HARP – On This. . .

It is not uncommon for commercial real estate investors to pool their funds for real estate investments. To obtain project financing, equity requirements remain relatively high. Loan to value ratios are in the 60% to 70% range in many circumstances. Even a modestly priced commercial project with a $5,000,000 price tag may require equity in the range of $1,500,000 to $2,000,000. The greater the price tag, the higher the equity requirement. A Real Estate PPM is an important tool when raising funds from outside investors for a real estate project.

TYPICAL INVESTMENT STRUCTURE

Private real estate investments are typically structured through a manager-managed limited liability company (LLC), with the project promoter or its affiliate named as the manager. Oftentimes, the business terms of the transaction will include a cumulative preferred return to equity investors, an attractive internal rate of return to equity investors until all capital is returned, and a waterfall that provides for a disproportionate percentage of distributable cash to be used toward repayment of the equity investment until it is repaid in full, followed by a permanent allocation of profits and losses based on percentage of ownership.

OUTSIDE INVESTORS – PROS AND CONS

The advantage to the promoter in raising capital from outside investors is that it places the promoter in a position to acquire and control more and larger real estate projects. A disadvantage to promoters is that they must give up a meaningful piece of project ownership and anticipated profits in return for using other people’s money.

 An advantage to outside investors is that they may realize high investment returns and certain tax advantages by participating in a real estate investment. A disadvantage is that they typically have little direct control over the project and must rely upon the knowledge, skill and efforts of the promoter to make money. Of course, if the outside investors don’t possess the knowledge and skill themselves, relying on an experienced real estate promoter may be their best bet for taking advantage of the opportunities real estate investment has to offer.

DUE DILIGENCE AND THE REAL ESTATE PPM

Whether investing in a stabilized real estate project, a project to be newly constructed, or a value-add project requiring redevelopment, renovation, or adaptive reuse, careful evaluation of the benefits and risks always require knowledgeable investigation using due diligence.

A good place for an outside investor to begin is by closely reading the investment PPM (private placement memorandum) which an outside investor should expect to receive from the promoter before making an investment. A well drafted Real Estate PPM will describe the project, the relevant history and experience of the promoter, sources of funds, uses of funds, material terms of the investment, including transfer restrictions, the exit strategy, and the identifiable risks of the investment and the project.

The Real Estate PPM, however, is only the beginning. A conscientious investor needs to go beyond the statements in the PPM to gain an understanding of the underlying real estate project itself, not unlike a conscientious lender would – but even more so, since the interest of an equity investor is subordinate to the interest of any secured lenders. If the prospective investor does not have the direct knowledge and expertise to evaluate and understand the underlying real estate project, it is highly advisable for the prospective investor to hire an advisor, attorney or consultant who has the skill-set to conduct the evaluation.

PPM – A DEFENSE DOCUMENT

Promoters sometimes resist preparing a fully developed PPM because they believe (naively) that it is an unnecessary burden and needless expense. Realistically, however, it is essential and its cost is a cost of raising money from outside investors.

Some promoters discount the value of a carefully prepared PPM because they think of it as a marketing brochure. With that belief, they conclude that their investors don’t need an expensive marketing brochure prepared by a lawyer. In truth, a PPM is not a marketing brochure. It is a critical defense document. Like insurance, it is only a waste of money if you never need it. Even the most well thought-out real estate project may not turn out as planned, or may not result in the impressive profits anticipated at the outset. In that case, believe it or not, there is a meaningful risk that the investors will sue – especially if they end up losing money.

Anytime a person is making a passive investment with the expectation that profits will be derived solely through the efforts of another, the investment is, by definition, an investment contract and, by extension, a security.  The party offering the security is required by law to make a whole host of disclosures to make sure the investor is fully informed of all material facts and risks. Failure to adequately describe the investment and disclose known and foreseeable risks exposes the promoter to serious potential liability under applicable securities laws and regulations.

When the investors sue, it will be for on a variety of theories, including breach of contract, fraud in the inducement, common law fraud, negligent misrepresentation, and violation of applicable securities laws. The investors will allege that the promoter made all kinds of promises and told the investor all kinds of things regarding the project and the investment, which the promoter knew, or should have known, were false.  The investor will also claim the promoter concealed or failed to disclose facts and risks known to the promoter which, if disclosed, would have caused the investors to decline making the investment. Since securities laws provide investment rescission rights and impose near strict liability on a broad range of promoters and persons controlling the investment, the promoter and its principal advocates can be exposed to significant personal liability absent an effective and reliable defense.

