Edited transcript from the Raise Private Money Legally podcast episode, “Is Your Offering Viable?”
Presented by host Kim Lisa Taylor, Esq.
Originally broadcast: Thursday, March 30, 2023
Kim Lisa Taylor:
All right. Hello, everybody. Welcome to Syndication Attorneys’ podcast. We’re now doing this twice a month. The purpose here is to educate syndicators and other real estate investors on things they need to know as they grow and build their syndication practice.
We often have a guest speaker. Today I’m going to actually teach a topic that is dear to me, just because we have a lot of people asking questions about different types of offerings and trying to do all kinds of different things, and we want to make sure that they have the best chance of success. In order to do that, we need to be able to assess what they’re trying to do and whether or not it’s going to be successful.
So we’ll go ahead and get started. The topic today is, “Is Your Offering Viable?”
One thing I will say before we get too far into this is that if you want to ask questions, go ahead, and you can either raise your hand if you want to ask a live question or you can put your question into the Q&A that’s at the bottom of your screen. We’ll leave some time to answer all your questions at the end of the call.
So the topic is, “Is Your Offering Viable?”— how to tell if your offering is viable. There are two hurdles you have to overcome in order to have a viable offering. The first one is, “Is it legal?” and the second, “Is it marketable?”
So for number one, “Is it legal?”, well, that’s really a question of are you complying with securities laws? Have you structured your deal in the correct way?
For anybody that might be brand new on the call that’s just getting their feet wet about syndication, if you’re raising money from passive investors by selling interest in your company and they are relying on you to generate a profit, then you’re selling something called an investment contract. Investment contracts are securities. So when you’re selling securities, now you either have to register your offering or qualify for an exemption from registration, and there are multiple exemptions that you can qualify for.
The registration process itself is very long and involved. That’s the process that people go through when they are setting up a public company or the initial public offering. You’ve heard those terms before. Google went public. Facebook went public. They had to go through this long, involved process of filing a lot of paperwork with securities regulatory agencies, getting them to ask a bunch of questions, looking at every aspect of what they were doing, making sure that it was available and appropriate for public consumption.
Once they got their approval from the regulators, now they could go out and sell it to the general public. They can advertise any way they want, as long as their ads are truthful. They can sell to anybody. They don’t have to look at their financial qualifications or pre-qualify them in any way before they can offer them these investment opportunities. They can even post their offerings on public exchanges, like the New York Stock Exchange or NASDAQ, assuming that they would take the offering. If you register it as a true public offering, then you you’re able to do all of that. But that’s a very long and expensive process.
Our clients are real estate investors. They don’t have the time, and they don’t need to go to that kind of an expense in order to be able to raise money for real estate. So the alternative available to them is to qualify for an exemption from registration. There are multiple exemptions both at the state (and federal) level. If everything’s contained within one state, you, your company, the investors, the thing you’re investing in, if everything’s in one state, you can qualify for an intrastate exemption. So then you would look inside that state’s securities laws and find out what exemption might apply to what you’re doing, and they could have some rule.
There’s certain states that have a rule that says, “Hey, if you don’t offer it to more than 15 people and you know them very well and you don’t advertise on social media, then you’re okay. You don’t have to do anything. Just go ahead and do your deal.” So we’d have to look at that state, see what their private offering exemptions are, and determine whether that would be appropriate for you.
Most of our clients are crossing state lines. So they’re buying property in one state. They’re forming their companies in maybe the state where they live. They have a management entity there. They have a company that they’re forming in the state where the property’s located. But they’re going to be bringing in investors from multiple states, and so they’re crossing state lines. When you start crossing state lines, if you didn’t follow a federal exemption, then you’d have to go into every single state where you have investors, and you’d have to try to comply with their state securities laws. That could become very burdensome and onerous.
