Ever wonder what SEC regulations apply to apartment building syndications? There is a lot to this subject and while it’s not crucial that you know everything, nor should you try, it is important that you have a basic understand of what’s involved and what to look out for.
This week I’m joined by SEC Attorney Steven Rinaldi who has been handling private offerings of securities for over 26 years. Steven is extremely knowledgeable and competent, and this episode is packed full of useful info!
[2:25] Definition and example of a syndication
[5:00] The types of entities Apartment Building Investors should use for Syndication
[8:08] How to structure a deal
[10:31] Legal documents required for syndication:
- Operating Agreement
- Prospectus/Private Placement Memorandum (PPM)
- Subscription Agreement
- Form D. File this in the states where the investors are located (not the property)
[13:12] Advantages of Delaware LLC’s
- Hard to break up
- Discourages disgruntled investors from filing lawsuits
- Delaware judges see these cases all of the time and are very familiar with business law
- Get out of trouble for as little as 10K vs. 250K
[17:38] What makes an investor an “Accredited Investor”
- Net worth of one million or more excluding their house, car and life insurance
- Husband and wife with a salary of 300K or more, with every expectation that will continue
- Or one spouse makes over 200k per year, (with every expectation that will continue)
- Less common
- Trust fund of more than 5 million, Corporation, Partnership or LLC worth more than 5 million
- Banks, Broker/Dealers, Mutual Funds, Insurance, Small Business Development Companies
[19:18] What qualifies as a “Prior Relationship”
- The SEC won’t define it
[21:10] How to go about advertising to accredited investors
- Go to a broker/dealer that specializes in alternative investments
[21:52] The difference between advertising and networking
[22:37] The importance of doing a PPM
- You are required to provide a PPM to all non-accredited investors
- You want to provide a PPM to accredited investors because they can sue you for fraud for not disclosing all “material information”
- If you don’t, and the deal goes sideways you could easily lose everything you have. In most states that includes your house and your kid's college fund.
- In most states, you cannot discharge a securities law judgment or fraud judgment in bankruptcy
- ALWAYS DO A PPM!
[26:43]- Time and cost of drafting an Operation Agreement and PPM
- Three weeks for initial draft
- Could be completed in as little as five weeks
[29:10] The basics of crowdfunding
- You can advertise to non-accredited investors BUT pay attention to the rules
- You must refund all money if you don’t hit your goal.
- More work for an attorney, therefore, more expensive
Connect with Steven Rinaldi
Phone number: 240-481-2706
Tell us a little bit about yourself and what you do
I’ve been handling private and business securities offerings for 25 years all across the country. These are for apartment buildings, putting funds together for distressed notes, I'm currently working on a convertible debt offering, oil and gas, entertainment. In the last 5 years I've done 10 apt building and 5 distressed real estate.
What's a syndication, and can you give some examples of syndications?
An example for an apt building, you can raise the down payment from investors. You could offer them shares, profit sharing, or subordinated.
What kind of Entities should apartment building investors use
In real estate, two things are important: the investors want pass-through taxation. Even if they can't deduct against their personal salaries, at least they can deduct from other passive gains. They're looking for partnership tax treatment, and most often this is the LLC and sometimes the LLLP. The LLC advantage is pass-through taxation and also protects all of its members from liability from the operation of the entity. If I'm a member, I know that they will depreciate the building over 39 years, the vacancies are managed, I know the roof gets to be replaced, I know I can deduct these against my capital gains in the market.
The second consideration for the syndicator is how to stay out of court when I have disgruntled investors. And if I do need to go to court, how to do this cheaply, quickly and before a competent judge. I know people get advised from their attorney to register the LLC in your state, but your state's court system may not be up to the task. That's why I recommend Delaware. They specialize in business court cases, and they do so in 10 weeks or less. You're not in district or circuit court for months on end in front of a judge who just heard a bunch of personal or small business cases. You want a judge who is used to dealing with business cases, in particular those involving investors. And you want to do this as quickly and cheaply as possible, and Delaware is the best state for that.
