This article outlines the economic factors which must be considered when purchasing real estate for syndication.

The benefits of group investments

The greatest benefits for a syndicator and a group of investors come from acquiring and operating high value properties, all other investment factors being equal.

The syndicator has an advantage over an individual investor. A syndicator pools capital from numerous investors, and thus buys property more valuable than most individual investors can afford by themselves. High dollar value properties are more efficient and yield a greater return than lower value properties.

Also, the syndicator’s compensation, typically based on the price of the property acquired, is far greater when his time and effort is spent on high value properties.

Less experienced syndicators, however, should initially stay with lower value properties. High value properties are a more difficult investment to acquire and manage. Errors due to lack of experience and knowledge are dramatically compounded in larger properties, and thus more costly to correct.

High value properties are more efficient and yield a greater return than lower value properties.

For syndication purposes, real estate can be broken down into five basic categories:

• existing residential or nonresidential rental properties;
• yet-to-be-built construction or subdivision projects;
• pre-builder land;
• agricultural land; and
• remote, unusable land.

This discussion assumes the limited liability company (LLC) will be formed to acquire existing income-producing property, which is by far the category of property most prudent for real estate investment groups.

The benefits derived from existing rental property include:

• an initial investment of capital without the expectation of future additional contributions;
• minimal investor involvement;
• spendable income for periodic distribution;
• equity buildup due to the loan reduction in monthly payments;
• value increase due to monetary inflation and asset appreciation; and
• tax benefits of depreciation and reinvestment.

The other categories of real estate investment do not offer all of these advantages.

Also, group investments in construction projects and agricultural or business opportunities automatically contain corporate securities risks. These “quasi-real estate” investment programs require the expertise of the manager in an ongoing activity that creates value by development, crops, production or sales after acquisition of the property.

For example, yet-to-be-built construction projects expose the investors’ contributions to all the risks of loss inherent in real estate development, creating a securities risk controlled by securities law.

If the LLC is formed to purchase undeveloped land, members must be willing to contribute additional funds to carry the property.

An infinite number of parties and factors – contractors, subcontractors, labor, architects, construction lenders, building permits, title insurance, costs – must be coordinated to complete improvements without which the investment program cannot succeed.On the other hand, remote, unusable land, while it does not create a securities risk since it is purchased merely to be held for profit on resale, does not make as attractive an investment. The value of fallow land is unlikely to increase because of surrounding development or economic activity anytime in the near future.

Also, land that is located in a remote area can be difficult to own. Since the land is unused and generates no income, investment groups tend to grow tired of constantly contributing for insurance premiums, taxes and loan payments which are required of owners of unusable property.

Undeveloped land that is not located in a remote region can make a successful investment if the syndicator correctly anticipates the land will appreciate in value due to local economic conditions and surrounding development.

However, the members of the LLC must be willing to make periodic contributions of additional funds to carry the property since undeveloped land generates no income. If the LLC is formed to purchase undeveloped land, the operating agreement should include a clause stating the members will be required to make additional cash contributions based on assessments set by the manager.

The operation of existing rental properties does not create a securities risk, since the investors receive an ownership interest in existing land and improvements which represents the current value of their contributions at the time of closing – when their funds are placed at risk. Also, rental property, if acquired with a sufficient down payment, can be held without further capital contributions, eliminating the risk that co-investors might default on periodic advances needed to maintain ownership.

Net worth in a property

The equity in a property is the property’s net worth. Equity is calculated as the difference between the property’s market value and the principal balance remaining on any financing that encumbers the property.

The owner’s equity in a property is the result of:

• cash invested to purchase or improve, but not carry the property, called a down payment;
• loan reduction through amortized loan payments or additional payments of principal, sometimes called equity buildup; and
• increased value of the property due to inflation, appreciation or management, sometimes called a growth factor.

Earnings on rental property

Residential or nonresidential rental properties generate annual earnings for the investors from four sources:

• net spendable income;
• loan reduction;
• increased valuation of the property; and
• tax benefits.

Net spendable income

The income received from rent payments makes up the property’s gross operating income. Operating expenses and loan payments are paid out of the gross operating income and, if income is insufficient, out of funds contributed by members. Any income remaining after disbursing operating expenses and loan installments is referred to as the property’s net spendable income.

Spendable income is a return on the investor’s capital contribution, comparable to the interest received on a savings account.

When spendable income is generated, the property is said to have a positive cash flow, providing the investors with income called cash on cash. Some rentals, however, produce a negative cash flow, or operating deficit, requiring periodic infusions of additional capital by members or loan funds.

