With regards to SEC exemptions and compliance, what are some of the common mistakes that syndicators make? What are the potential consequences if the SEC finds out you paid a GP to raise capital? How would you structure a deal for the GPs and LPs to hold real estate forever and get infinite cash flow? What are some of the legal challenges and opportunities in real estate investing today? Jonathan Tavares, Managing Partner of Premier Law Group, shares his knowledge.
Tell us a little bit about yourself.
I am the managing partner of Premier Law Group, which focuses on helping real estate syndicators to raise capital for their real estate projects and real estate funds.
What are some of the common mistakes that syndicators make, and how can we avoid these mistakes?
The first one is a conversation I have at least three times a week with existing clients. Often, new or prospective clients are not calling a spade a spade. What I mean by that is understanding what the difference is between a joint venture and an actual syndication where you’re selling securities.
The world we live in as a law firm is helping and guiding our clients with complying with the securities rules for raising capital for either project-specific syndications or in a fund model, where they’re acquiring multiple assets and raising capital from retail or sometimes institutional investors. But sometimes clients will come to us, especially with smaller deals, and say, “Hey, we’re raising capital from investors who are going to be passive. Can we just call it a joint venture so we don’t have to worry about doing a PPM?” Completing all those disclosures, filing forms with the SEC, and filing forms with the states where our investors are from, and all of that takes up time. There’s a cost to the compliance, and sometimes it can be tough, especially for smaller deals.
Unfortunately, you can’t just dictate whether your deal’s going to be a joint venture or a syndication. You have to have facts that support it. A syndication is going to be a model that we’re going to set up where the investors are passive. If your investors are passive, you’re selling securities. They are not actively involved in managing the underlying assets, or they don’t have voting rights in the investment vehicle. You have to provide them with appropriate risk disclosures, you have to find an appropriate exemption under the federal securities rules, and you also have to make sure that your notice filings are made accordingly. It’s called the Form D, when you’re raising capital under 506(b) or 506(c), and the states also require you to send them notice filings, as well. It does take work, but it’s the right way to do things if you’re raising from passive investors.
If you truly do have a joint venture structure, you can avoid all of the securities compliance and not have to worry about a PPM, not have to worry about investor questionnaires, subscription agreements, investor portals, or any of those things. Suppose you have a joint venture where all the partners are active. In that case, they’re contributing something to the joint venture, and part of it could be capital. It can also be know-how in a real estate deal, maybe someone’s a real estate broker, so they come in with expertise on valuations and understanding the market where the underlying real estate is located. They can bring other things to the table. Sometimes, in development projects, you might have a joint venture where one of the partners is a civil engineer, maybe an attorney, and so they can bring some of the zoning and land use planning. They can bring those skills to work inside the joint venture, but the key is that the partners are actively involved in the management of the real estate.
Your facts are going to determine whether you’re running a joint venture or a syndication. And that’s one of the biggest mistakes I see clients make. They want to dictate which path they go down without considering the facts of their underlying situation.
The second big thing is, can you pay GPs to raise capital? That’s always a question I get, and one of the biggest mistakes is that a lot of syndicators assume they can because they see other people doing it. A lot of coaching programs that I’ve seen are structured on the premise that, as a GP, you can bring on other co-GP partners and compensate them for helping to raise capital. That’s a big no-no in the SEC world. Co-GPs that are brought on to raise capital have to be licensed broker-dealers with the SEC. In my experience, for most of our client base, almost none of their co-GPs are licensed broker-dealers. There’s a huge compliance cost, and a lot of work is required to become a broker and earn commissions or other compensation for selling securities. You can’t share a real estate commission with a non-licensed real estate broker, and so the rule is the same in the security space. You have to be a registered broker-dealer with FINRA to participate in any compensation. The SEC calls it transactions-based compensation if you’re getting paid for helping to raise capital.
Now, that doesn’t mean that can’t be one of the jobs that a GP has. That’s one big, heavy lift, especially in bigger deals where you do have to raise a sizeable amount of equity. It’s a consideration, but it has to be part of the totality of what they’re doing. The SEC says that raising capital has to be incidental to their other duties, so they can do things like be part of acquisitions, asset management, investor relations, and marketing. The more jobs that they have, the easier it is to justify what you’re paying them, whether it be in straight fees or in equity that they’re getting as a GP member or any other compensation arrangement that you may have. Ensure your GPs are actively involved and have real jobs in your syndications and funds and aren’t getting paid just to raise capital.
What would be the consequence if the SEC finds out?