A well-crafted PPM can be highly effective in providing a strong defense by spelling out, in writing, all the material details and assumptions of the project and the investment, and all known and foreseeable risks inherent in the project and the investment. It will also limit the right of the investors to rely upon only the matters expressed in the PPM, and will clarify the distinction between statements of fact, and forward looking projections which constitute matters of opinion or belief which cannot reasonably be relied upon. As such, the Real Estate PPM is a powerful defense tool that no real estate promoter seeking investment from outsiders should go without. If things go poorly, it will be the firewall between the investors’ loss and the personal liability of the promoter.

INVESTOR RELIANCE ON PPM

From the investors’ perspective, the PPM is a valuable tool as well. If meticulously crafted, it will disclose the material details of the project and the investment, and will point out risks the investor should consider, even if they are risks the investor is willing to accept.   The investor will have the right to rely upon the facts and details set forth in the PPM unless expressly qualified or limited. If the PPM misstates the facts or omits to disclose known or knowable risks, the PPM can serve as a powerful piece of evidence in a claim against the promoter. It is precisely this evidentiary risk that impels promoters to dot the i’s and cross the t’s to make sure the PPM is complete and accurate – which makes it a valuable source of information for the prospective investor.

PROJECT DUE DILIGENCE BY INVESTOR

Even with the inclusion of necessary facts and disclosures in the Real Estate PPM, a detailed analysis and discussion of certain real estate fundamentals underlying the project may not fall within the purview of the PPM. If the disclosed risks are carefully crafted with broad language, in may be up to the prospective investor, in the exercise of due diligence, to evaluate the underlying project to confirm the suitability of the property for its envisioned use.

Due diligence by the investor is always appropriate. If the prospective investor does not have the knowledge on its own to understand real estate fundamentals, it is incumbent upon the investor to engage a real estate professional who possesses the necessary knowledge.  Regardless of whether a failure to adequately disclose and address gaps in the underlying project fundamentals is sufficient to expose the promoter to liability, imposing liability on the promoter is not the object of the investment. The object of the investment is to put the investor’s money to work in a profitable venture that will yield a favorable return – not a lawsuit.

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Whether raising money from outside investors, or considering an investment in a real estate project as a passive outside investor, a well-crafted Real Estate PPM is a vital component and critical step. Ignore it at your own peril.

Thanks for listening,

Kymn

At long last, the real estate investment market is beginning to show signs life. Commercial and industrial property transactions are increasingly common, and multifamily properties of all sizes are being snapped up by investors. Historically low interest rates, high occupancy rates, increasing rental rates, and rising property values are contributing factors.

Early transactions have often been cash deals, where the investor paid cash for the property rather than seek financing. This can be a great opportunity to achieve high yields for investors flush with cash, but what about everyone else?   What about potential investors who have limited cash on hand?

Unlike the easy-credit days preceding the Great Recession, real estate investment financing is more difficult to obtain and requires a significantly higher equity contribution by investors.  Common loan to value ratios are 60% to 65%, which means that for each $1,000,000 the investor needs, the investor can likely borrow only $600,000 to $650,000. Consequently, the investor must come up with between $350,000 and $400,000 in equity for each $1,000,000 of purchase price. For many investors, this may not be an easy task.

Solution? Go back to the way we did things in the old days – before the days of easy, near 100% financing: pool funds with other like-minded investors.

When raising capital from investors, keep in mind that you are engaged in a securities offering governed by state, and perhaps federal, securities laws. This is true even if the money is being invested by friends and family. A private placement memorandum (“PPM”) is advisable to protect against claims by investors that the investment turned out to be other than what it was portrayed to be. This is particularly important if the investment goes bad – as investments sometimes do.

PPM’s for real estate investments need not be particularly complicated, but they need to comply with applicable securities laws and include the disclosures and information necessary to protect the promoter from liability. The promoter must be particularly cautious if funds are being obtained from investors other than “accredited investors” as that term is defined by Rule 501 of Regulation D. Helping promoters comply with the law while raising capital is a key function for lawyers.

In September 2013, as required by the Jumpstart Our Business Startups Act (JOBS Act), new rules were established by the U.S. Securities and Exchange Commission to permit general solicitation or general advertising for certain securities offerings limited to accredited investors only. While this may prove helpful to promoters’ efforts to find investors and raise funds, the importance of a carefully crafted PPM has not diminished. Thoughtful promoters and lawyers will recognize that a well-crafted PPM may now be more important than ever.

Raising capital through a private offering of securities is a viable strategy for real estate investment, but it must be done with skill and great care.  Failure to fully comply with the law can be financially catastrophic.  Take care to do it right.