So there’s a federal rule called Regulation D, Rule 506 that supersedes all these individual state laws. All it allows the states to do is ask for a notice filing and a fee so that they can be notified that you’re selling securities within their jurisdiction. There’s a form called a Form D that we file with the SEC claiming this Reg D, Rule 506 exemption, and then the states want to have a copy of that as well (when) you bring investors in from those states.
So this is a really broad overview of how that works and how the exemptions work. Each exemption has a very specific set of rules. The one that almost all of our clients start with is Regulation D, Rule 506(b). Rule 506(b) allows you to raise an unlimited amount of money from an unlimited number of Accredited investors and up to 35 non-Accredited but sophisticated investors. But you can’t find them through any means of general advertising or solicitation.
So the way to prove that is to be able to demonstrate that you had a pre-existing, substantive relationship with each one of those investors before you made the offer to invest, because the rule says that you can’t make offers or sales — either offers or sales — to investors unless you’ve had a suitability conversation with them to establish that pre-existing, substantive relationship if you’re going to offer them these 506(b) interests.
The reason everybody likes 506(b) is because it allows you to bring in up to 35 non-Accredited but sophisticated investors, and most of us in our world have people that are not Accredited that would be fine investors, but they’re not Accredited. They don’t meet that criteria. So we want to be able to bring them into our deals.
The alternative to 506(b) is something called Reg D, Rule 506(c), and Rule 506(c) allows you to freely advertise your offering, but you’re restricted to only allowing verified, Accredited investors to invest with you. So according to the SEC, only about 10% of investors out there are Accredited. So you’ve really cut out 90% of the people that might invest with you, and in most cases, you’re cutting out your family, friends, and acquaintances who are the people that will invest with you before you have a track record.
So as you’re establishing your track record, you’re getting your feet wet in syndication, you’re doing your first two or three deals, somebody new that you meet that you’ve never met before, they’re going to be a little hesitant to invest with you, because they don’t know you. They don’t know how successful you’re going to be. They want to wait and make sure that you know what you’re doing before they’re going to take a chance. But your family and friends, they’re interested. They like you. They know you. They trust you. They want to participate in your new, exciting venture. So they’re going to be the ones who are most likely to invest with you initially.
Now, we have some clients that never stop doing 506(b) offerings, because they continue to meet non-Accredited but sophisticated investors that could be fine investors. But we do have others that eventually, they run through their list of non-Accredited investors. They get all of them invested with them. They’ve developed a sufficient track record. Now they can go out and start advertising their offerings under Regulation D, Rule 506(c), and that will allow them then to broaden their horizons.
Perhaps they’ll meet some new investors along the way that aren’t Accredited, and they can still put them into future Rule 506(b) offerings. They just couldn’t put them into a currently advertised Rule 506(c) offering. They would have to take the time to get to know them, determine their suitability, and then later on do a 506(b) offering that might include them.
So that’s really how those two Reg D, Rule 506 rules work together. As I said, most of our clients are doing Reg D, Rule 506. There are some other exemptions that are available that aren’t really all that practical. Either they have some financial limitations or the way that you can advertise is limited or there’s regulation crowdfunding, which you have to do through a crowdfunding portal. If you’re raising more than $500,000, you have to audit your offering. That becomes a cost item that makes it cost-prohibitive for a lot of people. You are not in control of how the offering is advertised. This portal is, that you have to pay to do that.
Then there’s a Regulation A+ offering, which really isn’t an exemption. It actually is a public offering. It’s just a streamlined public offering process. So that, again, is something that you would graduate into. You wouldn’t start there. You would do a series of Rule 506 offerings, and maybe you get to a point where you’ve got all your non-Accredited family and friends invested with you. You’ve advertised for all the 506(c) deals that you want, and now you want to be able to maybe offer it to just the general public. Then you would go through that Regulation A+ registration process. That’s going to be a lot more expensive than doing a Rule 506 offering, and it’s also going to take a lot more time.