Is the SEC ever going to find out that you’re paying GPs to raise capital? In a lot of circumstances, no. But it’s not a problem until it’s a problem. Generally, how those things come about is that you have a deal that goes sideways. Investors lose money, or the relationship between the GP and your partners starts to deteriorate, and your partners are looking for ways to get some money back, because a lot of times, there is money involved. When these relationships deteriorate, when these investments go sideways or start to go south, that’s generally when the SEC might get involved because someone might start reaching out to the SEC. They may hire litigation attorneys and start investigating to see how they can trip up the sponsor or see if there are any steps that they didn’t follow. The securities rules are a great place to start because the SEC is focused on protecting investors. If you’ve not provided the appropriate disclosures, if you have not disclosed compensation, or if you’ve compensated in a way that is not permitted by the SEC, those are always huge issues that the SEC will hit you on.
The SEC has a lot of options at their disposal.
1) They could just shut down the private offering. They could require you to discontinue operating under the exemption you’re operating under and require you to register your offering. For most syndicators, that’s a deal killer. If they can’t continue to operate under a specific exemption from registration, then registration’s not an option. It is like an IPO, where it may take several years to put together an offering, and you may be talking significant monies (six and seven figures). That’s only going to make sense for big funds.
2) The other option is disgorgement. If you’ve already been operating your syndication, making profits, and cash flow, the SEC may require you to claw back those profits from the GPs and require you to give back those profits to the company, and also pay back your investors’ capital.
3) In extreme examples, they could bar a syndicator from raising capital in the future, exempt offerings, or charge heavy fines, penalties, and, of course, you could serve prison time. But that’s generally in cases of fraud. We’ve all seen cases like Bernie Madoff and similar instances of securities fraud.
How is a syndication structured when the LPs and the GPs want to hold a piece of real estate forever, in terms of infinite cash flow?
There are absolutely ways to do it. The question is, does the model coincide with your investing strategy as it relates to your investors? Is that something that your investor base is going to be aligned with? When GPs want to keep the asset long term, they can either refinance and buy out the investors or secure another capital infusion to do so at a later point. It’s a forced exit that we call a call option, which the GPs can exercise to buy out investors after some time. We have encountered challenges with some clients in trying to implement this in the past, and much of it has to do with the investor base.
Have conversations, especially with your larger investors, about your syndication or fund, and make sure they’re aware at the outset what the long-term plan is, what the exit plan is, and your private placement memorandum. This is something we’re very focused on in disclosing upfront to make sure that when investors sign up for your syndication, they know what they’re in for.
When we structure a call option, it’s a forced exit of the investors at a certain point in the life cycle of the investment. You want to consider how that buyout price will be calculated and when you can exercise it. I always recommend to the clients that they should at least have a certain minimum number of years that the investors can participate in the investment so that if it is producing cash flow, you’re increasing the value of the asset. Then, you’re able to raise rents or, whatever the case is, which ultimately affects whatever those monthly or quarterly returns are that are going to the investors, so that you can at least guarantee them a certain amount of time in the investment to the extent that you’re going to hold onto that property.
For the most part, we always provide discretion for the managers to sell at any point. For example, you may have a five-year horizon, a strategy, and a syndication. Then, you decide in year two or three that things are going great. As the manager, you sell and divide out profits, and everyone’s happy. In the call option approach, the plan may be to hold onto this property long term, but maybe exit the investors at year three or year five. In that case, you would build a call option, which is what we call a lockup period for the GP, where they wouldn’t be able to exercise for a certain amount of time. It would provide comfort and protection for the investors, ensuring they can participate in the deal for the specified period.
On the low end, I would say at least two years, but in many cases, it’s three, four, or maybe five years, depending on the type of investment and what the long-term strategy is. And then, the buyout price may be based on some predetermined rate. Perhaps your projections indicate that the investors are going to get a 20% IRR or maybe a 25% IRR. At that point, you may say, “Well, we’re going to build the call option to generate just above whatever those projections are.” Or maybe significantly above the projections depending on what the investor base would want in terms of returns so that when you do exercise the call option after that lockup period, the investors are parting with you but they’re feeling that they’ve gotten a good return because maybe it would’ve taken them another year or two, or maybe longer to receive the returns they would’ve gotten had the natural course of the syndication taken place.
The biggest challenge is figuring out how to value the underlying investment at the time you exercise the call option. In other cases, it may be a multiple or a certain percentage above the fair market value of the property, which may be determined by a third-party appraisal. The theory behind this is that if you are going to buy out the investors, you want to make sure that they’re happy being bought out. Sometimes, that means giving them slightly above market value, which may seem like an odd concept. But suppose the plan is to keep the asset long term. In that case, you’re probably not concerned with overpaying a little bit to get investors out, if you know it’s an asset that is going to produce significant cash flow and have substantial equity long term.
What are some of the legal challenges and opportunities in real estate investing today, from what you’re seeing in the market right now, which is a unique market at this point?
With all of the global news, whether it’s a potential war, talks of inflation and tariffs, and the stock market, it’s like the stock market’s been ignoring it and has been running up on a tear. And then, you’re in the real estate world and trying to figure out all these different things that are going on economically and politically. The good news is, in terms of real estate, especially those involved in multi-family real estate, which is a lot of our client base, we know that people are always going to have to live somewhere. It’s an investment that’s not going away, although certain times are more beneficial and less beneficial for certain types of investments.
