The Definitive Guide to Legally Pooling Money for Real Estate Investments: Tips, Tricks and Traps.

27

“Whether you think you can or you can’t you’re right”

-Henry Ford

Having more deals than equity is a persistent obstacle active real estate investors will face.  It seems there are two ways to address this reality:

  1. Stay small and grow organically over time or
  2. Invite others into your opportunity via a private money campaign.

The concept of private money is a daunting and scary beast that doesn’t have to be. My 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.   I must counsel you to obtain legal and tax advice before acting on this information.

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Do Not Talk About Fight Club!

There are two rules about fight club…. 1. do not talk about fight club.  #2. DO NOT talk about fight club. Just like fight club  – I will argue there are two rules that should be considered before group investing

Rule #1:  Make really great deals.   This rule will make it easier to sell your first group investment if you do not have experience in the type of investment.   If you find a great deal – investors WILL be interested.   You 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.

Rule #2:  Almost every group investment, it could be argued, is a security!  Group investments require the sponsor to take on legal risk almost across the board.   In this article, I will describe how to minimize  this risk, but any discussion of any group investment must take this aspect into consideration.   This is why rule #1 is so critical in my book -successful investments are a lot less likely to draw scrutiny.

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.  Having said that – for the self sufficient risk seekers, here is the primer I promised.

What Counts as a Security?

Why did the myriad of SEC regulations come into being?   Before the Securities and Exchange ACT came into existence in the 1930’s, Kansas lead the state regulation of securities to protect the public.  The evil sought to be shielded from was “blue sky merchants” selling nothing but clear blue Kansas sky.   Indeed the same motivation underlies modern securities regulations today.

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

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

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.

LLC vs Syndication

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. The same rules apply to joint ventures, corporations or partnerships.  The choice of entity or family status of the membership is not relevant in this context.

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.

Tip:  If you chose to stay with the LLC group or other joint venture, document document document your organizational meetings.  Make sure major decisions regarding capital expenditures and acquisition/disposition require group consent.

Trap:  IF, within in the LLC group, someone decides they don’t 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.

Tip:  If you stick with the LLC structure, one potential benefit is increased control of the money partners.  They have more ability to replace you as the day-in, day-out manager.

Trap:   A tenants-in-common arrangement is a tricky grey area with regard to securities regulation.   A 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.  Sponsor beware.

Trick:   Vet your potential partners; screen them like you would a potential marriage – because it is.   Ask around town and people with mutual knowledge and don’t be so deal-hungry or expedient that you hop into bed with the wrong people.

Trap: 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.  Group of 10 are probably okay – but groups of 1000 would draw intense scrutiny even if you have a member-managed structure.

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.

Syndication and Private Placement Exemptions

If the venture satisfies the Howey test, it is a security and therefore must be registered.  Why is this a big deal to real estate investors?   The answer is cost – 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.  Clearly not cost effective for a single asset purchase.

However, all is not lost because the Federal regulation scheme permits you to elect a less burdensome process that permits exemption.

First some important definitions:

  • Accredited Investor:   An investor, or an investor with their spouse combined, who has a net worth of $1million or an annual income of $200,000 or joint income of $300,000 in the last two years – and a reasonable expectation of maintaining that level.
  • Sophisticated Investor:  A type of investor who is deemed to have sufficient investing experience and knowledge to weigh the risks and merits of an investment opportunity.

Those definitions are important in this arena because it reflects the attitude that they are “big boys and girls” and, therefore,  don’t need the same level of protections needed for widows and orphans.

Additionally the offerings may be identified as:

  • Specified offering:  The proposed investment is in an identified property.
  • Semi-specific: The proposed entity will invest in an identified property and  will conceivably invest in similar types of properties.
  • Blind pool:   The proposed investment is made almost solely on the basis of the perceived strength of the sponsor.

We now turn to the exemptions themselves:

Intrastate Offering Exemption (Rule 147):

This is an attractive option for when the property, the investors and the sponsor all reside within the same state.  The state law securities scheme will still be important, but in the right markets this is an outstanding option.