15 states have “series LLCs” that can own multiple buildings.
There are so many different ways to structure deals, can you give some examples of how some of your clients have structure their deals? I.e. how are profits split up between the syndicator and the investors. (talk about simple structures, i.e. every one is a member to more complicated structures that involve multiple classes of members, preferred pay outs, etc).
Most common: two classes: GP making day to day decisions, and then there are the members/investors have a limited vote on material matters like
In every single deal, there's always been two tiers of membership: the managing member who is the syndicator, who is day to day etc. And (2) are the investing members who contribute funds to the venture and get a share of the profits. But they don't have any operational authority. And you wouldn't want them to have an active participation because it's not practical.
What tends to happen is the middle range. Sometimes the investing members are given authority over the sale of the property. Or filing bankruptcy, changing the tax format of the business. If the operating agreement of the LLC is changed in a way that would reduce their distributions and voting rights, they will have a right to vote. I haven't seen too many deals where the investing members have no rights whatsoever because that's hard to sell.
How are some ways the syndicator could be paid (upfront, during the life of the investment, and upon disposition).
There's a bunch of ways: A property management fee from 5% to 15% on a flat fee basis not on a success basis. If you're a licensed broker, you can receive commissions from the sale or renting out the apartments. You can't get paid for the sale of the securities unless you're a licensed securities broker. NOTE: “He didn’t mention it on the call but afterwards, Steven added this: “The syndicator can pay him or herself an acquisition fee for as compensation for their time putting the deal together. If the fee was for the sale of the securities, that would be prohibited as you are not a licensed broker-dealer.”
What is the legal document that documents all of these things?
You need to form a Delaware LLC (my preference). Also an Operating Agreement.
Number one you need a PPM which stands for “Private Placement Memorandum” aka a Prospectus. The Securities Act of 1933 says that you need to disclose all material facts to the investors. The second reason is that in order to avoid a public offering to avoid a million dollars of attorney and registration fees, you have to park it in an exemption, typically Exemption 505. This requires a PPM. that's an offering of securities of $5M or less to 35 or less unaccredited investors and unlimited accredited investors. Then there's the operating agreement and the subscription agreement. The last document is the certificate of formation to set up the LLC in Delaware.
Then we need to file Form D’s in each state where your investors live (not where the property is). Form D is pretty uniform for each state except NY that requires a custom form.
Why do you prefer a Delaware LLC?
It keeps disgruntled investors from breaking up an LLC.
Can you talk about some of the more common Exemptions?
Rule 504: I don't use it that much because it's not always uniform across states, and that costs more.
I usually use Rule 505 which is probably the best for most apt buildings.
506b is an offering of an unlimited offering amount, to 35 unaccredited, and you can't advertise.
506c is new, which allows you to advertise to accredited investors.
You can go under the new crowd funding laws but they can be much more expensive.
What's an “accredited investor?”
Banks, mutual funds, insurance companies, businesses with more then $5M assets, individuals with more than $1M in assets NOT counting the house, car or life insurance. The last category is tricky, makes $200K per year. But in today's economy with uncertainties there are very few people where you can say this is reliable and can be counted on forever.
If the syndicator doesn't know the investor well, you may ask the accountant to prepare a personal financial statement. Most syndicators know their investors well and this isn’t necessary.
With these exemptions, can syndicators advertise to find investors? If not, what should syndicators do to comply with SEC laws?
Advertising is out with Exemption 505. You're approaching people with a prior relationship. You're offering a seminar and someone keeps listening in or attending you're starting to develop a relationship with that person which constitutes a “prior” relationship.
You can move to a 506c offering to accredited investors, which allows you to raise an unlimited $ and allows advertising to accredited investors only. You can make it available to 35 unaccredited too. But the state filings aren't completely uniform. But 90% of syndications get by with 505. The downside of the 506 costs more in legal fees because of the non-uniform state fees requiring research state by state, probably about a $1000 more or 5 hours time for a typical group of states.
