The Real Estate Syndicates: Money in a Hurry
Public syndication of real estate is a modern development which, in its eleven years of existence, has attracted more than $10 billion from inrestors. CAROLINE BIRD, a New Yorker who graduated from Vassar and received her M.A. at the University of Wisconsin, here describes the operations of the syndicates and warns of their dangers.
REAL estate syndicates, which are growing even faster than mutual funds, give hundreds or even thousands of junior partners small pieces of big income-producing buildings. In 1961, the first year they were required to file, new real estate syndicates in and from New York state drew a half billion dollars from the public. Public syndication of real estate is not yet twelve years old, but some observers think it has attracted more than $10 billion from investors.
The figure is a guess because the syndicates are hybrids. Real estate editors think they belong on the financial page, but financial editors pass them back to the real estate desk. The few who understand the syndicates worry and warn against them.
The danger to investors ranges from outright fraud and loss of money to bucket-shop promotion deceiving them about the risks they are running. The danger to all of us is tax evasion and inflation of real estate values until the bubble bursts with a bang that will hurt everyone who owns property.
The essential ingredient of a real estate syndicate is a promoter or syndicator who gets the cash to swing a real estate deal by cutting in a large number of limited partners under a complicated partnership agreement with twists original enough to baffle an ordinary lawyer or accountant. The following example is typical of the better offerings:
Early in 1961, a syndicator found a 510-room apartment house in the suburbs he could buy from the builder for $520,000 above the safe mortgage an insurance company supplied. He clinched the deal by putting $25,000 of his own money into an option to buy. His next problem was to raise the cash fast. To cover the $520,000 and reimburse himself, he raised $610,000 from limited partners, each of whom paid in one or more units of $$5000. As general partner, he agreed to give his hundred or more limited partners a share of the rental profits of the building amounting to 10 percent of their stake for ten years. He further undertook to manage the building in such a way that the limited partners would not have to pay income taxes on 65 percent of the money they got out of it. He then formed an operating company, which leased the building from the partnership for a rental which guaranteed the limited partners their 10 percent and gave him a small profit as operator too. Everyone won.
The builder got a fast, clear, cash sale.
The syndicator converted use of $25,000 for a few months into most of the $90,000 difference between the $610,000 raised and the $520,000 cash he had to pay. The profit went to him in various forms – real estate commission, syndication expenses, units reserved for himself for finding the deal. And, under the lease, he continued to participate in the rental profits.
The investors got $500 a year on each $5000 invested, and for ten years $325 of this distribution could be reported as depreciation or return of capital, and so was free of income taxes, giving them more money for themselves than would a comparable income from a savings account or any listed stock or bond, taxable or tax-exempt.
The catch, of course, is that a piece of a syndicate cannot possibly be compared with a savingsbank deposit, a mortgage, a bond, or even a stock. All of these pieces of paper entitle you to something tangible. If a corporation fails, a stockholder might theoretically lay hold of a nut or a bolt as his share of the fixed assets after the debts have been satisfied. He has a lien on something. A syndicate partner, on the other hand, has only a share in the hypothetical profits of selling or operating a piece of property when and if it is acquired. If the general partner cannot find enough money, or something is wrong with the deed, or any of a number of things stop the sale, the partners may even be out their stakes.
Other questions come to mind. Who guarantees the return? Who would buy your share if you needed money in a hurry? Could the property be sold without your consent? Could you be assessed if more money were needed to meet an unforeseen expense? How long will the building continue to make a profit? The syndicators of the new 510-room apartment house in our example budgeted only $14,000 a year for “repairs, maintenance, supplies, and vacancies,” but they cannot expect to get by on that after the first few years.
What is this 10 percent you are getting, and why is so much of it tax-free? Even the syndicate salesman doesn’t call it return, interest, or income. The tax-free portion of the distribution, as he calls it, is either that portion of your investment the general partners are giving back to you that year or the amount of the depreciation the Internal Revenue Service allows you to deduct from your income against the day when the building will be completely worn out and you will have to put up your share to buy a new one.
Neither the tax ride nor the 10 percent distribution will last forever. Theoretically, they ought to end together. When the building is 100 percent depreciated, you will have to pay full income tax on any revenue you continue to get from it. About the same time, the general partners might finish retiring the capital they raised from you, so that you would be entitled only to whatever share of the equity of the building the fine print of your contract with them provides. If they have postponed repairs to keep a little operating income above the 10 percent they undertook to distribute, they have been dipping into your capital. If you have spent the 10 percent as if it were income, you have been dipping into your capital.
