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Once you have achieved organizational readiness, it is imperative to properly structure the entity profile required to execute your business plan. In future articles, we will discuss potential investment sleeves available to maximize specific investor returns.
Before considering tailored alternatives to facilitate investor objections, a Sponsor must first determine whether they are raising capital for a diversified real estate fund (Fund) or a single property syndication (Syndication). At their base level, both a Fund and Syndication are typically taxable as partnerships to optimize pass-through taxation, minimize entity level taxes, and provide flexibility in allocations. However, there are a number of differences to consider when evaluating the alternatives.
Funds are typically structured as a single Limited Partnership (LP) or Limited Liability Company (LLC) taxed as a partnership, with the fund sponsor acting as either the General Partner or Managing Member. To provide limited liability protection, single-member limited liability companies (SMLLC) are established underneath the Fund to acquire the target assets.
Syndication may similarly be structured as an LP or LLC but may hold the project asset directly instead of in a separate SMLLC, allowing simplified registration and filing requirements with Secretaries of State. Additionally, holding assets directly through an LP may provide tax benefits in states with nuanced tax rules that treat LPs and LLCs differently.
Sponsors targeting significant amounts of tax-exempt capital may consider a Real Estate Investment Trust (REIT) structure to eliminate Unrelated Business Taxable Income (UBTI) exposure. To acquire the tax benefits of an REIT, specific asset and income tests are required (beyond the scope of this article). Future articles in our investment sleeve series will explore this option in more detail for investors seeking UBTI-free alternatives.
As an alternative structure, some projects may make sense to legally hold title via a Tenancy in Common (TIC) agreement, which allows multiple individuals or entities to co-own a property without establishing a separate business entity. The main benefit of a TIC agreement is to preserve the opportunity for a §1031 like-kind exchange or facilitate the replacement of an exchange for co-owners.
When pursuing a TIC arrangement, careful consideration should be given to maintain simple co-ownership status and not rise to the level of a business entity. The IRS has provided a safe harbor for TICs under Revenue Procedure 2002-22, which includes a limited number of co-owners, unanimous approval requirements on certain items, proportionate sharing of profits and losses, and restrictions on business activities.
Funds have larger capital needs due to the acquisition of multiple projects. As a result, there may be a longer fundraising period to achieve the capital required to launch. Target investors may be limited to institutional investors, family offices, and high-net-worth individuals, who may require more due diligence on the Fund’s investment strategy and Sponsor history. Capital commitments are typically agreed upon during fundraising, but capital calls are less likely to occur until specific investments are identified and funding is needed for acquisition or ongoing project costs.
Syndications only require capital for a single project, so the fundraising period can be compressed. As the total capital requirement is significantly less than that of a Fund, the target investor pool may be opened to other accredited investors, such as friends and family. Capital is typically contributed upfront, providing greater certainty in total commitments.
Funds aim to acquire multiple properties to reduce portfolio risk through diversification. To provide a consistent investor return, Funds typically target core assets across multiple states, providing a steady annual return with predictable cash flows. Funds may also incorporate a number of value-add or development opportunities to supplement returns on core assets with higher deferred potential, though the overall purpose generally remains a consistent annual return.
Due to the volume of assets and consistent returns on core assets, closed-end Funds typically target a longer-term horizon for liquidation than a single Syndication. Some Funds, however, are open-ended with no definitive timeline for liquidation.
As Syndications target a single asset, they typically focus on value-add or development projects that may not provide a steady annual return but allow for the opportunity of a higher return on exit. Since the goal of a Syndication is often the disposition of the asset for a large multiple on invested capital, the project timeline is generally shorter than that of a Fund but may provide less cash flow to investors throughout the project. Depending on investor appetite, Syndications may also provide more flexibility to defer gains via a §1031 exchange, as a smaller investor group may make it easier to receive approval for the entity to continue the investment.
Selecting the correct investment vehicle may have significant implications in a Sponsor’s ability to raise capital, as investors seek opportunities that are in sync with their ultimate risk profile and investment timeline. While upper tier investment vehicles play a part in achieving investors’ desired results, the asset level structuring is perhaps the most important choice a Sponsor will make, as it ultimately drives the economics of the deal.
Elliott Davis is here to help you evaluate the alternatives and develop a plan to achieve your ultimate objectives. Contact us today.
The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.
