In my video last week (“What Passive Real Estate Investors Want (And How to Give it to Them!)”, I talked about what investors look for in regards to terms and returns. In this episode, I talk about the different ways you can structure the investment, from a simple loan to a more sophisticated entity with multiple members (and SEC regs, oh my!).
So if you're curious about how to structure the deal with your investors, then watch the video or read the blog article below that.
Before I get into the different ways to structure the investment, let me just say one thing first:
In most cases, you’ll want to use an LLC. The reasons for this are beyond the scope of this article, but I will summarize by saying that it provides the right level of asset protection for you and is the simplest to set up, administer and tax.
I generally set up a separate LLC for each deal. That way, if something bad happens (like a lawsuit), then it might take down the one ship but hopefully not any of your others!
If you’re considering taking on outside investors, then you have a few options:
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Option # 1: Borrow the Money
This is the simplest way to use other people’s money in your real estate deals. The investor gives you cash and gets a promissory note in return. The promissory note is referenced on the deed, which is then recorded. This secures the investor’s interest, and you can’t sell the asset before the investor is paid back. This arrangement is so standard that most title companies can handle this for you without any problem.
This is what I use for my house flips.
I don’t like using this on buy and hold properties because normally you have to make at least interest-only payments. If you couple this with a traditional commercial loan, then the combined debt service leaves little or no cash flow at all. I’m not saying, don’t do it, just make sure the deal works!
Option # 2: Your Investors are Members of your LLC
A typical LLC has two “roles”: it may have one or more “managers”, which is you, as the syndicator, performing the day to day operations. And then there are the “members”, which are your investors.
You are a manager but you will also most certainly be a member. This is because in your deal, you will give yourself at least 20% equity in the building for putting the deal together and managing it. (If I can’t own at least 20% of the deal for syndicating it then it might not be a good deal in the first place!)
The document that governs the roles and responsibilities of the managers and members are described by the LLC’s “operating agreement”.
The operating agreement describes what you, as the manager, can and can’t do without requiring a vote by the members.
You can design your operating agreement (almost) however you want. You can give your members as much or as little decision-making authority as you want – as long as they agree to it, of course.
For example, you can give yourself (as the manager), nearly all decision-making authority, and the members nearly none. This makes the members “silent” investors.
Just remember that you are also a member, and that in this arrangement, you have an equal vote with the other members. For example, if you own 20% of the building, then you also only get 20% of the vote.
This is fine if your other members are friends and family (and generally unsophisticated) and will normally go along with whatever you recommend.
You can mitigate the risk of being out-voted by giving members basically no decision-making authority at all, leaving you as the manager with most of the authority.
This kind of LLC arrangement is fairly standard, and your attorney will normally charge you around $1,300 to draft an operating agreement that reflects your wishes. Each of your members will also sign the operating agreement to make it a binding contract.
Option # 3: Multiple Classes of Members
This is an advanced version of Option # 2, where, in addition to the manager role, you have two classes of members. The “Class A” members may have preferential treatment with regards to distributions or decision-making over “Class B” members, who may be largely silent and have different returns. This is just an example, the possibilities are endless with this kind of arrangement.
This normally only becomes relevant for larger deals involving more sophisticated investors. Just know it’s out there as an option.
SEC Securities Law Considerations
Anytime you take on investments from anyone else, you are essentially selling securities. As such, you must pay attention to state and federal securities regulations. I’m not going to talk about these here (later perhaps!), I just want to mention that this is an important consideration during this process.
Working with Your Attorney
While all of this sounds complicated, just relax in the knowledge that you are the business person. You’re not the CPA or the attorney, and you don’t need to be. As a syndicator, “you have people for that”. You just need to know enough to manage everybody. Just make sure you’re working with a competent attorney to set up the entity and draft the operating agreement. Your SEC attorney will make sure you comply with securities law requirements. The attorneys will handle the details. And I can assure that you will learn a lot!
It’s important that you know different ways to structure your syndicated real estate deal. First, because it opens you up to the possibilities so that you can visualize how it could be done. Second, you need to be able to explain it your potential investors. And third, you need to be able to tell your attorney what you want.
I’d like to close by saying, don’t let the apparent complexity of all this scare you from getting started today. Remember that you don’t need to know everything up front. Yes, educate yourself. Learn the rest “on the job”.
I hope you found the article useful … let me know what you think.