So just making sure that you understand what kind of regulatory framework you have to work into to make sure your offering is legal. The first thing, qualify for an exemption. Figure out what the rules are for your exemption, and follow the rules for that exemption. Document how you follow those rules, because that is also one of the requirements, is that you have to have a record-keeping system to prove how you followed the rules of that exemption.
These are all self-executing exemptions, so you don’t have to get the documents pre-approved before you show them to investors. We just have to file this notice form. But then if you were ever investigated by a securities regulator — either federal or state — you would then have to provide them with the paperwork to prove how you had that pre-existing, substantive relationship, that you’d had that suitability conversation with your investors before you made them offers to invest. You’d have to be able to prove that they attested to the fact that they are either Accredited or non-Accredited but sophisticated. You would provide all that documentation, and that would establish your defense if somebody was claiming that you were selling unregistered securities or not qualifying or not using the exemption appropriately.
So typically, when you’re doing an offering, then you are going to create a set of offering documents. The first main document is usually called a private placement memorandum. That private placement memorandum is going to describe how the deal is structured, who’s involved with management. What are you offering to investors? How are they going to get their money back eventually? How are they going to get a return on their investment?
There’s usually going to be two waterfalls that describe how distributions would be made during the period of time that you own the property or the operations period, and then another waterfall that would describe how you would distribute cash during a capital transaction. The capital transaction could be a refi. It could be a sale. It could be a 1031 exchange. So your syndicate could 1031 exchange its property for another property and graduate on up into a bigger property, taking those investors along with you.
Another thing that people need to understand, these securities filings, the SEC Form D and the Blue Sky notices, they have to be filed within 15 days of when investors’ funds become irrevocably contractually committed. So presumptively, if you don’t state something differently in your operating agreement, that’s going to happen when the funds are received. But in a lot of our clients’ cases, they’re receiving funds for a couple of months, four to eight weeks, before they’re ready to close on the property.
We don’t want them to start incurring preferred returns or even to accept those investors into their offering until they know that the deal is actually going to close, because if we stated in the documents that way that the funds are not irrevocably contractually committed until the day that the property closes — because at that point, you cannot give them back — then up until then, an investor could come to you a few days before and say, “Hey, something has happened. I’ve lost my job. I have a health issue,” or something like that. You would not force them to do the deal if they said, “I just can’t do it.” Our contingent is you would find a different way. You would find another investor. You would replace those funds, and you would give that investor’s money back.
So we actually state in our documents that the funds do not become irrevocably contractually committed until you close on the property and you’ve used those funds. Some of you might be thinking, “Well, that allows investors to back out.” It doesn’t really happen very often. Once they’ve made their buying decision, they’re committed to the deal, and they’re ready to go forward unless the deal starts stretching out longer, longer, longer for some other reasons, that the funds just aren’t getting invested. Then they’re going to want their money back. They’ll usually wait 90 or 120 days before they get a return. After that, they’re either going to want their funds back or they’re going to want to start seeing a return on investment. So that’s just the rules in a nutshell.
One of the first things you need to do is hire experienced securities counsel to help you correctly structure your offering, form your companies, draft your operating agreements, draft your private placement memorandum and your subscription agreement. Those are the other documents that we include in this “What is in an offering?” package. You’ve got the PPM. You’ve got the operating agreement for the company that’s going to hold title to the property and sell the interest to investors. We’re going to have a management company. It’s going to have its own operating agreement. There’s also going to be a subscription agreement.
But the offering package, the main three documents are the private placement memorandum, the operating agreement that the investors are signing onto, and the subscription agreement. Then also, we’re going to have you draft an investment summary or a property package that is going to tell your investors about the deal. It’s going to explain to them what the sources and uses of funds are for that deal. How much money are you getting from investors? How much are you getting from the bank? How is all that money going to be spent?
You’re going to have an itemized list of all your acquisition expenses, your down payment, your closing costs, your acquisition fees, legal fees, capital improvement budget, operating capital and reserves, anything else that you might need some money for upfront, any out-of-pocket expenses you have for pre-closing expenses, paying for property inspection reports or appraisals or lender fees. Those kinds of things are all reimbursable, so you just raise enough money to be able to reimburse yourself for all those things.