Trick:  The advantage of limiting yourself to a rule 147 offering is that there are no Federal limits to who may invest in your deal.

Trap:  The SEC will look to additional offerings by the venture and could conceivably bust your exemption.  The key here if  you intend on using the same entity to raise more money remember the rule:  What happens in your home state needs to stay in your home state.

Regulation D Private Placement Exemptions

Rule 504:  This rule provides an exemption from the registration requirements of the federal securities laws for some companies when they offer and sell up to $1,000,000 of their securities in any 12-month period.

Rule 505: This rule allows companies who are offering their securities to have those securities exempted from the registration requirements of the federal securities laws.  Rule 505:

  • Can only offer and sell up to $5 million of its securities in any 12-month period;
  • May sell to an unlimited number of accredited  investors and up to 35 other persons who do not need to satisfy the sophistication or wealth standards associated with other exemptions;
  • Cannot use general solicitation or advertising to sell the securities.

Rule 506: The sponsor may sell its securities to an unlimited number of accredited investors and up to 35 other purchases. Unlike Rule 505, all non-accredited investors must be sophisticated investors.

Selecting the right exemption and offering type is driven by the objectives and track record of the sponsor.   Generally, it is much simpler to start with a specific offering early in an investor’s career.

Changes in the Security Laws

We turn now into some changes in the securities regulation arena that may be of some interest to real estate investors.

Advertising and Rule 506 – The JOBS act set out to ease the capital formation process by permitting general solicitation to accredited investors in a Rule 506 offering.   However, there has been some debate about the actual effect of the change.  Most syndicators have chimed in and stated it will not change how they raise money at all.

The small business startup or small hedge fund user of the Rule 506 exemption may be the biggest winners.

The pool of potential investments is a stunning one TRILLION dollar or more.

Note that this exception applies to Rule 506 offerings only.    This change is slated to take effect on September 23.

Trick:  Under the new 506(c) there is an interesting shift in requirements to do more diligence to assure you are working with only an accredited investor.  Under the still available “old fashioned” 506 offering you could rely on the investor’s self-statement that they are indeed accredited.

Crowdfunding and Real Estate?

Crowdfunding and real estate is a jumbled mess.  To be clear, there is a distinct difference between the generic term crowdfunding and the small business options permitted in the Jobs act.

Crowdfunding is defined as is the collective effort of individuals who network and pool their money, usually via the internet to support efforts initiated by other people or organizations.

Trick:  Real Estate crowdfunding has been gaining it’s own momentum of sorts.  The various crowdfunding websites appear to all restrict their investments to accredited investors so far – which would make sense under the current regulatory scheme.

Tip: The smaller investor looking to move up the food change in my estimation will be better served by seeking a self initiated campaign either via LLCs or a small syndication.  The current crowdfunding sites are looking for the tenured real estate professionals and have a lot at stake because they are new.  The are likely to be hyper-picky about who they partner with, because bad deals are REALLY bad for a the crowdfunding websites.

The JOBS act purports to permit internet solicitation of non accredited investors, and also:

  • The scheme created by the statute creates a beastie called a “funding portal”.  Apparently these broker-dealers will be responsible for due diligence and basic suitability type education.
  • An investor is limited in the amount he or she may invest in the crowdfunding securities in any 12-month period:
  • If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to the greater of $2,000 or 5% of his or her annual income or net worth.
  • If the annual income or net worth of the investor is $100,000 or more, the investor is limited to 10% of his or her annual income or net worth, to a maximum of $100,000.

Trap:  The JOBS act attempt at crowdfunding is still up in the air.  So far, it looks like the regulations will be issued sometime this fall.   Critics argue that it will be too expensive to be of practical use i.e. audited financials will be required for amounts raised over $500,000.   The SEC may hate the idea so much they may make the regulations overly burdensome.

In the meantime, BE VERY CAREFUL on how you advertise including social media.