One of the biggest challenges we’ve seen is the downturn in the multi-family space as far as debt service. We saw a lot of clients several years ago getting bridge loans that were two- or three-year terms. They were fixed rates for that period, but a lot of them thought, “We could just refinance after three years, or we’re going to sell this property in three years, so it’s not going to matter once we reach maturity for this bridge loan.” However, with the exponential increase in property taxes, insurance, especially in certain markets like Florida and Texas, where there’s been so much property that’s been syndicated over the last several years.
There’s been a lot of oversupply in certain markets, specifically in Florida, which has led to situations where, in some multi-family properties and syndications, the cash flow can’t support the debt service and fixed expenses every month. At that point, you need to make a couple of decisions, either weather it out, or if you’re bleeding every month, then maybe you’re going to figure out some way to refinance and restructure your debt, which in many cases, a lot of lenders will want to see higher ratios of equity.
It meant going back to investors and asking them for more capital, which is always tough when you issue capital calls to investors. It’s not something investors want to hear about, and it’s generally difficult to get them to participate. One of the biggest challenges we’ve seen over the last 18 months is that a lot of capital calls try to restructure the cap table in numerous multi-family syndications. That’s been a struggle. We have to work with clients to be creative in what they offer to their existing investors to get them on board with some of these capital calls as they weather the storm of multi-family properties.
However, that’s also a created opportunity. In many markets, prices have dropped for multi-family properties, and that has provided some opportunity for syndicators, as well. I have noticed that some of our clients who are very active in operating funds and starting funds can capitalize on the drop in prices in multi-family and favorable markets in the long term. Now, they are facing some struggles.
I keep hearing from my few masterminds that you should call the bank and get them to reduce your loan amount because if they were to take over the property, which they don’t want to do, they already lost that value anyway, regardless of who’s going to buy next. It’s always a great idea to have a conversation with your lender.
For savvy operators, they know how to navigate those conversations with lenders. They may be difficult conversations, but I think they’re conversations that will be fruitful. But there are so many capital raisers in the syndication space that have been good at raising capital over the last several years, but don’t have experience, background, or understanding of the importance of operating. There were articles on the front page of the Wall Street Journal about a year or two ago, just showing green pools. In certain properties, one in particular that I saw was in Texas, of a particular syndicator, had accumulated so many properties, and they’d raised a lot of equity. But they weren’t doing the work and the asset management. These properties were not being managed effectively, and they struggled with the trifecta of tax rates increasing, insurance going up, and not being able to manage their debt service. Once these bridge loans expired, combined with the lack of the right management experience to effectively run these properties, led to a bad situation in many cases. And some don’t even know how to navigate those conversations with the lenders either, but arguably, maybe they should never have been in the business of syndicating, or should have brought the right people with them.
Is there anything else that we haven’t touched on or I haven’t asked that you think is important for our audience to know?
One thing that I think is important to mention, especially in the syndication space, is some new rules around accreditation. This does have an impact on syndicators who raise in 506(c) deals from accredited investors only. The SEC issued a no-action letter, which is basically guidance that comes from a letter from a law firm that presents a certain set of facts of a specific client looking for feedback from the SEC to prevent future enforcement actions. It’s a way to get advice without facing potential repercussions from the SEC, which can be helpful for the individual who’s writing the letter, the firm that’s writing it on their behalf, the securities issuer, and other syndicators.
One of the things that they clarified is that typically in a 506(c) deal, you have to verify the accreditation status of your investors, which means they are going to have a million dollars in net worth, excluding their primary residences, where they make at least $200,000 a year or $300,000 as a couple. But the SEC says you have to take reasonable steps, usually meaning they have to go to a third party and send them all their financials, whether it’s tax returns, W2s, 1099s or other financial statements or they go to their CPA or attorney and get them to review their financials and write a letter that says they’re accredited. This can sometimes cause a little bit of friction when you’re trying to onboard investors and raising capital. LPs familiar with the process and experienced in it recognize that it’s just a part of the journey. However, building relationships with new investors can be tough at times.
One of the things that the SEC came out with is that an investor can be considered accredited on their face if they put in $200,000 or more into an offer as an individual or through their entity. Many clients have been using that as: 1) a way to create less friction with investors. They’ll create a class, sometimes a higher class, even if they weren’t intending on doing it. For $200,000 or more investments, they’re able to tell investors, “It’s a simpler onboarding process,” which gives them the ability to potentially raise more from investors. 2) They can use that as an excuse for helping attract fewer investors who bring on more capital in some circumstances.
When did this happen?
This was back in March.
Jonathan Tavares
(508) 212-1193
jonathan@plglp.com
www.premierlawgroup.net