You are going to show the sources and uses of funds in your investment summary. You’re also going to show a five- or seven-year pro forma, matching the number of years that you plan to hold the property. We always recommend you do that in a range, like five to seven years. We don’t want you to say, “Five years, we’re selling the property,” because investors will want their money back in five years and one day.
Then we’ll have the subscription agreement, which is where the investors are going to explain to you that they understand the risks. They’ve figured out whatever financial or tax questions that they’ve had. They’ve either asked those questions of you or their advisors, and they’re going to do that.
The third thing, just to jump back a little bit … Sorry. I’m jumping around a little bit here. The third thing that you’re going to put into your property package is your exit strategy. So what is it? You’re going to make some assumptions, and you’ve got to write those assumptions down. You’re going to assume that you’re going to sell the property at this cap rate. “We will have created this net operating income. We will pay back the remainder of the loan and all the other closing costs, and this is how much money we expect we’ll have left.” Then you’re going to add that to whatever you gave the investors during the period of time you owned the property and show them, “All right. This would be your total lump sum that you would’ve received for the total life of this project. We’ll divide that out over the number of years that you’ve had the project, and that becomes your annualized return.”
So it’s important that you have those three pieces, where you’ve got the sources and uses of funds, which explains how much you’re raising; the pro forma, which explains how much you’re going to be giving them during the period of time that you have cash flow from the property; and then the third piece of that is the exit strategy, where you’re going to show them how that equity is realized on sale and how that is going to add to the return they’ve already received.
So this is a super big overview here, but for some of you who haven’t heard it before, I hope it’s helpful. For those of you that have heard it before, maybe you’re hearing something new for the first time or hearing it in a different way that’s kind of resonating with you a little bit better.
The second hurdle you have to overcome — we’ve talked about, “Is it legal?” — you’ve got your offering documents in place. You’ve figured out your deal structure with your corporate securities attorney. You are ready to go. Now, is it marketable? How are you going to get people to invest with you? You have to figure out how to market the offering.
Here’s where we get into trouble. So a client will come to us or a potential client will come to us. They’ll engage us to do their offering, and we’ll usually do what’s called a deal structuring call. It lasts anywhere from 90 minutes to two hours. During that call, we’re asking a whole lot of questions and gathering information that we need to be able to draft their customized offering documents.
During that time, we’re going to ask questions about, “How do you want to split money with investors? What portion of the company are they going to own? Are they going to get some kind of a preferred return? What happens after they get their preferred return? In that waterfall structure we talked about earlier, what are the steps? Who gets paid first? Who gets paid second? Who gets paid third? How is that money disbursed every time you make a distribution?” We’re going to ask you about all that stuff.
A lot of times, our clients don’t know, but a lot of times, we use this session to help counsel them on what other people do and what is marketable and what we’ve seen work. We’ve done this hundreds and hundreds of times, and we’ve seen things that do work and things that don’t work. So we can usually try to counsel our clients away from doing things that don’t work, but sometimes they come to us with very specific ideas.
Our statistics show, first of all, that a specified offering — having one project under contract that you’re raising money for right now — is the most likely to succeed offering. A lot of people think, “Oh, why don’t I just do a fund where I can go out and raise money I need and then go out and invest it, then find the investments?” That is the absolute hardest way to raise money. I know for a fact that we have written many offering documents for our clients that have never raised any money, or they’ve done a $5 (million) or a $10 million fund, and they’ve raised $300,000 or $400,000 or maybe $500,000 or maybe a couple million (dollars).
