{"id":46738,"date":"2013-08-09T10:22:18","date_gmt":"2013-08-09T16:22:18","guid":{"rendered":"https:\/\/www.biggerpockets.com\/renewsblog\/?p=46738"},"modified":"2024-06-06T06:32:58","modified_gmt":"2024-06-06T12:32:58","slug":"2013-08-09-pooling-money-for-real-estate-investments","status":"publish","type":"post","link":"https:\/\/www.biggerpockets.com\/blog\/2013-08-09-pooling-money-for-real-estate-investments","title":{"rendered":"The Definitive Guide to Legally Pooling Money for Real Estate Investments: Tips, Tricks and Traps."},"content":{"rendered":"

\u201cWhether you think you can or you can\u2019t you’re right\u201d<\/p>\n

-Henry Ford<\/p><\/blockquote>\n

Having more deals than equity is a persistent obstacle active real estate investors will face. \u00a0It seems there are two ways to address this reality:<\/p>\n

    \n
  1. Stay small and grow organically over time or<\/li>\n
  2. Invite others into your opportunity via a private money campaign.<\/li>\n<\/ol>\n

    The concept of private money is a daunting and scary beast that doesn\u2019t have to be.\u00a0My objective is to demystify the rules and provide no-nonsense advice so you may decide if this approach is something you would like to pursue. \u00a0\u00a0I must counsel you to obtain legal and tax advice before acting on this information.<\/p>\n

    Do Not Talk About Fight Club!<\/h2>\n

    There are two rules about fight club…. 1. do not talk about fight club. \u00a0#2. DO NOT talk about fight club. Just like fight club \u00a0– I will argue there are two rules<\/em> that should be considered before group investing<\/p>\n

    Rule #1<\/strong>: \u00a0Make really great deals. \u00a0\u00a0This rule will make it easier to sell your first group investment if you do not have experience in the type of investment. \u00a0\u00a0If you find a great deal – investors WILL be interested. \u00a0\u00a0You may need to partner with an experienced operator depending on the bank requirements and your balance sheet, but if you have a great deal you will always be relevant.<\/p>\n

    Rule #2<\/strong>: \u00a0Almost every group investment, it could be argued, is a security! \u00a0Group investments require the sponsor to take on legal risk almost across the board. \u00a0\u00a0In this article, I will describe how to minimize \u00a0this risk, but any discussion of any group investment must<\/em> take this aspect into consideration. \u00a0\u00a0This is why rule #1 is so critical in my book -successful investments are a lot less likely to draw scrutiny.<\/p>\n

    When evaluating the cost of legal counsel vs the risk of violation, it may be cost effective to hire an attorney for reasons of reduced risk. \u00a0Having said that – for the self sufficient risk seekers, here is the primer I promised.<\/p>\n

    What Counts as a Security?<\/h2>\n

    Why did the myriad of SEC regulations come into being? \u00a0\u00a0Before the Securities and Exchange ACT came into existence in the 1930\u2019s, Kansas lead the state regulation of securities to protect the public. \u00a0The evil sought to be shielded from was \u201cblue sky merchants\u201d selling nothing but clear blue Kansas sky. \u00a0\u00a0Indeed the same motivation underlies modern securities regulations today.<\/p>\n

    The statues on what is and is not a security are not very well drafted, unfortunately. \u00a0Therefore, the Supreme Court – in the benchmark case SEC v. Howey – attempted to improve certainty. \u00a0According to the “Howey Test” – if the venture has the following characteristics it IS a security:<\/p>\n

      \n
    1. investment of money due to<\/li>\n
    2. an expectation of profits arising from<\/li>\n
    3. a common enterprise<\/li>\n
    4. which depends solely on the efforts of a promoter or third party<\/li>\n<\/ol>\n

      Therefore, we will delve into common real estate group investments and debt offerings to determine if\/when you need to have a security lawyer review your scheme to stay copacetic.<\/p>\n

      LLC vs Syndication<\/h2>\n

      When I use the term LLC for the purpose of this article, I am envisioning a strategy where you would join a close group of friends, family or business partners to invest in a deal together.\u00a0The same rules apply to joint ventures, corporations or partnerships. \u00a0The choice of entity or family status of the membership is not relevant in this context.<\/p>\n

      Syndications, on the other hand, are a group investment where the sponsor exercises control for the benefit of the group and most definitely requires securities compliance.<\/p>\n

      Tip<\/strong>: \u00a0If you chose to stay with the LLC group or other joint venture, document document document<\/em> your organizational meetings. \u00a0Make sure major decisions regarding capital expenditures and acquisition\/disposition require group consent.<\/p>\n

      Trap<\/strong>: \u00a0IF, within in the LLC group, someone decides they don\u2019t like something you did for rational or irrational reasons, they may mount an attack saying, in reality, you were a totalitarian, iron-fisted dictator who really ran the show.<\/p>\n

      Tip<\/strong>: \u00a0If you stick with the LLC structure, one potential benefit is increased control of the money partners. \u00a0They have more ability to replace you as the day-in, day-out manager.<\/p>\n

      Trap<\/strong>: \u00a0\u00a0A tenants-in-common arrangement is a tricky grey area with regard to securities regulation. \u00a0\u00a0A small group with only a few investors – with group voting – could conceivably evade the requirement to register the offering, but the SEC dislikes this approach. \u00a0Sponsor beware.<\/p>\n

      Trick<\/strong>: \u00a0\u00a0Vet your potential partners; screen them like you would a potential marriage – because it is. \u00a0\u00a0Ask around town and people with mutual knowledge and don\u2019t be so deal-hungry or expedient that you hop into bed with the wrong people.<\/p>\n

      Trap<\/strong>: The more people you have in your investment group or scheme, (be it debt or equity) the higher the chances it will be found to be a security. \u00a0Group of 10 are probably okay – but groups of 1000 would draw intense scrutiny even if you have a member-managed structure.<\/p>\n

      So you have to choose: are you willing to give up control for the benefit of additional equity? That is THE central choice of real estate group investments when moving from a one person operation into a growing business.<\/p>\n

      Syndication and Private Placement Exemptions<\/h2>\n

      If the venture satisfies the Howey test, it is a security and therefore must be registered. \u00a0Why is this a big deal to real estate investors? \u00a0\u00a0The answer is cost –<\/em> in terms of time and money. To register an offering (in legal and accounting fees) it will run into the couple hundred thousand dollar range. \u00a0Clearly not cost effective for a single asset purchase.<\/p>\n

      However, all is not lost because the Federal regulation scheme permits you to elect a less burdensome process that permits exemption.<\/p>\n

      First some important definitions:<\/strong><\/p>\n