Unless you file special filings you aren't able to promote your offering to strangers and you need a prior relationship. Can you describe “prior relationship?”
If I send someone 3 emails, is that considered a prior relationship?
Perhaps you met them at a REIA, or you did some other deals together. Friends and family is a prior relationship. The SEC has never fully defined it.
You talked about disclosures and some of the legal documents required. What is the purpose of the PPM and what goes in there?
For real estate, the SEC has its own requirements. What's different about a real estate syndication is that you always have to ask the syndicator about their past history, what kind of deals have you done. You'll have to talk in detail about the properties you bought, sold, including prices, how did you finance it, residential, how much profits did you make over 3 years. The other thing that's somewhat unique is that there about 15 pages of tax and accounting disclosures. The big thing is disclosing the mortgage and its terms. The management discussion of financials, conflict of interest, the nature of the business. The terms of the operating agreement are in there as well. If you're buying distressed notes, I put in all of the bank holding company disclosures and that really adds to the length. A basic PPM for apt building is 60 pages. If you bring in debt offerings, that can go well over a hundred.
When is it necessary to give your investors a PPM? What if you're buying a small 4-plex? What are the risks if you don't do a PPM?
You have to give them the disclosures because they give you a check. So, yes, technically for a small 4-plex you need to issue disclosures.
If things go bad, the investors can sue you. And the LLC or LLLP can't protect you. They don't apply to securities fraud. This means all of your house, kids college education is wide open. Securities fraud judgment are non-dischargeable in bankruptcy. Maryland, for example, is very pro-creditor, you can't use even the homestead exemption to protect you. Not disclosing everything required is inherently fraud. Investors would go to an attorney and are disgruntled. I tell them to contact the director of enforcement at the states securities agency and they'll investigate. They make money with fines and penalties.
What is the typical timeline for completing the operating agreement and PPM and being ready for closing?
I'd like to do it in about 3-4 weeks but it depends on the number of revisions.
Can you describe the closing process from your perspective, i.e. what paperwork needs to be signed and how does one get the funds from the investors?
I need to interview the syndicator: what are you going to charge the investors, how much are you raising, what are the mortgage terms, what's the occupation rate, what's the general condition of the property (that's material information), what kind of renovations are required and how much does it cost. After the interview, we sign the retainer, I start the documents. We review the drafts and we make changes. Then we send out the final documents to the investors for signatures. To sign the operating agreement, just do the signature pages, send them to me, and wire the money to the escrow account. Oftentimes there's no physical closing, it's done by email. Once all of the documents and funds are in escrow, we can go to closing.
What does all of this cost?
I work on a flat fee basis. I'll give you an estimated number of hours to draft the documents, etc, and I don't exceed that. For a basic apt deal where $250,000 is raised, all total of $8000 for my time and then the State filing fees and certificate of formation in Delaware. State charges average about $250 with NY on the high-end at $1,000. If someone is putting a $10M fund for distressed debt, it would cost about $10,000 of my time.
There have been some changes in securities laws recently, for example, those that enabled the crowd funding phenomenon. Can you talk about some of the more important new laws?
The biggest is the regulations (not so much the “jump start your business” laws). The advantage to crowdfunding is that you can have to 500 members to avoid being a reporting company. You can advertise to unaccredited. But you're going to need a web portal and a broker dealer. You're also limited to $1M over 12 months. Unaccredited investors can only invest $2000 or 5% of the offering, whichever is lower. You need to prepare a disclosure document and they're a little different. You have to disclose a target offering amount. If you don't get to the target amount, you have to refund the money. If you're raising $100K – $500K you need to produce unaudited financial statements produced by a CPA. If more, you need to produce audited financials, which is expensive.
What's the best way for people to contact you?
Phone number 240-481-2706