Trick: Aggressive state legislatures in Kansas and Georgia have passed their own versions of crowdfunding.  North Carolina and  Washington are working on adopting their own versions as well.  (See this Business Week article)

Debt Offerings and Securities:

Another fine mess in the securities arena is the issue of whether a “debt offering” constitutes a security.  The Howey test eventually was found not complete enough to judge whether a note was a security or not. (See this great article by Matt Dickstein).

The Supreme Court in  Reves v. Ernst & Young, 110 S. Ct. 945 (1990) identified  notes that fit into any of these categories are NOT securities:

  • A note delivered in consumer financing.
  • A note secured by a mortgage on a home.
  • A note secured by a lien on a small business or some of its assets.
  • A note relating to a “character” loan to a bank customer.
  • A note which formalizes an open-account indebtedness incurred in the ordinary course of business.
  • Short-term notes secured by an assignment of accounts receivables.
  • Notes given in connection with loans by a commercial bank to a business for current operations.

For uncertainty, when a note is or IS NOT a security:

  • Whether the borrower’s motivation is to raise money for general business use, and whether the lender’s motivation is to make a profit, including interest.
  • Whether the borrower’s plan of distribution of the note resembles the plan of distribution of a security.
  • Whether the investing public reasonably expects that the note is a security.
  • Whether there is a regulatory scheme that protects the investor other than the securities laws.  Examples include notes subject to Federal Deposit Insurance and ERISA.

Tip:  Function over form definitely applies in the note arena.  If it operates like a security, then its most likely a security

Trick:  The note arena is unsettled, therefore, you may not have legal certainty when undertaking a note offering scheme.  Clearly a commercial loan from a bank is not a security, but what about a note from six private money partners to do a small apartment rehab?  The interesting thing about small transaction is that it may be cost prohibitive to do a private placement so you may have to fly without the net?  Your risk tolerance will be tested here.

Trap:   State Law may force a separate result in the note arena. Tread very carefully.

Trap: Offering equity participation is likely to push any private note into the securities arena.

Conclusion:

Overall, an investor has a choice about how to remove the “more deals than equity” obstacle.   The next logical step is to perhaps team up with other like-minds to jointly manage a larger property in an LLC.  However, if you prefer control over the investment or want to go BIG and FAST, private placement is the way to go.

While there has been a lot of noise about the changes to the securities law – the actual effect may be null. There is a lot of buzz about crowdfunding, but the practicalities of the structure perhaps will render it impractical for real estate investors. And the offering of a debt obligation may very easily constitute a security. Form over function really matters: i.e. the greater the debt operates like a security the more likely it is one…5 people or 500 matters.  Status of the lenders and expectations of the lender matters.

Henry Ford said it best.  Do you think you can?

Further Resources:

Books about syndication and private placement:

  • Principles of Real Estate Syndication: With Entertainment and Oil-Gas Syndication Supplements Included by Samuel Freshman
  • It’s a Whole New Business! By Gene Trowbridge

SEC commentary on Funding Portals: http://www.sec.gov/divisions/marketreg/tmjobsact-crowdfundingintermediariesfaq.htm

Photo:~jjjohn~

About Author

Douglas Dowell

Douglas Dowell J.D. is a commercial and multifamily investor. His blog will focus on legally raising private money, risk mitigation with due diligence and management science. He is also an avid student of success principles with a focus on modeling success factors.

27 Comments

  1. Doug: Thank you for this excellent and succinct summary! I cannot tell you how many times I have to explain these points to clients who want to pool funds. Usually it is the flipper whose been successful in one or two deals (Rule #1) who suddenly has friends wanting a piece of the action and willing to write checks but don’t want to get their hands dirty. (Rule #2). Ultimately, I think it comes down to the “Duck” test, and investors should consult with an attorney familiar with the rules and real estate investing before putting themselves at risk.