The spendable income from positive cash flow rentals is a primary source of earnings for investors. Viewed as a percentage return on the investors’ capital contribution, the spendable income generated is comparable to the interest received on a savings account.

Thus, the possibility of earning spendable income without having to be involved in the day-to-day management of the property is a major incentive for investors to become members in an LLC program.

Loan reduction

The annual principal reduction on a trust deed loan, due to loan amortization built into the payment schedule, is calculated as a percentage yield on invested capital. This yield is a secondary but important source of earnings. Taxwise, the annual principal reduction is best viewed as a return of capital. Annual depreciation deductions more than shelter the loan reduction from taxation as income during the initial years.

Typically, the principal balance owed on a long-term real estate loan is systematically reduced by an amortized loan payment schedule until the debt is fully paid. The reduction of the debt “builds up” an equal amount of additional equity in the property as long as the market value of the property is maintained over the life of the loan.

When income property produces a positive cash flow, all loan payments are made from the rental income paid by the tenants. No further capital contribution is required from the investors to carry the payments on loans encumbering the property.

On the resale or refinancing of the property, the equity built up by the amortized loan reduction is cashed out, generating profits (sale) or capital (refinance) for the investment group.

Often the investment circular will set forth a schedule stating the annual dollar amount of loan reduction over a 10-year period of ownership by the LLC. The annual equity buildup attributable to the loan reduction during each of the 10 years is then represented as an average annual percentage return on the investors’ original capital contribution.

Increased value

Real estate values in areas of population growth tend to increase over time due to a combination of inflation, appreciation and efficient management of income and expenses, called growth factors. All the while, the physical aspects of the property remain unchanged.

It is the syndicator’s task to choose a property likely to increase in value.

Inflation is the decline in the purchasing power of the dollar, measured by the federal government and reported in the consumer price index (CPI). Thus, after time, more dollars are required to purchase the same property. Inflation is reported as the periodic increase in the dollar price paid for goods and services, not as a decrease in the quantity of goods and services the dollar will now buy. Over the years, the value of properly maintained real estate tends to keep pace with inflation, if: the location of the property has a static or increasing population and employment base; and the per capita income of potential tenants increases annually no less than the rate of inflation.

To reap the “benefits” of inflation, the manager of a property need do nothing more than maintain the property by keeping it in good repair and replacing fixtures to avoid physical obsolescence.

Occasionally, property appreciates in value in addition to the rate of inflation because of local economic conditions, primarily composed of consumer demand for the location. It is the syndicator’s task to choose a property likely to increase in value. The syndicator looks for property whose local conditions will build up the population (or its per capita income) and thus increase demand for residential and nonresidential rental space.

Finally, an increase in property value may be achieved by the syndicator’s management ability to cut operating costs and increase rental revenues. Efficient management increases the property’s net operating income (NOI). Thus, the value of the property is increased since capitalization rates for setting value are applied to the NOI.

Tax benefits

Tax aspects of ownership are a collateral and minor source of earnings compared to earnings generated by the property, such as spendable income, loan reduction and increased property value. The major tax benefit is the tax-free return of invested capital (down payment and secured debt) reflected in the annual depreciation allowance for improvements which is deductible from the property’s NOI.

Consider an income-producing property with an annual gross operating income of $120,000 and operating expenses of $40,000. The property’s NOI is $80,000.

To determine the annual reportable operating income or loss on the property, the interest paid and the depreciation allowances are deducted from the NOI.

Depreciation is the owner’s capital recovery and a deduction from the property’s NOI, not an expense of operating the property. Depreciation deductions provide for the orderly return to the investor of the cost of improvements over their useful life.

Suppose the annual interest payments amount to $60,000, along with a depreciation deduction of $30,000. Thus, the property has no reportable operating income (or loss), since the amount of the interest paid and depreciation deduction equals (or exceeds) the NOI. However, it is the NOI minus the loan payments of principal and interest which produces spendable income. Depreciation is not a factor in determining spendable income. However, taxation of the spendable income as either ordinary income or a return of capital depends on the depreciation schedule and the amount of principal reduction.

The major tax benefit is the tax-free return of invested capital reflected in the annual depreciation allowance deductible from the property’s NOI.

Since the property does not produce a reportable income, no part of the spendable income generated by the property is taxed in the first year of operation. The spendable income (and loan reduction) is “sheltered” annually by the depreciation deduction as a tax-free return of invested funds.

