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How to Raise Money for Your Real Estate Investing

by Clint Coons on January 6, 2011 · 18 comments

  

“It is natural to indulge in the illusions of hope. We are apt to shut our eyes to that siren until she allures us to our death.” – Gertrude Stein.

For many real estate investors, the thought of raising capital to increase their purchasing power is an irresistible allure.  However, how one goes about this business can have serious long-term ramifications for the uninformed. 

When you’re dealing with other people’s money, you need to make sure you are setup correctly. In the post Madoff climate, we now find ourselves with state and federal agencies that are pursuing a take no prisoners attitude when it comes to investors who raise money.   Failure to comply with the securities laws increases an investor’s risk of lawsuits by other investors – and can even lead to criminal prosecution.  Remember, ignorance of the law is no excuse and even an innocent mistake can lead to court and likely jail. 

If you are not deterred by these warnings . . .

Here are a few things to consider if you plan on raising money for your real estate investments:

  • If you plan on raising money with an LLC, start by registering your LLC in the state where you will be working.  A mistake made by many investors is raising money through a Nevada entity without proper registration. This is a path to jail where you will not pass “go” if things turn south for your investors.

  • Draft an operating agreement that details how the funds will be invested, distributed, managed and any fees paid for management.  This is a crucial step for any investor because the operating agreement puts everyone on notice as to how the funds will be handled i.e., it’s a point of agreement between you and your investors about how the LLC will operate.

Many real estate investors will not proceed past this point in their fund raising activities.  In other words, I have my LLC so let’s start making money.  Unfortunately, to stay completely legal (out of jail) you must also be mindful of state and federal securities laws. 

When one or more people buy into your LLC, you are selling what the government calls "securities" and there is an extremely complicated set of laws that govern this activity.  For example, most real estate investors are not aware that borrowing money from outside investors can be construed as a security.  It’s sad but true and I have read of a few situations where the SEC put promoters in orange jump suits for their borrowing activities.

It sounds scary, but if you follow the rules from the beginning, it’s not that bad. Generally, when raising money your fund will fall under "Regulation D," which gives several exemptions. Here are some general guidelines, but as I tell everyone with this idea – CONSULT A SECURITIES  ATTORNEY IN YOUR STATE: 

  • Try to Partner only with Accredited Investors who meet one of the following criteria:
    • An individual with annual income of more than $200,000 per year, or a joint income of $300,000, in each of the last two years and expect to reasonably maintain the same level of income.
    • An individual who has a net worth exceeding $1 million, either individually or jointly with his or her spouse excluding the personal residence.
    • An individual who is a general partner, executive officer, director or a related combination thereof for the issuer of a security being offered.
  • Keep your offering private, never blatantly advertising to the public.  On the other hand, you can provide general information about what activities and why you need money.
  • Raise no more than $5 million
  • Require your investors to sign a Subscription Agreement
  • Do not guarantee a rate of return or refer to performance of past offerings

These are just some of the concerns you should address prior to raising money for your investing. Remember, it is better to spend a few thousand with an attorney on the front end of your business rather than tens of thousands if things go wrong.

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{ 18 comments… read them below or add one }

Kevin Kaczmarek January 6, 2011 at 7:14 pm

Excellent post Clint. All very important things to consider if you want to raise money. What regulation changes have you seen if you have a single investor who is secured by an individual free and clear property?

Reply

Clint Coons January 9, 2011 at 12:31 pm

Kevin,

Could you be a little more specific so I can answer your question? Thanks.

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MartyBoardman January 7, 2011 at 9:51 am

Clint, I appreciate you bringing attention to this very important subject on Bigger Pockets. Most new investors don’t realize that in many states they are creating a security with a prom note or LLC. If the investment makes money no one complains. However, if a deal goes bad everyone involved gets sue happy.

Another reason most investors don’t do what you recommend is that it’s expensive and time consuming. It can cost $10,000 or more to have a Private Placement Memorandum and subscription agreement prepared by an attorney for filing with the SEC. My firm recently put a private equity fund together for real estate acquisitions and we spent many hours drafting the PPM. But, I couldn’t agree with you more that in the post-Madoff era it is the safest way to raise capital.

There’s an additional hidden benefit to writing a PPM and subscription agreement – it requires that you put your entire business model on paper and spell out all of the risks for your investors. This exercise puts you on a higher level and you will attract more sophisticated investors because you took the time to explain in detail how you run your business.

