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US Business law: use of llc for cre transactions

Commercial real estate projects are usually initiated by project developers, who seek profit opportunities between the costs of acquiring, developing and operating real estate properties and the revenue such properties can generate. On the one hand, the success of a project depends largely on the skills of the developers. On the other hand, the capital of the projects are usually funded by external equity investors and debt lenders. The participation of investors and lenders dilutes both risks and rewards borne by the developers, and alters their incentives compared to a project fully fund by themselves. The developers' profitability becomes less restricted by the profitability of the projects. To some extent, the business model resembles that of an investment fund. The dynamic interaction between the interests of different parties requires a sophisticated structure to balance the risks, rewards, rights and obligations between the involved parties. 

Before diving into the structure of CRE transactions, the concept of limited liability company (hereafter "LLC") needs to be introduced. LLC is a form of legal entity between corporation and unincorporated business forms. In previous articles, we discussed how a corporation entity can shield owners from liabilities but is subject to double taxation; and how unincorporated business forms cannot limit liabilities for owners but are eligible for pass-through taxation. LLC, as a mix of both, is capable of both limiting liabilities for owners and providing owners with pass-through taxation (or not, at the choice of the owners). This feature makes LLC highly preferrable in most scenarios. Unfortunately, LLC has not been adopted by provinces in Canada yet.

The structure of a CRE project usually uses three layers of entities. A limited liability company specifically organized to own the property sits at the first layer.(the “Holding Company”) The Holding Company is owned completely by another limited liability company set up for the purpose of pooling all the resources together, (the “Syndication Company”) which sits at the second layer. The Syndication Company usually issues two types of membership interests, limited membership interests for the investors and general membership interests for the project developers. The Syndication Company, in turn, is managed by another limited liability company  at the third layer, (the “Manager Company”) specifically organized to manage the Syndication Company. This Manager Company is usually completely owned by the project developers, which allows the project developers to indirectly own all the rights the to manage the Syndication Entity. This constitutes the three-layer structure.

The three layers of entities have complex legal relationship beyond just ownership and such relationship are specified through contracts. Each entity has its own internal operating agreement that connects it to the entity one layer above it. At the bottom level, the Holding Company’s operating agreement is usually a “Single Member Operating Agreement” that describes the purpose and ownership of the Holding Company. This document is comparably simple because having only one owner subjects the Company to little contention. The most important contract is the Syndication Company’s operating agreement, usually called the “LLC Operating Agreement.” It is a comprehensive document that specifies how the activities of the Syndication Company can be carried out, from how to raise capital, distribute shares, distribute dividends, make decisions, to the dissolution of the company. It specifies the different rights and obligations that the project developers, investor, and (sometimes) lenders carry. This document also allocates the rights to make decisions to the Manager Company. The Manager Company is in turn controlled by its own operating Agreement, the “Manager Company Operating Agreement.” This document allocates the ownership and the decision-making power to the project developers. Through these contracts, the project developers now have the substantial rights to manage the property at three layers above the property. 

It is common for project developers to include a number of different properties in the same project. In such transactions, it is helpful to set up a number of Holding Companies at the first layer, each owning one property. The complete and separate ownerships in the underlying properties provides both convenience and protection to the Syndication Company. First, if any liability related to a specific property arises, the liability will be limited to the specific Holding Company. The funds invested, the loans borrowed, and the operation of other properties will be protected. Second, if the project developer wants to add a property to the project or removes a property from the project, he can do so with more ease than if the Syndication directly owns all the properties. Third, it provides lenders with direct and simple ownership interests to attach security interests. Comparing to an entity that blends different asset ownerships, debts and security interests together, an entity that separates the financial liabilities according to the legal ownership is more favorable to the lenders, and provides the project developer with more flexibility regarding how to design the capital structure. Further, if the project developer wants to refinance or sell any specific property, the operations of other properties can easily remain unaffected. 

At the second layer, the Syndication Company acts as the main entity that carries out most activities of the project. The liabilities and risks related to investment, loan, regulation and securities will be limited at this layer, leaving the Manager Company and project developer protected to certain extent. After the Syndication Company is capitalized, the project developer proceeds to acquire and develop properties through this Entity. The PSA are usually contracted under the name of the Syndication Company. When revenues are realized or when properties are sold, cashflows available for distribution will be distributed through the Syndication Company according to its operating agreement. Investors invest in and receives equity shares of the Syndication Company. Lenders lend money to and receives repayment from the Syndication Company. The ownership in the Syndication Company reflects the true ownership of the project. Thus, the Syndication Company is the main entity that needs to comply with security regulations. 506(b) and (c) of Regulation D are two exemptions commonly used by commercial real estate transactions. 506(b) is available when the project does not solicitude in the public and has less than 35 non-accredited investors. 506(c) is available when the project is limited to accredited investors. When either one of these two exemptions is met, the Syndication Company can be exempt from very nuanced filing requirements.

Lastly, the management works are carried out through the Manager Company at the third layer. The business decisions of the Syndication Company must be authorized by the Manager Company, the decisions of which must be authorized by the project developer. Management liabilities are limited at the Management Company level, and thus the project developers are protected from personal liabilities. On the contrary, if the project developer directly manages the Syndication Company, he will be subject to much larger exposure. Having a separate Manager entity also allows cash distributions to be more transparent. Because the project developers receive both distribution of profits and management fees from the Syndication company, there can be disputes regarding whether a transfer is a distribution of profit or a management expense if the project developer receives both types of distribution directly. With the Manager Company as the recipient for all fees, there will be a clear separation between these two types of transfers. The creation of the Manager Company also separates the management interests from the economic interests. Project developers may bring in new management partners or sell their management interests more flexibly than if they directly manage the project. The use of a Manager Company also limits the liabilities for the Syndication Company regarding service contracts. The operation of a property usually involves service contracts with third parties, such as property management companies. Having the Manager Company as the party for these service contracts will limit the liability to itself and protect the Syndication Company and all the important assets owned by the Syndication Company. 

The three-layered structure delineated above is the most common form that commercial real estate developers use to carry out their deals. The Holding Company at the first layer holds the real estate property and limits property-related liabilities to itself. The Syndication Company at the second layer owns the Holding Company, and performs most duties of the transaction, including raising funds, borrowing loans, complying with securities regulation, distributing dividends, etc. Investor and project developer’s ownership in the project are reflected by their ownership in the Syndication Company. Financial and regulation-related risks are largely limited to this layer. The Manager Company sits at the third layer. The project developers manage the operation of the project through this entity. The Manager Company limits the management risks to itself and protects the project developers to some extent. Limited liability company’s ability to offer both limited liability and pass-through taxation is also a core advantage of this structure. The strategic use of LLC, combined with a well-structure hierarchical relationship between different layers of entities, contributed greatly to the success of the commercial real estate market.