Depreciation is often casually viewed as an additional source of income for the investors – a yield on the original investment – even though depreciation is technically classified as a return of capital, not income at all. The rationale allowing the return of capital to be viewed as income is that real estate values are not perceived to be negatively affected by the aging of improvements. This dismissal of aging is a result of the offsetting effect of inflation, appreciation and proper management of income and expenses.

The $25,000 rental loss deduction

Some or all of a reportable loss from annual operations may be deducted from each member’s adjusted gross income (AGI) on federal tax returns if the member qualifies under the $25,000 rental loss deduction rules.

A member’s AGI includes net income and profits from all three income categories:

• trade or business income;
• rentals (passive) income; and
• investment (portfolio) income.

Rentals include all residential and nonresidential income-producing real estate with an average occupancy of more than 30 days.

For each member, the rental property’s reportable losses from annual operations initially offset any reportable income they may have from other rental properties and passive business investments, since both are reported in the passive income category.

However, operating losses that exceed the member’s income from rental category investments do not disappear. Remaining operating losses are:

• deductible from the AGI to determine taxable income, called the $25,000 rental loss deduction;
• suspended for use in future years to offset income or profits of the property generating the loss, called suspended losses; or
• an adjustment to gross income if the member qualifies as being in a real estate-related business.

To qualify for the $25,000 rental loss deduction, a member must have at least a 10% ownership interest in the property.

Suspended losses carried forward by inactive members are used in later years to offset any reportable annual income from operating the property, or profits on resale of the property generating the suspended loss.A member active in management is classified as an “owner-operator” of the LLC’s rental property, such as the manager. Initially, an owner-operator qualifies for a rental loss deduction of up to $25,000. The deduction is taken from the member’s AGI to determine his taxable income. [Internal Revenue Code §469(i)]

However, limited partners – which includes inactive members of an LLC – are barred from claiming the rental loss deduction should the LLC file a partnership return and the members file a schedule K-1 with their Internal Revenue Service (IRS) 1040 form. Alternatively, the LLC could avoid the partnership filing which would then permit each member to claim the loss on a Schedule E with their IRS 1040 form. [IRC §469(i)(6)(C)]

Thus, a member of an LLC can claim the rental loss deduction only if:

• the member qualifies as an owner-operator; and
• the LLC is exempt and does not file an IRS 1065 form under the small partnership exemption, since the member will not report to the IRS as an LLC member with a fractional interest and limited liability.

However, other facts may disqualify the deduction. For example, to qualify for part or all of the $25,000 rental loss deduction, a member must actively participate in the management of the property generating the reportable loss. Also, to qualify as actively participating in the management of the property, the owner must have at least a 10% ownership interest. [IRC §469(i)(6)(A)]

To indicate they are active participants in the management of the LLC property, each member should sign the property management agreement employing the manager to operate the property on their behalf. Taxwise, the property management agreement demonstrates a member’s control over the property as an owner-operator; the LLC merely holds title for the benefit and on behalf of the member.

The deduction is also restricted based on the member’s AGI. To qualify for any part of the $25,000 deduction, the member’s AGI must not exceed $150,000.

Further, the deductible amount of any rental operating loss is reduced by 50% of every dollar by which the member’s AGI exceeds $100,000. Thus, the owner may deduct the full $25,000 if his AGI is less than $100,000, and decreasing amounts for an AGI between $100,000 and $150,000. [IRC §469(i)(3)]

When the AGI reaches $150,000, no part of the $25,000 remains to be deducted.

Editor’s note – The members will most likely be limited to the $25,000 rental loss deduction if they qualify as active participants. However, the manager of an LLC may be able to use the operating losses from the LLC’s rental property to reduce his AGI.

To qualify for an AGI adjustment, the manager must be sufficiently involved in real estate-related business activities. A real estate-related business means the manager spends more than half of his time and no less than 750 hours per year rendering services in real estate business activities, such as developing, constructing, acquiring and managing income properties, and real estate brokerage activities.

Controlling the property

Consider a syndicator who locates an income-producing property that appears to be suitable for an LLC investment program and can be acquired on acceptable terms.

The syndicator does not initially commit himself to the unconditional purchase of the property, but will do so when he has fully investigated and approved the condition of the improvements and operations of the property, called a due diligence review. Also, the syndicator needs time to prepare an investment memorandum with which to solicit and subscribe investors.

For the syndicator, the option agreement imposes no obligation to purchase the property.