It’s very difficult to do that. So if you do want to do a fund structure, you still have to coincide it, your raise with when you have properties under contract. You can do a fund that says, “We’re going to buy multiple properties. Here’s the first one under contract. We need this much money right now,” get the second one under contract, reopen the raise, raise the money for the second one, and so forth. You can continue to do it that way, but the easiest way is to be able to show your investors how that project’s going to perform with that property package or investment summary. Those terms are used synonymously. That’s going to be the best way to help them understand how that’s going to work and most likely that they’re going to invest in that.
So those are the two main things, is specified versus unspecified or versus a fund. I would definitely say you want to graduate into a fund, just like you want to graduate into doing Rule 506(c) offerings. A fund is not something you’re going to do until you have a significant track record, already buying four, five, six properties, and maybe even having them go all the way start to finish. So just think about that.
We get people that come to us with interesting ideas sometimes. For instance, I remember many years ago, somebody came to me and was trying to explain something to me that I frankly couldn’t understand. Okay, so if I can’t understand it, I can’t help you do it. I’m not going to help you do it, because it probably doesn’t make any sense. So that’s the first thing. You’ve got to be able to explain it to your securities attorney in a way that they can comprehend it, because if they can’t, then your investors never will, or it’s just not viable, and your idea is really not suitable for a for-profit venture.
So here’s some different cases. Oh, by the way, there is an article on our website. If you go to www.syndicationattorneys.com and go into our library and select “Articles,” search for, “Is your offering viable?” There is an article that talks about the same things I’m talking about here that you can read as a companion to this podcast. Would be happy to have you guys do that.
So here’s one that we get a lot: Somebody wants to do a fund, and they try to invest in everything and anything, right? So we could invest in five different asset classes. “We might invest in gas stations. We might invest in multifamily. We might invest in self-storage, industrial warehouse, retail, commercial, office, whatever it is we want.” The more things you add, the more likely you are to lose investors, because the investors will say things like, “Well, I understand multifamily, but I don’t know those other asset classes, so I’m not comfortable investing in that,” or you try to mix up development projects with value-add projects.
Most people understand value-add. They understand you buy an existing house. You’ve got to do some renovations to it, make it better, and then it’s worth more. They can get that. They can wrap their heads around that, if you buy a value-add multifamily. The people are always relating it to their own lives, right? “What are you saying, and how would I relate that to my own life to be able to understand that?”
If you explain to somebody, “Well, we’re going to buy vacant land, and we’re going to build,” well, they perceive that as a much higher risk. So your development investors, there are a lot of investors that will take those risks, but there are a lot of investors that won’t. So if you tried to add development projects with value-add projects, you’re going to lose some investors as soon as they read, “development.” So what we’re trying to do is we’re trying to create an offering that doesn’t weed out investors who might otherwise be good and viable investors for you. We’re trying to make it most attractive to the greatest number of people.
I call those offerings where you’re offering too many different asset classes “kitchen sink offerings.” Another example is trying to add securities to real estate, right? So it’s like, “We’re going to invest in real estate, but we’re also going to loan money to somebody else, and we’re going to invest in other people’s offerings.” So, again, you might have had people … If we’re investing in multifamily, they would’ve all said yes, and then all of a sudden, you added these other things they don’t know anything about. They’re now saying no. So be careful of trying to combine that.
Also, if your company is buying and owning real estate directly, then you have some exceptions from some other rules that could come into play. If your company is going to be buying securities in somebody else’s offering, meaning you are buying interest in their offering, just like your investors are buying interest in yours, if you are going to be investing your investors’ funds into somebody else’s offering, you’re now buying securities, and that opens up two new rules you have to comply with. One of them is the Investment Company Act of 1940, and the other is the Investment Advisors Act of 1940.
So what happens is you have to now find an exception from the Investment Company Act, or you have to register as an investment company, which is a big ordeal, and there is one that applies. It’s called the 99 Investor Rule or Less Than 100 Investor Rule, where you would have to have less than 100 investors in your deal. But it doesn’t exempt you from then having to register as an investment advisor, because the SEC views you now as acting as an investment advisor to your fund.
