantially the same as those found in Regulation A and Regulation Crowdfunding. Under the bad actor disqualification provisions, an offering is disqualified from relying on Regulation D (and similarly, Regulation A and Regulation Crowdfunding) if the issuer or any other “covered persons” have a relevant criminal conviction, regulatory or court order or other disqualifying event. “Covered persons” under Rule 506(d) include (i) the issuer, including its predecessors and affiliated issuers, (ii) directors, general partners, and managing members of the issuer, (iii) executive officers of the issuer, and other officers of the issuers that participate in the offering, (iv) twenty percent beneficial owners of the issuer, calculated on the basis of total voting power, (v), promoters connected to the issuer, (vi) for pooled investment fund issuers, the fund’s investment manager and its principals, and (vii) persons compensated for soliciting investors, including their directors, general partners and managing members.

Moreover, sponsors are entrusted with the responsibility of finding and acquiring the real estate syndication’s target property/properties, managing and operating the property/properties, conducting the real estate syndication’s securities offering in compliance with federal and state securities laws, and distributing profits generated by operation of the property/properties to investors. As such, sponsors are not only subject to certain fiduciary duties to investors as provided for under the real estate syndication state of formation’s applicable corporate laws, such as the duty of loyalty and the duty of fair dealing, but are also subject to anti-fraud laws, including those of the Securities Act, the Exchange Act, the ICA, and the Adviser’s Act.

In general, sponsors should be experienced real estate professionals with a deep understanding of the real estate market relevant to the real estate syndication’s target property or properties, should have proven track records of successful real estate investments, and should also have demonstrable financial stability.

Real estate syndications almost always involve the offer/sale of LLC interests that are considered securities, thus falling under the jurisdiction of the federal and state securities laws. There are certain limited scenarios in which federal and state securities laws may not apply. One example where an LLC interest may not be deemed a security is in the case of a joint venture, where all joint venturers are maintaining substantial managerial efforts and control over the venture. As described in greater in the FAQ titled “What is the difference between a syndication and a joint venture?”, below, investments by participants in a joint venture may not be considered a “security”, and therefore, such investments would not be subject to federal or state securities laws. It’s essential to consult with legal experts and consider the specific circumstances and applicable laws in your jurisdiction to determine whether a particular joint venture is classified as a security.

While real estate syndications and a joint ventures share the same ultimate goal (i.e., to acquire and operate real estate and generate a return), the two have substantially different sets of legal considerations, which hinge on the determination of whether the investor or joint venturer’s investment in limited liability company or limited partnership interests is deemed an “investment contract”, which is a type of “security” under the U.S. federal securities laws.

The U.S. Supreme Court’s Howey case and subsequent case law have found that an “investment contract” exists when there is the investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

Syndications involve two distinct groups: (i) the sponsor group, responsible for structuring, managing and operating the real estate syndication and underlying real estate asset(s), and (ii) the investor group, responsible for providing investor capital in exchange for LLC or LP interests in the real estate syndication vehicle. Notably, investors are merely passive participants in the real estate syndication and generally do not participate in management. This type of investment structure clearly satisfies the Howey test’s four prongs and, as a result, real estate syndications are regulated under federal and state securities laws.

Conversely, joint ventures typically involve the pooling of capital by two or more partners who are all actively involved in the management and control of the venture and the underlying asset. Structured this way, no participant’s efforts are the ones which affect significantly the success or failure of the joint venture. Consequently, key elements of the “investment contract” analysis under Howey and its progeny are not satisfied, and therefore, the investments of the various joint venture partners are not deemed securities. In turn, joint ventures are primarily governed by contract law rather than securities laws.

While there are many similarities between a real estate syndication and a real estate fund, there are a few of the noteworthy distinctions that differentiate the two real estate investment structures.