Meanwhile, the syndicator needs to control the property so he will have an enforceable purchase agreement should he decide to acquire the property after conducting his due diligence review.

To control the property without committing himself to its purchase, the syndicator has a number of contract choices, including:

• a purchase agreement with contingencies;
• escrow instructions with contingencies but without an underlying contract; or
• an option to purchase the property.

A contingency is a provision in a purchase agreement setting forth a condition that must be satisfied or waived by the buyer before the buyer is obligated to purchase the property.

Contingency provisions should include the syndicator’s approval of the condition of the property’s improvements, leasing income and operating expenses, financing, title condition, natural hazards and conditions surrounding the location.

The purchase agreement or escrow instructions might include an investor-funding contingency, allowing the syndicator to cancel if he is unable to fully subscribe an LLC investment group to fund the acquisition.

Escrow instructions entered into in lieu of an option or purchase agreement must include the contingencies needed by the syndicator. When a written purchase agreement does not exist, the written escrow instructions signed by the buyer and seller take the place of a purchase agreement. [Tuso v. Green (1924) 194 C 574]

Thus, when no underlying written purchase agreement exists, any contingencies in the escrow instructions have the same effect as contingencies in a purchase agreement. Likewise, the contingencies stated in a purchase agreement need not be restated in escrow instructions.

The syndicator, as the buyer, will include a vesting provision in any offer he makes, allowing him to assign his purchase rights to the LLC and receive the seller’s cooperation to deed the property directly into the LLC vesting.

Purchase options

Sellers tend to be uncomfortable with purchase agreements full of contingencies. The contingencies could interfere with the seller’s ability to cancel the transaction should the syndicator be unable to close the purchase by the scheduled date.

The seller might not want his property to be subject to a binding purchase agreement which may ultimately be rendered unenforceable by contingencies.

An acceptable alternative for the seller might be to grant the syndicator an option to purchase the property. In an option agreement, the seller grants the syndicator an irrevocable right to purchase the property within a fixed time period, called the option period.

After the option period expires, the seller will be able to sell the property to another buyer, unaffected by the expired option. If the option is recorded, the option will not expire as a cloud on title until six months after the expiration date stated in the recorded option agreement or memorandum. [Calif. Civil Code §884.010]

For the syndicator, the option agreement imposes no obligation to purchase the property. Conversely, the seller is obligated to sell should the syndicator decide to buy the property by exercising the option during the option period – an acceptance of the seller’s irrevocable offer.

In exchange for the seller’s grant of an irrevocable offer to sell the property, the syndicator pays the seller a consideration, called option money. The option is not enforceable unless the seller receives consideration, although the amount of the consideration may be nominal. [Kowal v. Day (1971) 20 CA3d 720]

Syndicators typically use options with short option periods – three to six months – to control the property, have time to investigate it and form an investment group to fund the purchase of the property. The option money is set for an amount that will compensate the seller for keeping the property off the market during the option period.

Often a small amount of option money is paid for a short initial option period, sometimes called a “free-look” period. The term of the typical free-look option is 20 to 30 days, for an option money payment of as little as $100.

Since the syndicator may need more time after the free-look period to decide whether he wants to or can acquire the property, the syndicator might negotiate for an option with one or more extensions of the initial option period in exchange for more option money when he needs to extend the option period.

Any number of additional option periods may be agreed to, one following the expiration of another, depending only on the seller’s willingness to grant extensions and the syndicator’s willingness to put up more option money.

For his part, the seller not only receives the option money, but, if the option is not recorded, he is assured the property will not be tied up by the syndicator after the option period expires.

Liquidated damages and liability limitations

Without an option, or contingencies allowing cancellation of a purchase agreement or escrow, the syndicator’s failure to close the transaction exposes him to liability for money losses incurred by the seller.

Usually the seller’s only loss on a failed transaction is due to a decline in the value of the property between the time of agreement and the buyer’s breach. Money lost by the seller would be the reduced net proceeds on a resale of the property.

The seller’s recovery of actual money losses resulting from the syndicator’s breach may not exceed the agreed-to limitation.

Two types of money damages provisions in purchase agreements address the seller’s losses on the syndicator’s wrongful cancellation or failure to close: a liquidated damages clause, also known as a forfeiture provision; and a liability limitations provision.

A liquidated damages clause states a predetermined amount of money the syndicator will pay the seller in the event of the syndicator’s breach of the purchase agreement, whether or not the seller lost any money on account of the breach.