So now you have to become an investment advisor. There’s a way that you can become an exempt reporting advisor by filing a form with the SEC, which works up until you get $25 million in assets under management. The form is called Form ADV, Part 1. You can look it up online. It’s 83 pages long. It asks you questions like, “Who is your compliance officer? What have you done for cybersecurity? What safeguards do you have in place?” You’re going to have to spend a lot of lot of time thinking through all of this and hiring ancillary services that are going to be able to provide those services just so you can invest in somebody else’s offering.
Additionally, even though you can become an exempt reporting advisor for the SEC, you may still have to comply with the state laws where the investors live. That might mean that you would either have to hire an investment advisor or you become an investment advisor in those states, which could require taking a test, getting a license, and some ongoing reporting.
So the whole idea here is that you’re here because you want to invest in real estate; stick to real estate, all right? (If) you’re here because you want to invest in multifamily, stick to multifamily. Get really good at that, and then go out and branch into other asset classes. If your experience is in retail, then do a retail fund. If your experience is in the commercial office, do a commercial office fund. But just be aware of trying to lump all those things together unless you have direct experience with those things. Then it is possible to maybe do two or three asset classes in one offering. All right? So don’t do kitchen sink offerings where you’re throwing everything in but the kitchen sink. Just do very specific fund offerings that really narrow down the asset classes that you’re going to invest in.
Here’s one: You’re trying to advertise for investors before you have a track record. So everybody thinks, “Well, 506(c), I can go out and do that. I can advertise for anybody.” But you don’t have a track record. The only way this is going to be successful is if you have someone on your team who does have a track record. You are going to have to team with other experienced operators that already have doors under their belt sufficient that it’s going to impress investors you’ve never met before that your team is experienced enough to handle their funds in this type of investment. So that would be my recommendation. If you don’t have a track record and you don’t know investors and you feel like you need to advertise, then you’ve got to have team members with the right experience.
Here’s another one: You’re trying to allow the wrong people to invest. I get a lot of people that come to me and say, “Well, I want to be able to allow my church members to invest or my peers in my neighborhood. I feel like these are underserved communities.” These are really noble causes, and I applaud you for thinking about that. You could do that under a Reg A+ offering. You cannot do it under a Rule 506 offering, because under 506(b), they have to be Accredited or non-Accredited but sophisticated, which means somebody more than just some savings and a job. They have to have some other educational background or financial experience to be able to understand the risks and merits of the offering, either a loan or with the help of an investment advisor in order to qualify as sophisticated. The investment advisor cannot be someone connected with you.
So you need to make sure that you’re offering to the right people and that the right people are going to be able to invest with you. While I applaud your efforts in wanting to go out and help your wider community, again, this is something you should graduate into after you’ve developed a track record, and then do some 506(b) offerings, prove some success with that, make sure that you like doing it, and then go on and think about doing a Reg A+ offering that you would be able to advertise to the general public and get those people to invest with you as well.
Here’s another problem: You’re spending your time chasing single-check writers, when you should be developing relationships with $50,000 to $100,000 investors. We get a lot of clients, this is what I call a rookie mistake, that they’ll talk to family offices, they’ll talk to pension funds, and they have lofty goals. I applaud their efforts in having the bravery and the courage to go out and talk to those people, having big, lofty dreams.
But the thing is, those people are too polite to say no to you, so they’re going to give you a bunch of conditions. “Well, I would invest if you did this or if that or if you had these people on your team or if the deal was this.” It’s always things that you can’t fix, or they’ll string you along. “Well, yeah, send me some information. Well, yeah, do this.” You think you’ve got a big fish on the hook, and really what you have is someone who’s just trying to be nice. Ultimately, when it comes down to it, they don’t invest with you. They end up, “Oh, gee, something came up. I had to spend my money somewhere else. I’m not able to do your deal,” or they’ll come back with changed terms that make it no longer viable for you, where they’ll say something like, “Hey, I can give you 5% of the deal, and we’ll just go ahead and buy it.”