    • Douglas Dowell on

      Thank you Jeffery,

      Its an area fraught with risk and opportunity. It seems DIY is great on hgtv. I am not so sure its good on Court tv lol

      Btw: your blog is most excellent. I really enjoyed the information about arbitration. I am a big proponent but your point think your point is correct….choose/draft wisely. Your pretty much gonna live with that choice.

  2. Wow! Great post Doug!

    My main question is how do you determine a sophisticated investor? I mean are there certain thresholds or qualifications that a person must meet? I know they must have investing experience but how much or what kind?

    Also, say you are in a room giving a capital pitch, how do you determine if the people are sophisticated or not?

    • Douglas Dowell on

      Thank you Nick,

      That’s an excellent point. Its not possible to determine suitability of your prospect out of the bat. I think the way to market is to an generic educational presentation WITHOUT discussion of any returns offered.

      Once you establish a relationship you will then be able to provide a suitability questionnaire where you can make an inquiry of whether they meet the standard of accredited investor. At that point you can get more detailed on what the type of properties are in your investment criteria. To my knowledge you may not put them in deals under contract. I understand this perhaps will be a change IF you have an accredited investor campaign in September but I need to do more research on that point.

      If you are doing a mass media campaign or working with sophisticated investors you have a high diligence stand to show you made a reasonable inquiry. Unlike accreditation their is no bright line determination of who is or is not sophisticated.

      Stay tuned…I am going to tackle the securities compliant private money campaign the post topic in the next few weeks.

  3. Doug
    While you’re looking into the compliance issues, I’d be very interested in your thoughts as to when a private placement memorandum (PPM) would be required and/or recommended. The preparation of the PPM represents one of the more significant costs for the project manager, and the range of complexity of these documents spans the spectrum from gold-plated prospectuses to what one attorney referred to as “fish wrap.” Thanks in advance.

    • Douglas Dowell on

      I think any time its a security a ppm is a cost of doing business. Its my understanding that 506 disclosures might allow for a lite ppm. They investor has a better standing with a solid ppm if litigation transpires. This is a reason for great legal counsel in my book.

      This may be a reason to go member managed if a ppm is cost prohibitive.

  4. Douglas – what an excellent post and couldn’t be more timely. I’ve just began taking meeting and conducting a feasibility study of syndicating – this seems to be a logical next step for me. You and I definitely need to chat!

    Excellent!!!

  5. Ben…..that would be awesome! I can’t wait to hear more about your progress and potential deals.

    I have a meeting with a successful syndicator this week who specializes in 100+ unit complexes and I’m really excited!

    • Douglas Dowell on

      I think your ready Nick. In my estimation you are doing all the right things.
      Mind over matter…..if you don’t mind….it don’t matter.

      BTW….I think a syndication mastermind group would be amazing. Seminars are great but the devil is in execution. Thoughts anyone???

  6. Doug – Kudos to you as this is a great article. I run one of the crowdfunding for real estate websites, http://www.realtymogul.com, and we get a ton of questions around syndication and how to pool capital from a variety of investors. As the internet opens up the ability to raise capital more efficiently, I look forward to seeing more real estate entrepreneurs have greater access to capital. As for a syndication mastermind, count me in, sounds like it could be a great place for us all to help grow our businesses and build lifelong relationships.

    • Douglas Dowell on

      Thank you very much Jilliene,

      It would be great to have your insight in a mastermind group. Your innovative approach is impressive. I will most definitely touch base to get that rolling.

  7. Douglas,

    Thanks for a very clear and insightful article. I attended a seminar on this exact topic in Baltimore a few months back and learned a lot, but your article adds even more.

    I did have one question. You note that the registration of an offering runs into the “couple hundred thousand dollar range.” My eyes bulged a bit on that one. Can you expand on this point, maybe breaking out the expected parts of the registration expenses? It’s hard for me to see how the expenses would be that much (I was imagining costs in the neighborhood of $25k or so), unless the registration fees includes a substantial percentage of the funds raised through the offering. Any additional thoughts you might have on this topic would be helpful.

