Since we’re on the topic of raising money, what better time to discuss the 506b vs. 506c syndication? What are the differences between the two investment offerings? How do you figure out which real estate syndication structure to use? Is one better than the other? All of this and more is covered in this episode of the Syndication School!
Best Ever Tweet:
This episode is sponsored by Stessa, which provides users with a simple way to track rental property performance. When you create your free account at stessa.com/bestever, you’ll get dashboard reporting, smarter income and expense tracking, and tax-ready financials.
Structuring Your Commercial Real Estate Syndication
Joe Fairless: There needed to be a resource on apartment syndication that not only talked about each aspect of the syndication process but how to actually do each of the things, and go into it in detail… And we thought, “Hey, why not make it free, too?” That’s why we launched Syndication School.
Theo Hicks will go through a particular aspect of apartment syndication on today’s episode and get into the details of how to do that particular thing. Enjoy this episode and, for more on apartment syndication and how to do things, go to apartmentsyndication.com. Or, to learn more about the apartment syndication school, go to syndicationschool.com so you can listen to all the previous episodes.
Theo Hicks: Hi, Best Ever listeners. Welcome back to another episode of the Syndication School series – a free resource focused on the how-tos of apartment syndications. As always, I am your host, Theo Hicks.
Each week, we air a podcast series about a specific aspect of the apartment syndication investment strategy. For the majority of the series, we offer a document, a resource, or a spreadsheet, for you to download for free. All of these documents, as well as past and future Syndication School series, can be found at SyndicationSchool.com.
This episode is part two of either a four-part or a six-part series – not exactly sure how many episodes will be in this one yet… But the series is entitled “How to Raise Capital from Passive Investors.”
If you haven’t had the chance to, I recommend listening to part one. In part one, we had you take a test to gauge your mindset as it relates to raising money. We also talked about how to overcome any fears or limiting beliefs you have about raising money, and then we also learned why it is that someone will invest with you in the first place. So part one was focused mostly on mindset.
Deciding on a Commercial Real Estate Syndication Structure
In part two we will have a discussion about the different types of syndication structures, so you’ll learn the differences between a syndication and a joint venture, as well as the differences between a 506(b) and a 506(c) investment offering. Now, the reason why we are talking about this now in the series about raising capital is because, before you can start the process of reaching out to investors, you need to understand the structure of your syndication and the type of offering you are going to provide because that will dictate how you can reach out to these investors and the requirements these investors need in order to invest in your deals.
Syndications and Joint Ventures
Syndication versus JV – I wanted to talk about that because there’s a lot of questions about “Should I do a joint venture, or should I do a syndication?” Obviously, this is Syndication School, so we do not talk about joint ventures here, but I just wanted to go over the differences between the two, just for your knowledge so that, if you happen to wanna do a joint venture in the future, you can… But this is probably the only time we’re gonna talk about JV, right now.
What’s the Difference Between Various Real Estate Syndication Structures and JVs?
The best way to determine whether you should do a joint venture – I’m gonna refer to joint venture as JV moving forward – or a syndication is to ask yourself these two questions. Question one, “Will investors invest money in a common venture with you?” If you answer yes to that, that’s a syndication or a JV. The second question is “Do your investors have an expectation of profits based solely on your efforts, skills, and experience?” If the answer is yes to that second question and yes to the first question, then it is a syndication. If the answer is yes to the first question but no to the second question, then it might be a joint venture.
JVs are Made Up of Active Investors
For a joint venture, all of the partners are active in the investment. All the partners in the JV have some sort of active involvement in the investment. A perfect example of a joint venture would actually be the general partnership of a syndication. For example, me and my business partner are technically a joint venture together because we’re both bringing capital to the deal and we both have active roles or responsibilities in the deal. Essentially, we’re not passive, we’re active, and that would make that a joint venture.
There are no restrictions on advertising for joint venture partners, so I can go on Bigger Pockets or Facebook and say, “Hey, I’m doing this deal. I need someone who can do asset management.” There’s no restrictions on that. And there is unlimited liability for all parties involved. Everyone involved in the deal has unlimited liability.
Commercial Real Estate Syndication Deals Require Passive Investors
Now, the syndication is different because, unlike the joint venture, if you’re doing a syndication, then obviously the general partners are going to be active but the people that are bringing the money aren’t active in the deal. They’re strictly passive investors; all they’re doing is bringing equity to the deal. And, per that second question, those investors have the expectations of profits based solely on your efforts, skills, and experience… Not theirs but yours. And there are restrictions on advertising for syndication partners. We’ll talk more on this later.
Then there is unlimited liability for the general partners because, again, that is actually a joint venture but there is a limited liability for the limited partners or the passive investors.
An Example of JVs and Syndications
An example of a joint venture would be me and you partnering up together to buy a fix and flip together. We both bring in half the capital. We both do half the work; that would be a joint venture. Or if we and three other people partner up to do a apartment syndication, then we would be a joint venture, but our agreement between us and the investors would be an actual syndication, and we would have to be adherent with the securities law.
Who’s Allowed to Invest in Deals Under the Real Estate Syndication Structure?
Now that we know the differences between the syndication and the JV, let’s now focus on the syndication. So who is actually allowed to invest in apartment syndications? Well, high-level, this is going to be your target audience that you defined in an earlier Syndication School series episode; that episode is 1534, so make sure you listen to that to learn about how to select your primary target audience for your brand, which, again, you’re using in order to attract potential passive investors. But, more specifically, the two types of people who can invest in syndications are accredited investors and sophisticated investors.