So just be careful of spending a lot of time with single-check writers. Just like Accredited investors, just like doing a fund, this is something you should graduate into. This is not something you start with. When you start with $50,000 and $100,000 investors who will invest with you all day long, every day, those are the people that will really help you build that track record by yourself.
So think about that. You’re better off to have a database of 300 pre-vetted investors that you’ve developed relationships with that will invest $50,000 to $100,000 with you. They will fund probably more deals than you know, than you can even think of doing right now, anyway. Even if you start with 50 of those people, you’ve got a really, really great start.
So spend time developing your own investor marketing plan, how you’re going to meet people, how you’re going to develop these relationships with them, how you are going to stay in touch with them, and then how you’re going to present offers to them. All of those elements need to be in your investor marketing plan for you and your team, and you need to go out and just start working it. Start doing it on a regular basis, in addition to the fact you’ve got to have people on your team, or maybe you, too, are out looking for deals. So it’s really two different departments within your syndication company. One’s finding and vetting deals. One’s finding and vetting investors. When you get a deal under contract, we put them together. Now you’ve got a syndicate.
Here’s another one: You’re trying to get people to invest using too many investment vehicles. We have people that are like, “Hey, I want crypto. I want people to invest crypto. I want to sell NFTs. I’m going to do all of this in order to buy real estate.” Well, ultimately, it all has to convert to cash to be able to buy real estate, because the sellers aren’t going to take crypto, and they’re not going to take NFTs. So you’ve got to have a way to convert that all into cash. If you let people invest that way, that risk is on you to convert that into cash, and if you are unable to do that or you don’t get as much cash out of it as you thought you were going to do it, you still have to give that investor back what you promised them and the value of what they thought they invested with you. So you could end up losing in that game.
I had somebody one time come to me and say, “Hey, we’ve got one investor who would invest $200,000 with us, but has to be in crypto, because he’s trying to avoid taxes.” Well, guess who’s going to pay the taxes? If he doesn’t, you will, right? So someone will pay the taxes. You’re the last person in control of the deal. You may be the one left holding the bag on that one. So just be careful about that. Also, if the crypto or the NFT becomes worthless, again, you could be the one left holding the bag, and yet you still owe these investors something.
Here’s another one: Your offering terms are not in line with market norms. For decades, investors have wanted 8% cash flow returns, and they also want a share of profits on exit that will bump their annualized returns in the mid to high teens. Five or six years ago, that was the low to mid-twenties. It’s shifted now to the mid to high teens. We have been seeing for the last several years a lot of 70/30 splits. So investors will get 70% of the company ownership in exchange for 100% of the cash, management will retain 30% ownership, and then when it comes to the waterfall and there’s distributions from cash flow, the money will be first given to the investors 100% until they get to their 8% for the year. Usually, that’s determined quarterly, like 2% per quarter, and then the syndicate management team can take their cut.
We’ve seen a shift recently where we’re starting to see more 80/20 deals, just because the deals are a little skinnier with the interest rate rises. That makes it a little harder for cash flow. So just be careful. It’s not worth doing 90/10 deals. You’re taking on a huge, huge amount of risk for 10% of a deal, and you’re going to have to do a whole lot of lot of deals in order to make a living. So be careful of taking on this kind of a risk if all you’re getting is 10%.
We do see some of our clients that are buying really big deals, $30 (million) to $50 million properties, that are doing 80/20 splits. They’ve been doing that for a long time. It’s worked for them, because 20% of that large chunk of money is still a fair income. So don’t think of this as a get-rich-quick scheme. It’s a get-rich-quick-slow scheme or get-rich-slow scheme, not get-rich-quick.
I’ve seen clients that have significantly changed their lifestyles in six to eight years, where they’ve gone from ordinary person with a job to buying their dream house and taking dream vacations and doing those things. But at the same time, their investors are also increasing their lifestyle, and they’re achieving their dreams at the same time.
