What documents should you expect to see as part of a syndication? (An Introduction to Syndications Article 3/3)

Because the LP is a completely silent partner and has no influence over the investment, the SEC considers syndications to be securities [1] as the profit expected to be made (by the LP) is due exclusively from the actions of a third party (the GP). This makes it a very different situation than when you and your friend buy a rental property together – since in that case, you would typically work together to make the rental successful (even if you both did different things) or you would borrow the money from your friend and give them a mortgage on the property. Most syndications are not publically traded and typically fall under an exemption to the broader SEC rules (a topic for a different article). But ensuring that this is the case requires following the rules, which makes the paperwork somewhat intimidating the first time you see it. The rules for syndications are also slightly different than the rules for private REITs. Although the high level goals are often the same (i.e. pool funds to invest in real estate) syndications typically have a smaller number of investors, charge lower fees, distribute money differently, and give the GP more discretion about when to return money to investors than REITs.

Because the government is setting the rules for syndications, the amount of paperwork involved is a lot higher than you may expect. You should expect to see at least 4 documents from your GP: a summary of the deal, the Private Placement Memorandum (PPM), the operating agreement, and the subscription agreement. Combined, these documents will be around 150 to 200 pages, so you want to take your time going through them and making sure that your lawyer reviews them as well (yes, you really need a lawyer to look at this stuff, you won’t be able to understand it all, even after doing multiple deals).

The summary document, or pitch deck, isn’t part of the legally required paperwork, but provides a high level overview of the deal. It will often come as a webinar or powerpoint presentation, but may also be a 1 or 2 page overview of the deal. This is the most accessible of the documents as it targets the investor directly and doesn’t need to be buried in legalese. It should include the basic information about the property or other assets the syndication will be purchasing, the expected duration of the deal, the expected rate of return on the investment (ideally both the IRR and the cash flow), how that rate of return is going to be generated (e.g. where is the additional value coming from), and how the GP will be paid. You want to make sure that the high level perspective provided here lines up with the legally binding documents that you will be signing since the legal documents are binding and the summary is not.

The summary is typically a reasonable, but “happy case”, scenario based on a variety of assumptions. Since this isn’t an official document, it is a good place to start to see if the deal aligns with your investment philosophy. You also need to review the assumptions being made to see whether or not you agree with them – for example, do you agree with the expectations about rents, interest rates, and cap rates that are being made by the GPs? If you aren’t sure about why the GPs assumptions are different than yours, ask. If still think your assumptions are better, you need to decide if it is worth investing in the deal under your assumptions. Right now, many deals are in danger of returning less money – or even losing money – because the assumptions made about interest rates 3 years ago aren’t aligning with the reality of today. Not that most people would reasonably have expected rates to double in a year, but this highlights why understanding the assumptions and potential mitigations that go into a deal is important. That said, there are always assumptions that mean a deal wouldn’t work, so you need to be realistic in your assumptions as well, otherwise you will never invest.

The PPM is the primary document you need to understand and will typically run between 50 and 100 pages. It contains the detailed description of the security being offered (i.e. exactly what you will be buying). It outlines the terms of the sale, who the target investor is, under what circumstances you will be paid, how profits will be split between the LPs and GPs (the waterfall, preferred returns, etc.), all of the fees associated with the deal, information about the GPs, and a long list of risks associated with the deal. It is extremely important that you understand this document since it defines exactly what you are investing in and how the money is expected to flow. The fees outline what the GP will be paid before distributions are made, which allows them to cover their costs for different phases in the syndication (for example, recovering the money paid out for due diligence when purchasing property). However, they shouldn’t be making a lot of money from the fees. Most of their money should come from their share of the distributions, so that they share in the success or failure of the project along side you. How this works is included in the preferred returns and waterfall payments defined in this document. If you don’t understand what you are seeing, ask questions until you do.

After reading the risks associated with the offering, you may decide that you never want to invest in real estate, ever. If you have that reaction, take a step back and understand that every investment has risks and the GP is trying to be as transparent as possible about what those risks are so that you understand if things don’t go exactly as planned. It also gives you some idea of the problems that the GP is considering and how they might adjust their strategy based on events. If you have questions about how they will mitigate a risk, ask them. In the real world, things happen, and while the GP will do their best to address events as they come up, there are always things that are unexpected and can impact the investors. For example, when the Covid lockdowns hit the country and eviction moratoriums were put in place, no-one knew what the impact would be for landlords. As a result, many multi-family syndications stopped making distributions so that they could hold on to the cash in case they needed it to pay bills if the rent stopped coming in. Once the situation stabilized, most syndications were able to resume distributions. Failing to predict unexpected events like the pandemic doesn’t make the GPs bad people, but they need to update their plans bases on the current environment – and that may impact their investors. Use any risks that concern you as a way to understand your GPs approach to adjusting plans. Given recent history, most GPs can provide specific examples of what they did to mitigate risks to their investors.

The operating agreement is the legal document that describes how the company being formed will be governed. A sponsor typically creates a new legal entity (usually an LLC, but not always) for each deal. The operating agreement describes the purpose of that company, the registration details (e.g. where the company will be registered, who the managers are, etc), the types of investors who will participate in the company, the rights and responsibilities of the managers and members of the company, how shares in the company can be transferred, how disputes are resolved, and how the company can be dissolved (which typically happens when the syndication completes). There is a fair amount of overlap between the operating agreement and the PPM, and it is important that the two documents are consistent on the key points (for example, fees paid to the sponsor). While typically shorter than the PPM, this document will often run over 50 pages.

The subscription agreement is your agreement to participate in the company. When you sign this, you are committing to provide funds to the syndication. In addition to the amount of money you are committing (there is usually a minimum investment amount, but you can usually invest more), you get to specify how your shares are being held (e.g. are you investing in your own name, through an LLC or company you own, through a revocable living trust, through your IRA, etc). This document will also typically require you to confirm that you are an accredited investor (which may have already been established through a third party).

I know that is a lot of information to take in if you have never been exposed to this before. You may also be seeing some terms for the first time – I know I wasn’t familiar with many of them when I started looking into syndications. Don’t worry, I plan future posts to define terms and help you understand how they factor in to my decisions.

If you have any questions about this post, please email them to me at terence@mbc-rei.com, I will reply to the questions that are straightforward and will turn the questions requiring more detailed answers into future blog posts.

For additional reading:

[1] https://www.investopedia.com/terms/s/security.asp