• Syndications are typically project specific, while real estate funds typically have a broader “charter” and instead invest in a wider range of real estate assets that are in most instances to be determined after the capital raising has already begun. For example, a real estate syndication may target a known apartment building in a target locale. In contrast, a real estate fund may target multi-family residential properties in a target locale that have yet to be identified. In this vein, real estate funds are commonly considered to be a more diversified portfolio of assets than syndications, while affording investors less transparency at the time their investment decision is being made.
• Real estate funds may be structured as either “closed-end” or “open-end.” A “closed-end” fund has a set date at which the capital raising period ends, while an “open-end” fund has no set date at which the offering period ends, allowing investors to continually contribute capital in exchange for equity interests in the fund throughout the lifetime of the fund. While real estate syndications’ capital raising periods are structured akin to closed-end funds, open-ended funds allow investors to invest on a continuous basis and redeem their capital, subject to the sponsor’s terms.
• While real estate syndications are typically funded by investors at the time of their subscriptions, real estate funds normally only require investors to fund deposits at the outset, and then call capital as target properties are identified and acquired during the fund’s investment period.
• Another important distinction is the fund-of-funds structure. In a fund-of-funds structure, rather than the fund investing directly in real estate assets, the fund will instead acquire securities of other funds, often referred to as “target funds.” In turn, each “target fund” acquires its own real estate asset(s). In effect, a fund-of-funds structure adds an additional layer of ownership by each “target fund.” Notably, because a real estate fund-of-funds is not directly acquiring real estate assets and is instead acquiring securities of another company that is in turn acquiring real estate asset(s), a real estate fund-of-funds is often exposed to the registration requirements of the ICA and the Adviser’s Act, or it must rely on exemptions from registration thereunder, if available.

A special purpose vehicle, otherwise known as an “SPV,” may be introduced into a syndication or fund’s organizational chart as a vehicle to take title to a specific property, rather than holding title by the syndication or fund entity directly. In the event the syndication or fund is intending to acquire multiple properties, each property’s title may be held in a unique SPV. Such SPVs would be wholly owned by the syndication or fund vehicle.

In contrast to the many similarities between a real estate syndication and a real estate fund, a REIT has far more distinguishing factors that differentiate the REIT from these other structures.

• Investment Strategy: Private REITs often focus on specific types of real estate assets, such as commercial properties, residential properties, or a combination thereof. Their investment strategies may be geared toward income generation, capital appreciation, or both. REITS do not normally provide investors with property-specific due diligence information. Investors may not have visibility into exactly where their money is going at the time they invest.
• Redemptions: Some private REITs offer periodic redemption programs, allowing investors to sell their shares back to the REIT at specific intervals, although these programs often have limitations and fees.
• Distribution Requirement: To qualify as a REIT, the trust is required to distribute at least 90% of its taxable income annually to its shareholders in the form of dividends. These dividends are then taxed at the individual shareholder’s tax rate.
• Shareholder Taxation: Shareholders of a REIT report the dividends they receive on their individual tax returns. These dividends are generally taxed as ordinary income, but a portion of them may qualify for the lower qualified dividend tax rate.
• REIT Deductions and Exemptions: REITs can deduct dividends paid to shareholders from their taxable income. Additionally, they can benefit from certain exemptions and deductions related to their real estate activities.
• IRC Requirements: It’s important to note that REITs must meet specific requirements outlined in the Internal Revenue Code (IRC) to qualify for the special tax treatment. These requirements include:
  • Holding at least 75% of its total assets in real estate assets.
  • Deriving at least 75% of its gross income from rents, interest, dividends, and gains from the sale or disposition of real property.
  • Having at least 100 shareholders.
  • No more than 50% of its shares can be held by five or fewer individuals (known as the “5/50” rule).
  • The REIT must be managed by a board of directors or trustees.

There are two primary factors when considering how to structure a real estate syndication: portfolio structure and type of property.

