The Real Deal New York

AG clarifies rules on syndication offerings, letting investors convert interest to condo ownership

Once frowned upon practice could boost smaller developers, land prices
By Katherine Clarke | July 08, 2013 03:00PM

The New York Attorney General’s office has issued a new memorandum clarifying the laws governing home buyers and investors who purchase new construction condominium units via syndicates, before a developer has filed an offering plan.

The memorandum, issued June 19 by the AG’s Real Estate Finance Bureau, explicitly allows the so-called syndication purchases — a legal but frowned upon method of drumming up funding for residential developments — so long as developers make certain disclosures and allow investors the right to opt out of the acquisition of a condominium unit as part of the syndication offering.

And it could have wide-ranging consequences, from pushing up land prices, to giving lenders a better sense of the demand for projects to allowing smaller New York developers, previously blocked from the market by tight lending practices, to get access to necessary funding, sources told The Real Deal.

Here’s how it works: prospective buyers can reserve the right to purchase a predetermined unit in a new development by acquiring an interest in a syndication or in the development company building the project. Once the AG approves the offering plan, the buyer can choose to cash out or convert the investment to the ownership of the unit.

As usual, the developer can use syndicated funds to build the project and, when seeking financing, to convince lenders of the demand for the units. The developer can also now count the syndicate units towards the total number of contracts required to have the offering plan declared effective. And for investors, syndications represent a chance to purchase units for below-market rates.

Still, the offering plan must be approved before any contracts are signed and, if the project goes belly up, the buyer has no recourse as an investor. The memo is silent on situations where a syndication is coupled with a right to acquire a condo unit in a residential rental building being converted to co-op or condo.

While buyers have previously bought condo units through syndication offerings — indeed, the AG issued the memo in response to the increasing number of such transactions — the practice had been occurring without any regulation or guidance from the AG.

In fact, the AG often paid close attention to these kinds of transactions, since it is a violation of New York State’s General Business Law for prospective buyers to invest in a syndication without the ability to opt out of buying the unit when the offering plan is approved.

However, the AG’s approval of the practice may remove any hesitation from developers who were previously concerned about the legalities of allowing prospective buyers to enter a syndicate, without an approved offering plan, industry sources said.

“The theory is that if the investor is sophisticated enough to weigh the risks of investing in the original development, it is not necessary to worry about protecting them as much as the individual condo unit purchaser,” said real estate attorney Terry Oved of the law firm Oved & Oved.

The AG’s recognition of the practice may have some effect on the market for land and financing in the New York region, sources said. For instance, it may drive up already exorbitant Manhattan land prices by allowing developers to pay a larger amount of their costs upfront, said Jon Kully, a managing partner at development and architecture firm FLANK.

A typical lender would refuse to finance a property acquisition above a certain price per square foot, but developers backed by syndication investors could “pay a land basis that was otherwise viewed as absurd,” Kully said.

“This is basically an enabler to go after the really sought after boutique coveted properties in elite neighborhoods because it allows you to pay up,” he added.

Another byproduct may be an uptick in the number of small residential developers able to find financing for their projects, sources said, since lenders may be more willing to bet on a newbie developer, or a developer without much of his or her own equity, if they can see the promise of sales when the project is still in its earliest stages.

Indeed, if enough prospective buyers line up to join the syndication, their investment could even be seen as a substitute for mezzanine financing, especially in projects smaller than 100,000 buildable square feet, where buyers’ equity represents a significant portion of the overall investment needed to advance the project.

“Lenders would be able to see this additional equity [coming from prospective purchasers] and at least a partial sellout of the project,” said Douglas Heller, a real estate partner at the law firm Herrick, Feinstein. “This could expand the market to some extent.”

Still, for buyers, this process is risky, especially if they do not have a firm grasp of the market or any previous experience investing in real estate.

By investing in the developer or the project before it’s built, buyers are risking their money without the protections usually afforded a condominium down payment. If the project hits a bump or the market takes a turn, the buyer could be left with nothing.

“It’s like going into the stock market except it’s not publicly traded so it’s even riskier,” Heller said, noting that he expected more foreign buyers than local New Yorkers to invest in these syndicates. “I can’t see New Yorkers putting their money at risk like this but I could be wrong.”

Indeed, Kully disagreed with that assessment, saying he thought local buyers looking to upgrade to larger apartments in prime Manhattan neighborhoods would see the syndicate model as a means of snapping up an apartment at a lower cost.

It would also offer buyers, as part of the sponsorship entity, the opportunity to customize their unit before purchasing.

“I see [this appealing to] homegrown New Yorkers who are really neighborhood people,” Kully said. “They’re Gramercy-centric or West Village-centric and have found that prices are getting away from them. The only way to upgrade to a home in a location they want is to form some kind of syndicate as part of this wholesale transaction. I can’t imagine someone being 10,000 miles away taking part in a complicated transaction where they have to take on some risk.”

To alleviate the hazards — both for the investors and the developer depending on them to go through with closings — Kully said he would insist that investors put up no more than 35 percent of the total cost for the unit they wanted.

He said he could see buyers who have previously missed out on units developed by FLANK pushing the company to use a syndication model so that they could secure their units and avoid a rush to ink contracts once the offering plan was approved.

Herrick’s Heller also advised investors, in a memo on the firm’s website, to consider doing additional due diligence and carefully reviewing the conditions of the offering before doing a deal with a developer.

In fact, Kully said, investment by future buyers should never be considered an alternative to conventional debt or equity.

“What you would definitely not want is an overleveraged syndication,” he said. “The syndication could get in a lot of trouble if a few of its investors were unable to perform on their commitment when they translate their ownership interest into condo ownership.”

  • Graveshift

    Not sure how this is news. Syndication have been going down for a long time and “user deals” have always had a competitive edge when the size and scope of the project is small in an A location that can attract high net worth investors who aren’t looking to pay market price for cookie cutter condos. Question is if major developers of large sites, such as 100k-1M sq ft, open syndication to the public. That would certainly change the dynamic of land value and open all types of new doors and cans of worms

    • craignyc

      the news it that now it is approved by the AG, before it wasn’t as it was against the Martin Act, so many developers declined to do that type of deal.