Few syndicates are old enough to have run out of money, even if it were possible in today’s rising market. Practically speaking, income-producing real estate has grown steadily more valuable every year for the entire eleven-year history of real estate syndicates. Inflation has generally more than offset the depreciation allowed against taxable income. As a wheeler-dealer, the general partner or syndicator has usually cashed this gain long before term, often by a swap under which his delighted limited partners get a larger dollar share of a new deal, though their equity is smaller. Common sense suggests that there must be an end to this process, but, like the end of a rainbow, it seems far off and likely to wind up in a pot of gold.
Startling returns were easy in the beginning. Most big buildings were held by corporations. Convert the corporation into a partnership, and you double the income by saving the 52 percent corporate income tax. By means of tapping a new source of funds, the public, syndicators could put in automatic elevators or otherwise realize the potential of investment opportunities which did not happen to fit into the plans of any of the limited groups which regularly watch for such chances.
News of the magic spread. Where else could you get 25 percent, or 15 percent, or even 10 percent on your money and keep more of it than usual from the tax collector too? What could be more solid than a few bricks in the Taft Hotel, the Squibb or General Motors building, or the old Wanamaker store? As Albert Mintzer, whose well-publicized SIRE (Small Investors Realty Plan) offers participations as small as $500, explains, syndicates give the middle-income investor the thrill of owning a tangible part of America, the romance of buying a major property. Syndicates are big in Hollywood, the city of dreams.
THE first fortunes have already been made. The real estate syndicate as we know it was born on December 1,1950, when Lawrence A. Wien invited the public to share ownership of the office building at 200 Fifth Avenue on the basis of a 15 percent return, with an opportunity for more if it became available. It did. In the past four or five years, 200 Fifth Avenue has been paying its syndicate participants 25 percent on their original stakes. As for Wien, he is now so rich, and knows so much about taxes, that he spends $250,000 a year on 250 charities and a great deal of his time on the hundred foreign students he is seeing through Brandeis University. His most recent venture has been the purchase of the Empire State Building.
Most of the original syndicators were not real estate brokers. Wien was a lawyer. So was A1 Mintzer. Marvin Kratter, the first to put a corporate roof over his partnership syndications and to offer the stock for public trading, was an accountant. The late Robert A. Futterman started out his career as a $75-a-week rent collector. Of the spectacular successes, only J. M. Tenney and Louis Glickman were born into the real estate business.
All of these pioneers have consolidated their gains and are out of the syndicate business. They are corporations, even if corporations do pay income taxes. Their former limited partners have marketable stock in companies operating a diversified portfolio of real property which pays dividends that are downright stodgy compared with the old participations in a single building. These pioneers say there is precious little left in New York City that can be safely or honestly syndicated at more than 10 percent.
They warn in vain. A new generation has flocked in to take their places. Louis Glickman thinks that the number of syndicators actually doubled during 1960. Sanders Kahn, a veteran New York City appraiser, now Supervisor of Real Estate Education at the City College of New York, thinks it was easier to sell syndications in 1961 than it was a year before. “There are probably ten times as many, and thinner ones at that, as there were in 1957,” he adds.
The pressure of syndicators on available New York City property has pushed the prices up to the point where yields are lower. One solution is to take lower-percentage distributions. Another is to syndicate apartment houses, office buildings, and other prime income-producing property out of town. Neither solution is popular with the New York market for syndicate participations, now considerably swollen by people who are out to duplicate early killings.
“To determine the potential success of a less than 10 percent offering, it is merely necessary to call a meeting of the syndicator’s relatives and ask how much they intend to invest,” Preston Golden, a colorful New York syndicator, laments. “There are times I feel that the syndicator who wants to build a motel in Oshkosh would do just as well by building it on the moon,” he says. “At least on a clear night some of his investors might be able to look up and proudly remark, ‘That’s my building.‘”
The solution, of course, is to sell participations in Oshkosh to people who can drive by every morning and say, “That’s my motel.” This is being done, frequently by successful New York syndicators looking for fresher fields. Some of them insist that the syndicators will roll across the country like a tidal wave until every major building in the country is taken.
IN New York City, meanwhile, the new syndicators have to run faster all the time to maintain the fabulous returns their followers expect. This leads to abuses:
First, they are syndicating property which has no business being syndicated. Contractors stuck for a loan have syndicated construction jobs, beginning distributions out of collections before the building is ready for occupancy. Leases have been syndicated. Edward N. Gadsby, until recently chairman of the Securities and Exchange Commission, reports the syndication of a stretch of desert improved only by a growth of cactus, presumably in hopes of a long-term capital gain.
The commonest danger, however, is that syndicators are reaching out to syndicate real estate which is dependent on the operation of a business. Motels, hotels, swim clubs, country clubs, bowling alleys, nursing homes, medical centers, and dairy farms are high-risk service industries which ought to return 25 percent or more to their investors. They are certainly no bargain at the 10 or 12 percent return offered by the syndicators.