With respect to portfolio structures, while most real estate syndications often target one specific property, otherwise referred as a “single asset” real estate syndication, real estate syndications may also target multiple properties, referred to as a “multi-asset” real estate syndication. In addition, real estate syndications may either “know” their target property/properties, “know” only one target property (in a “multi-asset” structure) while having an idea of the type of other property/properties being acquired by the real estate syndication, or it may only have an idea of the type of other property/properties being acquired. The first structure is referred to as a “known” real estate syndication, the second referred to as a “semi-blind” real estate syndication, and the third referred to as a “blind” real estate syndication.

Moreover, with respect to the types of property commonly acquired by real estate syndications, there are several and few, if any, limitations. Depending on the expertise of the sponsor group, real estate syndications may acquire single-family property, multi-family property, commercial property, industrial property, mixed-used property, or even vacant land. In the context of development deals, often referred to as a “ground-up developments, the real estate syndication will typically raise capital to not only acquire a target parcel, but to also develop and perform construction on the property to eventually flip the development or operate a revenue-generating development for some period of years.

Payments to ‘unregistered finders’ when raising capital for a syndication can present complex legal challenges. The term ‘finders’ typically refers to individuals or entities that assist in connecting issuers were potential investors, often receiving a success-based fee known as a “commission” or “transaction-based compensation.” However, under the Securities Exchange Act of 1934, those who engage in the business of effecting securities transactions for others, including finders receiving transaction-based compensation, may be required to register as broker-dealers.

The Securities and Exchange Commission (SEC) has outlined several factors that can indicate when someone should register as a broker-dealer, including soliciting or recruiting investors, finding investors for broker-dealers, providing investment advice, and receiving commissions based on securities transactions. Additionally, when real estate investments are offered as part of a pooled investment vehicle, they may be considered securities, and real estate brokers or agents may not be exempt from broker-dealer registration.

While there was a proposed exemption for finders in October 2020, it was not formally adopted by the SEC. This exemption would have created two categories of finders, Tier I and Tier II, each subject to specific conditions. The proposal aimed to provide regulatory clarity and permit certain capital-raising activities for small businesses. However, given the complexity and potential risks of using unregistered finders, participants in capital raising, including issuers and fund managers, should carefully consider the legal requirements and associated penalties, as well as the absence of an adopted exemption, before engaging in such activities.

The distinction between a ‘finder’ and a ‘broker-dealer’ under federal securities law is crucial due to the significant legal and business implications. The SEC has brought several actions against finders acting as unregistered broker-dealers, emphasizing that such activities remain a focus area for regulation. Acting as an unregistered broker-dealer could lead to severe consequences such as cease-and-desist orders, civil and criminal penalties, potential rescission rights of investors, and reputational harm.

In several recent cases including SEC v. Sky Group USA, LLC, et al., 1:21-cv-23443 (S.D. Fla. Filed 9/29/21) and SEC v. Richard Eden, et al., 2:19-cv-09358 (C.D. Cal. Filed 10/31/19), the SEC charged individuals and entities with carrying out activities requiring broker-dealer registration while unregistered. These cases typically involved activities such as identifying potential investors, securing their investments, participating in securities offerings, and receiving transaction-based payments or ‘success fees.’ Such actions have resulted in substantial financial penalties and permanent injunctions.

It is important for companies and individuals involved in capital raising and corporate transactions to understand the rules surrounding these activities. The SEC continues to monitor intermediaries closely, and engaging in activities that require broker-dealer registration while unregistered can lead to significant legal and financial consequences. It is therefore critical for businesses to understand and stay within the permissible boundaries.

There are multiple risks to both the issuer and the finder for using/acting as an unregistered finder. One such risk is the voiding of agreements and rescission. Violation of the broker-dealer registration requirement could create a rescission right in favor of the investors. If the investors succeed in exercising their rescission rights, the issuer would be required to return the money it received from the investors for the purchase of its securities. Additionally, an issuer could claim under Section 29(b) that its obligations to a finder under the finder’s engagement agreement are void if the finder is acting in violation of the Exchange Act’s broker-dealer registration requirement.