    Thanks again,

    Mike

  8. Douglas Dowell

    Thank you Mike,

    They registration fees for an listing are referring to a public offering i.e. IPO’s.
    clearly not cost effective for single asset investing. The accounting fees and legal fee’s get expensive quick.

    The private placement option avoids a significant part of the cost
    For syndicates I see fee’s range from $5,000 on the very low end to 7,500. The max I have heard of is in the $50,000 range. It really depends on the level of work you do before you engage counsel.

  9. Doug – fantastic article. I’m the CEO of crowdfunding for real estate website, http://www.realtyshares.com and a former real estate and securities attorney, and this article does a great job discussing both past and future laws on syndication and securities offerings. I’d love to collaborate on future articles as the industry progresses. Thank You!

  10. Ernest Warner on

    I hope you can help me with a question? Unfortunately I need to give you some background. Our church is trying to buy a building. Original cost $6M. We have raised roughly just $2M in about a year and one-half. So we owe $4M. But the final payment is due this Sept. 30th 2014. We came up with an idea: 100 people with $40K and we are done. (our church has about 5,000 attendees). So, we started and in one week we have about $1M raised. What makes this UNIQUE is all of the people have put in (so far just a pledge) that they would be co-owners with the church of the building and then the church would buy them out (thus becoming the only owner) in less than 5 years but there would be NO INTEREST PAID. Thus no profits expected. EX: my wife and I are putting in $50K, we will be a co-owner of the building and then the church will pay us back $50K within 5 years (but no guarantees). We do not consider it a loan (it’s close!) as we do become co-owners. Now the question: How to set it up so that it is legal (and quick as we are under time constraints) and SIMPLE? Can we have a simple contract for each person (Note: some only put in 5K, some 10K etc. so there will be way more than the 100 originally envisioned)? Can we have one simple contract and each person sign it? We need to make sure that each owner will sell when the church start to pay back, for example. Any if someone dies during the time, that the church will pay his/her heirs. etc…. I am sure you get the idea.

    • Hello Ernest,

      I will say I cannot offer legal advice as I not anyone’s attorney. My opinion is this is pretty straight forward with an LLC formed to own the building with the church members as members of a MEMBER managed LLC. The LLC will then have an operating agreement that spells out the rights and duties of the individual members. The LLC will in turn hold the deed to the church in its name. The nice thing about the LLC is that the agreement will spell out the redemption rights and what ifs.

      The other way messier approach is just hold the deed to the church as tenants in common but I think the flexibility of the LLC approach is far superior with no downside that I can see versus the TIC approach.

      For sure you need to have legal counsel in your jurisdiction to draw docs.

  11. Troy Price

    Douglas,

    Great article. It’s getting me closer to where I need to be. I see that a Member managed LLC is probably the way I should go but could you expand on the note option. I’m trying to help a local pastor who occupies a building now being offered to the church for around 100K. The church has to move somewhat quickly and would need some investment partners. They have some people who are willing to help out and get them that number. Between 10-12 members.

    Thanks

  12. Carlos Espinoza

    Great article, shed some light to the way I should proceed.

    I am currently working in the mental health field in which I have been able to make great contacts with many people. I have 8 years of experience finding housing for adults who are struggling in finding a place to reside. Throughout my years I have been able to make great lasting relationships with housing vendors, mental health programs and potential investors who are looking to add housing inventory to have a steady stream of resources for their clients or a steady flow of income coming from renting out their houses.

    I am hoping to get some direction from experience groomed investors regarding my primary business plan and required actions I would need in setting up a LLC or LP???

    I have already established contacts that are willing to invest their money in real estate. In the talks I have had with them knowing and discussing the risk that comes in with any type of investment. I have systemically explained how one can potentially invest their money in real estate, profiting from renting out to a certain population and then selling property to vendors who are willing to continue to run houses as is with the continued cash flow of residents already placed in the house. These vendors are mostly out of the country individuals.

    Any advice on how to get started? Definitely trying to stay away from being viewed as a security. There would be less than 10 investors that I would be pooling their money together. Thanks for any help.

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