Second, they are dressing up the deals to look better than they are. Alvin A. Levy and Irving Magot of Estate Securities Co., Inc., New York and New Jersey realtors, report several dodges for artificially inflating the value of syndicated property. One way is to pay so much more for the property than it is worth that the original owner is willing to kick back some of the price by agreeing to lease it from the syndicate at more than it can earn. Another way is simply to collect more from the participants than is needed and pay them back their own money. Levy and Magot cannot understand how the syndicators get theirs.
Some of the new syndicators are merely outsmarting themselves. Occasionally they are as confused about what they are doing as their limited partners are. Carl Madonick, assistant attorney general in charge of New York state’s Bureau of Securities, tells the story of a Queens housewife who gave a syndicate salesman $2500 and then tried to figure out the piece of paper he gave her. On the advice of a neighbor, she sent it to the attorney general. Neither Attorney General Lefkowitz nor Madonick nor his accountant could make head or tail of the two sloppily mimeographed sheets, so they called in the accountant who signed the balance sheet – who finally admitted he could not understand it himself.
More or less legitimate, but somewhat opaque to the unsophisticated investor, are devices for deferring expenses so that the deal looks good today. Because the amateur investor is interested in the rate of return, the sophisticated syndicate designer starts with the rate he thinks he can sell and figures back. He may, for instance, balloon the mortgage by arranging for increasing payments on the theory that improvements in the property will make the mortgage easier to carry later on.
Third, there is more pressure on syndicators. In some cases, the deals are so thin that the only way to make the return is to sell the property and put the syndicate participants into a new and thinner deal. Many syndicators now have employees to keep busy.
Selling has taken over, and it is hard sell. Direct mail, newspaper advertisements, and, in the case of SIRE, radio commercials are used, but the syndicator’s lethal weapon is the telephone. The telephone campaign is well organized. Platoons of syndicate salesmen work lists from batteries of telephone cubicles in midtown Manhattan which resemble the bucket shops and boiler rooms no longer allowed to offer stocks.
They always call you at dinnertime. The case is urgent. If you act within x days, you can get a piece of a well-known building acquired under extraordinary circumstances (one salesman keptsaying a building had been bought “from the King and Queen of England”). They are “guaranteeing” you 12 percent, which is more than you get from a savings bank. It’s a “sure thing,” and they are trying to do you a favor.
It is tempting to be a little rude and ask, “If there is so much in it for me, what’s in it for you? Why are you willing to go to all this trouble to make me rich?”
A straight answer would disclose some startling arithmetic. Mr. Kahn says that selling and organizing expenses once figured at 10 percent are now running as high as 20 percent, which means that one dollar out of every five you put into a syndicate goes to pay for selling you. Free-lance syndicate salesmen now go from syndicate to syndicate, taking 6 to 10 percent off the top before the syndicate’s regular selling expenses are deducted from the money available to pay for property.
Nobody is quite easy about the conditions of syndication to date. As Louis Glickman, president of the Association of Real Estate Syndicators, puts it, “In any new and growing field there are those who operate in the shadows of misrepresentation and incompetency.” A little exuberance in selling, some sharp corners, an extra cut for the promoter may be the inevitable price we pay for a bouncy new field of mass investment. But there have been outright frauds, cases of fly-by-night syndicators who literally absconded with paid-in funds after switching them illegally from syndicate to syndicate.
Regulatory agencies are frankly worried. Until recently, syndicates evaded scrutiny. Paul Windels, Jr., the alert young New York SEC administrator under Eisenhower, brought some syndicators to court to establish the right of the SEC to require them to register, but the agency does not have the men or money to ferret them out.
Larry Wien registered from the start, but some of the other syndicators have cooked up a series of ingenious ways around the registration law. The current fashion is to print on the prospectus, “This offer limited to residents of New York state.”
New York intra-state dodgers ran straight into the open arms of Attorney General Louis J. Lefkowitz, an energetic syndicate watcher from the beginning. He has forced syndicators to modify their advertising to make clear that the high rate of return is in part a return of capital, rather than a return on it. After three tries, the state legislature passed a disclosure law with teeth.
Responsible observers, and particularly the operators themselves, are urging amateur investors to stop, look, and listen before they plunge. “Real estate can be the safest place to put your money and the fastest place to get rich, but the professionals get the best of both worlds,” Windels points out. “The banks and insurance companies take the first mortgages that stand up when values fall. The promoters and builders take the equity which multiplies when values rise. The amateur or public investors are invited in to cushion the deal. Usually they get some kind of unsecured promise to pay which may neither cut them in on big capital gains nor protect them from a real drop.”
The syndicates are a warning. Real estate is not well regulated or well understood. It is sold in a way that builds inflation. The tax laws encourage the tendency for the price of real estate to rise as it wears out. The mechanics of real estate financing makes prices rise whenever property is sold; it is the sale that makes the price, not the price that makes the sale.
If 1929 ever happens again, it may begin with a break in real estate.