Now, an accredited investor, for the formal definition, is a person that can invest in securities, a.k.a. they can invest in an apartment syndication as a limited partner by satisfying one of the requirements regarding income or net worth. The current requirements, as of December 2018, to qualify are an annual income of $200,000, or $300,000 for joint income, for the last two years, with the expectation of earning the same or higher, or a net worth exceeding one million dollars, either individually or jointly with the spouse.
So an accredited investor makes $200,000 a year themselves, or $300,000 a year with their spouse, for the last two years, and expects to make more or at least the same moving forward… Or they have a net worth of a million dollars. So it’s one or the other. That’s what an accredited investor is.
A sophisticated investor, the formal definition is a person who is deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity. Very vague, and there are no income requirements. It’s just saying that they have to have sufficient investing experience and knowledge of investing. We’ll go over a little bit more about the qualifications, what you need to do for someone to be considered a sophisticated investor.
Choosing Your Real Estate Syndication Structure
Now, the reason why I discussed the accredited and sophisticated investors is because there are two main types of syndication structures, and based off of which one you select, you might be able to only have accredited investors or you might be able to add in a certain amount of sophisticated investors as well… And these two different structures are 506(b) and 506(c).
There is something called Rule 506 or Regulation D, which is something from the SEC, and it provides two distinct exemptions from registration for companies when they offer and sell securities. These are the 506(b) and the 506(c).
For 506(b), which is actually what Joe does, you cannot use general solicitation or advertising for investors. You can’t go on social media and advertise your deals. You can’t send an email out to a general email list you have about a deal. You can’t stand on a street corner with a banner saying, “Invest in my deal.” None of those things are allowed.
Instead, you must have a substantive, pre-existing relationship before you make the offer to invest. That means you’ve already had a conversation with this investor about their finances or about their business or about their investing experience before you actually send them a deal to invest in.
Also, for the 506(b), you’re able to sell to an unlimited number of accredited investors and up to 35 sophisticated investors. So, if you have someone who you have a pre-existing relationship with, who you’ve already had a conversation about their finances or their business, and they are not accredited (they do not meet that million-dollar net worth requirement or they do not have that single income of 200k or that joint income of 300k), then they can invest in a 506(b), and you can actually have up to 35 of those people.
So 506(b) is actually really good for those who are just starting out because, unless you have a network of high net worth individuals, then you likely do not have many accredited investors, but you probably have access to a lot of sophisticated investors within family, friends, and work colleagues. Since you can have up to 35, you could definitely do a deal with only sophisticated investors.
So for those listening who haven’t done a deal before, this is most likely the route you’re going to take. I probably should have said this in the beginning of this episode, but I’m gonna say it now as a disclaimer – I am not an attorney, so the advice that I’m offering is just general advice. I’m not telling you what’s good or bad, what you should or shouldn’t do to determine which partnership type is best for you. Please discuss this with a real estate or a syndication attorney.
Now that that disclaimer is out of the way, the last thing to know about the 506(b) is that, in order to essentially certify that they are an accredited or a sophisticated investor, it’s a self-certification process through a questionnaire… So they can self-certify that they are an accredited or a sophisticated investor without having any third-party involved.
Now, 506(c) is essentially the opposite. You are allowed to do advertising for your deals; general advertising is permitted. As I said before for the 506(b), you aren’t allowed to advertise on social media or email database or stand on a street corner with a banner. If you pursue the 506(c) option, then you are allowed to do that because you can advertise and you do not need to prove a pre-existing relationship with the investor.
Now, the caveat is that you can only take on accredited investors. So, unless you live in New York City or a big city, then standing on the corner with a street sign is probably not the best way to attract accredited investors but, again, who knows…
Unlike the 506(b) where there’s a self-certification process, for the 506(c), you must take reasonable steps to verify the accredited investor status. So that means that you or a CPA or an attorney or a registered investment advisor must review the investor’s documentation, such as their W-2’s, tax returns, brokers statements, credit reports, things like that, to determine that they do meet that accredited investor qualifications. So self-certification is not permissible.
A Final Comparison Between These Different Real Estate Syndication Structures
Overall, the differences between 506(b) and 506(c) is that, with 506(b), you can’t advertise. You must have a pre-existing relationship with the investor. You are allowed to take on sophisticated investors, and the investors can self-certify that they are accredited or sophisticated.
For 506(c), you are allowed to advertise, you don’t need a pre-existing relationship, you’re only allowed to take on accredited investors (so no sophisticated investors), and you must take reasonable steps to verify the accredited investor status.
Now, I mentioned earlier that Joe does 506(b), but they only take on accredited investors. Again, I’m not an attorney, and all I wanna do is provide you with the information on the differences between 506(b), 506(c), as well as the differences between a syndication and a joint venture… But, at the end of the day, in order to determine what’s best for you, you need to consult with a real estate attorney and a securities attorney. To learn more about those two team members, you can go to SyndicationSchool.com and check out those episodes on building a team.
Now, I know this was a short episode, the shortest probably of all that I’ve done so far, but I wanted to have a standalone episode that went over the JV versus syndication and the 506(b) versus 506(c).
This concludes part two. In part three and part four, we’re going to start talking about how to actually raise money from passive investors. Those two episodes are gonna focus on the different strategies and tactics for actually raising money from passive investors, and then, likely, part five and six are gonna focus on how to actually have these conversations with investors once they start to reach out to you through your various lead generation methods.
Then, from there, once you’ve actually secured your verbal commitments, then we’ll talk in the next series about how to actually find deals. In the meantime, I recommend listening to part one, as well as other Syndication School series about the how-tos of apartment syndications. And be sure to check out the episodes with the free documents as well. All of that is available at SyndicationSchool.com.
Thank you for listening, and I will talk to you next week.