Real Estate Financing Tips

How To Bifurcate Equity

by Marvin Levin

In the mid-1960s, both private and public syndicators began to think about the possibility of dividing equity ownership in income property into different classes of ownership.

This would not surprise Wall Street investment bankers who, for more than 100 years, created corporations with preferred and common stock.  The preferred stock had priority for receipt of income, leaving to the common the appreciation in value.  Investment bankers would also issue ordinary debentures, debentures convertible into common stock, preferred stock, and ordinary common stock.  Some corporations were formed by the issuance of “super stock” with preferential voting rights.  In that case, all of the shares had equal financial benefits, but the investors in the super stock, who, for example, might have contributed only 10% of the equity, were often awarded the privilege of voting as majority stockholders.

In 1971, Consolidated Capital, an Emeryville, California-based sponsor of public limited partnerships, raised equity from the public by issuing Class A limited partner units and Class B limited partner units.  The A units received 80% of the cash flow and 20% of future appreciation, without any tax write-offs.  The B units received 20% of the cash flow and 80% of future appreciation, with a 100% allocation of tax benefits because the B units were subordinate to the A units and would suffer any initial financial loss.

Although the Tax Reform Act of 1985 eliminated substantially all of the advantage of allocating tax benefits, there still remains some possible advantage of dividing benefits from income property ownership into two or more classes.

Probably the simplest way of accomplishing this division is to use a limited liability company as owner of the property, and then cause the limited liability company to issue notes and membership interests.  As an example:  Suppose a syndicator wishes to raise $200,000 to make a $1 million purchase.  His target may be to issue ten $20,000 investment units.  However, instead of proposing ten LLC membership units for $20,000 each, he instead proposes to issue five $20,000 notes and five $20,000 equity units.

The notes might be issued for straight interest at a market rate, or might be issued for something less than market coupled with small profit sharing.  An example might be straight interest notes at 11% per annum, or 7% plus 15% of the project profits.  The interest expectation on the notes, however constituted, should be approximately half of the expected return on the equity side.

The notes would probably contain a “cash flow” provision because a default on note interest should not give note holders a right to foreclose on the property.  In substance, a note holder is not a creditor in the strict debtor/creditor sense; rather, the note holder has a preferred equity position.  And, the equity holder should be entitled to receive a greater rate of return because of the priority awarded to the note holder. 

Some investors will not be able to decide whether they would prefer to be a note holder or an equity holder.  For those investors, they can solve that dilemma by buying one of each unit, or possibly a one-half unit of each.

Although some investors will neutralize the impact of the Class A and Class B unit structure (in my experience, about 15%), the majority will select either the Class A, in order to achieve more security, or the Class B, in order to achieve a greater participation in future appreciation.

Probably the best approach to both administer and to explain to investors is to create a note (or a note that participates in profits) and an LLC membership equity unit.  Also, some investors for estate-planning purposes will elect to keep the note in their own portfolio and give the membership to their heirs or into a family trust, thereby bailing out appreciation from their own estate.

If you come across a value-added income project, please contact me.