The use of an unregistered broker-dealer in an earlier transaction also creates disclosure obligations in related securities filings and may impact subsequent financings and acquisitions. Many filings required by the SEC and state blue sky laws require disclosure of compensation paid to finders. Disclosure about an unregistered finder could dissuade future investment and prevent the issuer’s legal counsel from delivering required legal opinions.

Lastly, there are a host of regulatory enforcement actions and penalties that the SEC could bring. Issuers could find themselves subject to an action under Section 20(e) of the Exchange Act for aiding and abetting an Exchange Act violation. Furthermore, a finder’s failure to disclose the fact that it is not registered as a broker-dealer could also itself be characterized in regulatory enforcement proceedings or private litigation as a misleading omission that amounts to fraud by the issuer. These actions may subject an issuer to several different penalties under federal and state securities laws, the most typical of which is a temporary or permanent injunction barring it from participating in the purchase or sale of securities. Further, the SEC has the power to impose even more severe sanctions, including disgorgement of funds and civil penalties.

In general, there is no minimum size requirement. The amount required only depends on the specific goals and needs of the sponsors of the syndication. It is important to note, however, that there are certain fixed costs that will arise regardless of the offering size, such as new entity formation fees, registered agent fees, and legal fees. It is important to evaluate the cost of capital in your evaluation of the feasibility of the strategy. That said, we have experience working with new sponsors, whose offerings tend to be smaller as they build their track record in the beginning. Hence, we occasionally service offerings with a maximum offering amount under $500,000.

While broker-dealers may add value in their provision of placement agent services in support of sponsor teams willing to pay commissions, sponsors are not required to do so. Under the “Issuers’ Exemption,” an issuer (including a private fund or syndication) that deals only in its own securities (such as limited partnership interests or LLC interests) is neither a broker nor a dealer as it does not effect transactions for the accounts of others and is not engaged in the business of buying and selling securities for its own account. However, where a private fund’s employees or agents regularly market the fund and solicit investors, they may be deemed to be acting as an unregistered broker-dealer, particularly where those individuals receive commissions for their efforts. The SEC generally takes the position that the payment of a commission or other transaction-based compensation may be sufficient to trigger broker-dealer registration requirements. That said, Rule 3a4-1 promulgated under the Exchange Act provides a non-exclusive safe harbor from broker-dealer registration for associated persons of an issuer. An “associated person,” in the context of a private fund, is a natural person who is a partner, officer, director or employee of (i) the private fund, (ii) where the private fund is a limited partnership, its corporate general partner, or (iii) a company or partnership that controls, is controlled by, or under common control with, the private fund.

To comply with the safe harbor, the private fund’s associated person must not be (i) subject to any “bad actor” disqualifications under Section 3(a)(39) of the Exchange Act, (ii) compensated through commissions, and (iii) an associated person of a registered broker-dealer. In addition to those general restrictions, associated persons may only place securities to a limited class of investors, such as banks, registered investment companies or state-regulated insurance companies. They must also perform substantial duties on behalf of the private fund other than the marketing of fund interests, must not have been associated with a broker-dealer for the prior 12 months, and not have participated in more than one offering for the private fund in a 12-month period. Finally, associated persons must restrict their activities to either preparing written materials to be approved by a senior management person of—or investment adviser to—the private fund, or responding to investor inquiries based on information otherwise provided in the offering materials, such as the private placement memorandum (PPM).

Under Rule 506(b) of Regulation D of the Securities Act of 1933, audited financials are required when an issuer offers securities to non-accredited investors. In most other Regulation D offerings, hiring an auditor and providing audited financials are not required from a federal securities law perspective. Still, state securities law may require the provision of audited financials, particularly in the case of fund of funds by way of example. Notably, however, even when audited financial statements are not required, issuers should still provide investors with accurate and appropriate financial information to enable them to make informed investment decisions and stay appraised of the fund’s affairs. It is also important to note that both federal and state law may have specific requirements regarding audited financial statements for offerings relying on other securities exemptions beyond Regulation D.