However, liquidated damages clauses are unenforceable in real estate transactions, as liquidated damages constitute a forfeiture, which is barred by law. [CC §3275]

To recover money damages on a wrongful cancellation or unexcused failure to close, the seller must prove he sustained actual money losses as a result of the syndicator’s breach.

The syndicator and the seller may agree to insert a liability limitations provision in the purchase agreement, thus limiting the syndicator’s liability in the event of a breach of the agreement.

Again, the seller is only entitled to recover his actual money losses resulting from the syndicator’s breach, and the amount may not exceed the agreed-to limitation.

Thus, if the syndicator wrongfully fails to close and the property’s value declines, the limitation on the syndicator’s liability has already been set – no matter how far the property value drops below the purchase price.

The good faith deposit as a purchaser’s lien

The syndicator generally makes a cash deposit, called a good faith deposit, as part of his offer to purchase. Occasionally, the deposit is in the form of a postdated check or promissory note, payable after contingencies are eliminated.

If the syndicator breaches the purchase agreement after making a deposit, he is entitled to recover the deposit, less money losses actually sustained by the seller.

For example, a syndicator breaches a purchase agreement at a time when the rental property’s value is equal to or greater than the purchase price agreed to in the purchase agreement. Thus, the seller has lost no money from the syndicator’s cancellation and is not entitled to recover anything.

Since escrow is not going to close, the syndicator demands the return of his deposit. The seller refuses to authorize the release of the syndicator’s funds, claiming the deposit is forfeited because of the syndicator’s failure to close escrow.

However, forfeitures in real estate transactions are barred by law. Since the seller will not return the syndicator’s funds, the syndicator is entitled to a purchaser’s lien on the seller’s property for the amount of the good faith deposit. The purchaser’s lien is enforced by filing a judicial foreclosure action and recording a lis pendens on the property. [CC §3050]

Options and contingencies also allow the syndicator to avoid a purchase agreement without incurring liability. However, even without the protection of an option or contingencies, the syndicator is assured he will incur no greater liability on his breach of the purchase agreement than the seller’s actual money losses, limited to the amount stated in the liability limitations provision.

Escrow period

For the syndication of a property, the time period for closing an escrow after entering into a purchase agreement should be 120 days or more. The 120-day timetable of events after contracting to purchase an existing income-producing property is broken down as follows:

1. First 30 days: Complete an investigation of property and clear contingencies.
2. Next 15 days: Complete the investment circular, articles of organization (LLC-1), and LLC operating agreement.
3. Next 45 days: Solicit investors until the LLC is fully subscribed.
4. Last 30 days: Extra time for closing.

If the LLC is not fully subscribed within 45 days after the investment circular is first presented to investors, it becomes increasingly unlikely the LLC will ever be fully subscribed. Without investors, the purchase escrow will not be closed. Taxwise, escrow should be opened in the name of the syndicator, for the same reason the syndicator made the offer to purchase in his name – to establish property rights in his name. Before closing, the syndicator will file an LLC-1 with the California Secretary of State and assign his purchase rights to the LLC.

To assign his purchase rights to the LLC and fund the closing, the syndicator can open two separate escrows.

To accomplish the assignment and fund the closing, the syndicator can open two separate escrows. The first escrow is the purchase escrow, in which the syndicator as an individual is initially named as the buyer. During the escrow period, the syndicator’s right to purchase the property is assigned to the LLC in exchange for a Class B membership interest in the LLC.

Thus, the purchase escrow is opened by the syndicator (as an individual) and closed by the LLC. Title to the real estate will be vested in the LLC.

However, neither the LLC nor the members should initially deposit funds in the purchase escrow. The deposit of funds is the function of the second escrow, known as a funding escrow. The sole purpose of the funding escrow is to hold the funds deposited by the LLC members until the purchase escrow can close.

Escrow is instructed to transfer the funds deposited in the funding escrow to the purchase escrow only when the purchase escrow can close, vesting title to the property in the LLC.

The purpose of the double escrow is to protect the investors’ capital in the event of any complication in the closing of the purchase escrow. The investors can recover the funds deposited in the funding escrow without the consent of the seller in the purchase escrow.

Some escrows allow a return of funds deposited directly into the purchase escrow by the investors for the benefit of the LLC. Escrow receives these funds under a “receipt of third party deposit,” stating the conditions for use or return of the funds. The investors are the third parties, the seller and the LLC being the contracting parties.

Another alternative is an interest-bearing bank account in the name of the LLC which will hold the investors’ funds until disbursement to escrow – when escrow can close.

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