Real estate syndication involves pooling funds from multiple investors to finance a real estate project. While syndication can be a profitable investment strategy, it also comes with various legal considerations and potential issues of which syndicators and investors need to be aware. Below is a non-exhaustive summary of key legal issues that may arise with real estate syndications:
- Investor Accreditation: Securities laws often require that investors meet specific income or net worth requirements to be considered accredited investors. Accredited investors are individuals or entities that meet certain financial criteria set by regulatory bodies such as the U.S. Securities and Exchange Commission (SEC). Ensuring that investors meet these qualifications is crucial to comply with relevant regulations. As a matter of safe practice and policy, many syndicators will only accept subscriptions from accredited investors. since accredited investors are assumed to have a certain level of financial sophistication and resources and understanding of investment risks. By limiting participation to accredited investors, syndicators can avoid potential issues arising from investors lacking the necessary knowledge to evaluate complex investment opportunities.
- Exit Strategies: Well-thought-out and diversified exit strategies are essential in syndications to ensure that investors have a clear path to realizing returns, while also enabling syndicators to adapt to changing market conditions and optimize investment outcomes. The syndication agreement should outline the exit strategy for investors, including the process for selling the property or liquidating the investment at the end of the project. Common exit strategies involved buy/sell mechanisms between investors, selling the property, refinancing to capture equity, or conducting a 1031 exchange (a tax-deferred exchange of like-kind properties). The choice of exit strategy depends on factors such as the investment’s business plan, market conditions, the property’s performance, and the preferences of the syndicator and investors.
- Conflicts of Interest: Potential conflicts of interest between the syndicator and investors should be disclosed, and steps should be taken to address them fairly. Many investors need to know that attorneys preparing the entity documentation often represent the investment company, rather than the individual investors. For this reason, attorneys will often recommend in writing that investors should consult with independent counsel prior to executing any binding documentation or committing funds to the project.
- Operating Agreements or Private Placement Memorandum (PPM): Syndicators typically create legal documents, such as operating agreements or private placement memoranda, to outline the terms of the investment, roles of parties involved, and potential risks. These documents should be carefully drafted to protect both the syndicator and investors, as well as clarify the parties’ respective expectations and intent.
- Securities Laws Compliance: Syndications often involve the subscription of securities, such as limited partnership interests or membership units. As such, syndicators must comply with federal and state securities laws, including registration requirements or qualifying for exemptions from registration under Regulation D of the Securities Act. The process of filing under an exemption (and nominal cost associated therewith) is highly recommended to avoid violations of applicable securities laws. Syndicators also need to avoid sending mass solicitations to third parties with whom they do not already have an existing relationship.
- State and Local Real Estate Regulations: Real estate laws and regulations can vary significantly from one jurisdiction to another. Syndicators must be aware of and comply with local laws governing real estate transactions. Syndicators also need to be mindful of the residency of each of their investors, as those state’s securities laws will need to be satisfied.
- Disclosure Requirements: Syndicators have a fiduciary duty to provide full and transparent disclosure to investors about the project, potential risks, and the syndicator’s fees and compensation. Failure to provide adequate disclosures can lead to legal liabilities and disputes. It is best to be fully transparent from the outset, to avoid surprises and best preserve credibility and future business relationships.
- Due Diligence and Risk Assessment: Conducting thorough due diligence on the property and its financial projections is essential to provide accurate information to investors and avoid potential claims of misrepresentation.
- Commingling of Funds: Syndicators must maintain proper accounting practices and avoid commingling investor funds with personal or other business accounts. There are also liability reasons for maintaining separate accounts, related to maintaining corporate formalities, to minimize the likelihood that third parties can reach the personal assets of syndicators or investors.
- Regulation of Syndicator Fees: State laws may impose limits on the fees charged by syndicators, and failure to comply with these regulations can lead to legal consequences.
- Investor Reporting and Communication: Clear communication and regular reporting to investors are crucial to maintain transparency and foster a good working relationship.
To navigate these legal issues successfully, real estate syndicators should work with experienced attorneys specializing in securities law, real estate transactions, and syndication. Additionally, investors should conduct thorough due diligence on both the syndicator and the investment opportunity before committing their funds.