Syndication Exit Strategy -- "Sell" Asset to Yourself>

[Stephen Resch]

Hello BP Community! Active Duty Army Engineer about to retire after 22 year of service. Pursuing REI fulltime now, about to close our first syndication -- 41-unit Senior apartment complex in Iowa, PP $3.7M, raised $800K.

Need advice on an exit strategy:

Apartment is completely renovated so no traditional value add.  But it does have two vacant acres we plan to develop and build a 36 unit assisted living center by Year 5.

Original exit plan was cash out refi at Year 5, return 75% equity to investors, then sell in Year 10. 

However, we (and many investors) want a full exit a Year 5. However, based on projected income, five years is not enough time to build enough equity to pull out enough cash.
Structure: 8% pref ret, 60% equity
PP: $3.7M
Loan: $3M
Investor Capital: $1M
Year 5 Projected Value: $5M
Year 5 Loan Balance: $2.5M
Year 5 Cash Out Refi Avail: $1.5M (80% LTV @ $5M = $4M)($4M - $2.5M = $1.5M)

Selling at Year 5 will easily meet this mark--but we do not want to sell. Rather, we want to expand this into a "Senior Campus" with the second building .

Question then: In Year 5, can we "sell" the property (i.e. "Senior LLC") to another LLC we own, say it's called "Senior Campus LLC"? Senior Campus LLC will already be set up in Year 2 with a construction loan for the new build. This way, we can realize the full market value gain of the original building and have enough capital to cash out investors.

Understand that "Senior LLC" would be responsible for capital gains tax based on sale price. But we could avoid the 3-5% broker/agent fee since we are selling it ourselves. At an approx $5M value in Year 5, that's not insignificant!

So is this a viable and legal plan or not? Am I missing anything or perhaps there is another alternative? Thanks in advance!

[Brian Burke]

Originally posted by @Evan Loader:

Also, how does one ensure that doesn't happen aside from the sponsor's reputation. @Brian Burke have any insight on this? 

The practice that the OP is describing is called a "Recapitalization."  It's done all of the time in the institutional world, and it's done quite often among the larger and more established syndication shops.  There's nothing wrong with the practice as long as the sponsor is disclosing what they are doing and they are recapitalizing at a basis that provides substantially similar economics to the investor as would an arms-length sale.

In the institutional space there's little room for fraud because the outgoing institutional LP has analysts and is sophisticated enough to detect any nefarious intent, plus they probably also have some major decision rights.  In the syndication space with unsophisticated individual investors, or even sophisticated individual investors who do not have decision rights (which is the case most of the time), the recapitalization practice is ripe for fraud by unscrupulous sponsors or even well-meaning sponsors who just don't know, or make an effort to know, the true value of the property in an arms-length sale.  Less-experienced sponsors could intentionally or unintentionally screw this up and ultimately make a bad name for themselves, leaving them with a short career.  Maybe they should avoid the practice just to avoid the potential black mark.  Investor's best defense is to invest with well-established sponsors who have a reputation to protect.

For experienced sponsors who treat their investors fairly, the practice not only makes sense, it's commonly deployed. The use case is typically where a sponsor has two different kinds of investors. One type wants to maximize returns--this usually means "buy, fix, and sell" to maximize property value in a short time, and deliver the highest IRR. The other type of investor is a "lower cost of capital." In other words, they aren't seeking the highest return. They are looking for longer hold times, less risk, and steady cash flow, and are willing to accept a lower IRR (or don't even care about IRR at all) than the first type of investor.

So the strategy is to acquire the property with investor type A, fix it up, raise rents, pump the value, and exit...but instead of exiting to a third-party, they recap with investor type B and hold the property for years or even decades.  Everyone gets what they want.

When you hear of sponsors out there with 10,000 units and more, they probably didn't reach that size doing 3-5 year holds.  They would have to acquire dozens of properties per year if that was the case.  Instead, they got there by using investor A to acquire their portfolio and recapping to investor B to grow their portfolio.  I know of large sponsors who have NEVER sold a property to a third-party.  Are they crooks?  Not at all.  Are their investors satisfied?  Yes, both investor type A and B.  They wouldn't have reached the scale that they have if that weren't the case.