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MH January 7, 2011 at 4:37 pm

Good post. investing isn’t quite as brave a brave new world as it used to be, but let’s hope that things are changing for the better.

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Joshua Dorkin January 9, 2011 at 12:25 pm

Clint – I believe that this is one of the more important posts that we’ve seen on the blog recently. Far too often people try to raise capital and have little clue as to the intricacies – especially legally – that come with it. We’ve made a link to this article a sticky post in the forums and will be pointing people here whenever the topic comes up. Great job.

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Joel Owens January 9, 2011 at 6:39 pm

I don’t know to much about this but I was under the impression the rules varied by state and that small investor groups didn’t amount to the level of being considered securities.

It would be great for a follow up article to explain more.

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Clint Coons January 9, 2011 at 8:55 pm

Joel,

You are correct that securities laws do vary by state and there do exist exemptions that allow for investing with friends and family. I wanted to make everyone aware how dangerous raising money can be if you do not seek legal counsel. I meet a lot of investors who take legal planning into their own hands by creating LLCs through legal zoom with form documents they obtained from a seminar. For the most part in these situations the risk is yours alone if you didn’t set it up correctly. When dealing with other investors you have upped the ante considerably because now you are acting in a fiduciary capacity with investor’s monies. I think it is well worth the $500 to $1000 a securities attorney might charge you for a consultation about your business if you plan to travel along the this road. The risk in my opinion is just too great not to do your homework.

All the best.

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Paul Timmins January 10, 2011 at 8:36 am

Clint
Excellent post
Its all real estate investing.
Two guys I know just closed on 232 units, Syndication fee at closing was 400K it was worth the 15K investment in setup.

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Mike Grayford January 16, 2011 at 9:40 pm

Hi, Clint. Thanks for the post. Does this warning also apply when giving one or two lenders a Promissory Note and a Trust Deed for purchasing a single home?

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Clint Coons January 17, 2011 at 7:50 am

Mike,

No. Where people can run into trouble is when they solicit for funds from the general public. I have seen situations where the purported loan was a disguised equity share arrangement. What you described is a typical mortgage scenario.

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Mike Grayford January 17, 2011 at 1:48 pm

Thanks for the reply, Clint. There have been a few similar conversations in the forums of BiggerPockets recently as well, so I’m trying to get it clear in my head. So, would you think it would be okay to post on my company website that I offer investors a certain interest rate for loans that our company uses to buy, fix, and resell homes? Or is this form of advertising generally a bad idea, even if I’m only offering a fixed interest rate return?

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Clint Coons January 17, 2011 at 3:03 pm

Mike,

I think you should consult a local atty on this. You can not offer a “Guarantee” and you must provide certain disclosures. Be safe with this because the costs can be enormous.

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Mike Grayford January 17, 2011 at 3:13 pm

Okay, thanks, Clint!

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Anonymous November 11, 2011 at 2:34 pm

What about in California?

I am thinking about gathering some money for real estate investing. We simply want to collect money, sign a promissory note and back their investment by the property. How or where do I begin?

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Josh November 7, 2012 at 3:52 pm

Clint,

Thanks for writing this post, it has been pretty helpful. I’m thinking of doing something with my father and brother, and I’m curious if the securities regulations you mentioned would apply to us? Is it different if it’s a family thing?

We will create an LLC and clearly define the goals, buyout options, etc. so that we can minimize problems. I didn’t think about the SEC though, but now I’m wondering if we’ll need to find a different lawyer to help with that.

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Clint Coons November 8, 2012 at 11:19 am
BILL March 9, 2013 at 7:56 am

I would like to know the easiest way to sell a house in need of repair without using my own capital. I have the buy and hold investors, so i just need to know how to protect them until the house in completed and they have the deed in their name. The investors share will be equal to the rent minus the expenses plus the equity. I will repair the house and sell them the finished product. I need the use of their funds up until closing. I have a ppm, but I have been told that’s it is not necessary when borrowing for investment property and reg. Z is the proof. A flow chart to explain the above would be greatly appreciated.

Bill

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Ali Langston May 19, 2013 at 11:40 am

I was thinking of trying to raise money for real estate investing. What do you mean by have the investors sign a subscription, how does it work what are the benefits?

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