Unfortunately, I also read the SEC publication that comes out once a week, and I see a lot of enforcement actions against people who are stealing money and enriching themselves at the risk of their investors. That does not last long before they get caught, and they ultimately usually end up in jail. So don’t be that way. Also, keep a close watch on the other members of your management team. Make sure that there’s more than one person handling bank accounts and unrelated people handling bank accounts and always double-checking each other. Trust, but verify. Trust, but verify.
Here’s another one: You have too many steps in your distribution waterfalls. There’s too many things going on. It’s very, very complicated, and there’s eight or 10 steps in there. Nobody can understand it. That’s a way to lose investors. So keep your waterfalls simple. They’ll say no if they don’t understand them, and they’ll be embarrassed to ask you to explain it.
Here’s another one: Your fees are too high. We have people coming to us, saying, “Oh, I’m going to take a 5% acquisition fee on an $8 million property.” That’s probably not going to happen. First of all, your lender might prohibit it, and second of all, your investors might push back on that, because that is just a very large amount of money. There’s not a significant amount of difference between the amount of work you have to do to close on a 10-unit property versus a 100-unit property. But if your fee is 10 times more, it may seem disproportionate to your investors, and they may think, “That’s unfair. I’m not doing that.”
Property management fee of 20%. I’ve had people come to me and say, “We’re going to do a 20% property management fee.” Well, that’s not in market norm. If people can hire somebody else off the street to do it for less, then they’re going to expect you are going to provide that same rate if you’re providing those services or less.
So keep your offerings simple. Stay within the norms. Listen to your securities counsel. Find somebody who’s got significant experience doing corporate securities offerings so that they are giving you that kind of guidance based on their experience with hundreds of other offerings, some of which succeeded, some of which did not. Listen to their advice about what to offer your investors, and try to stay within those norms.
If you don’t have experience with buying the kind of asset classes that you want to buy, then go get some training. There are plenty of trainers out there teaching people how to buy multifamily. We love RE Mentor, Jake and Gino, Vinney Chopra. Those are some three really great sources of finding these kinds of coaching and training programs. There’s other ones out there as well. Be sure to hire securities attorneys that are going to have the experience, but also that are going to be honest enough to tell you if they don’t think your deal is viable.
I spent a whole lot of time talking people out of doing funds who believe that they want to do a fund, just because I don’t think that they have the right track record to pull it off, and I don’t want them to waste their money. I would rather steer them into a syndication that I think would be more suitable for them and that they’re far more likely to succeed at.
Just one last thing: Don’t hire your attorney too soon, right? We want people to contact us when they have an accepted LOI, and we’ll send them a fee agreement. But we don’t want them to hire us until three things have occurred: They have a signed purchase agreement, someone from their team has physically visited the site, and they’ve reviewed the financials. Once those three things are done, our statistics show that they’re 85% likely to close on that deal.
We need to start drafting documents at that point while you conduct the rest of your due diligence so that while you’re out doing your property inspections and things like that, you may run across things, but those become deal negotiation points more often than they become deal killers, and we need to get the documents done. There’s a period of time that it takes to get those done and for you to review them and us go back and forth a couple times until you get your final docs.
So it’s two to four weeks for new clients, three to four weeks to get your offerings done. From the time you engage us until you have final docs in hand, you’re ready to go, for returning clients, it’s more like two to three weeks, because we’re going to draft them. You’re going to review them. We’re going to make sure they’re 100% correct, give them to you, and then you’re ready to go out and start raising money. In the meantime, you’re doing a million other things for the deal. So we recognize that you need that period of time in order to get it done.
So anyway, that was my little pitch that I wanted to make today, is that if you keep things simple and you keep focused, stay focused on one thing, and get really good at it, then expand into other horizons, you will have a very rewarding, successful career, and you’re less likely to make $100,000 mistakes with other investors’ money, which is always going to stunt your ability to grow your business.
I can see that we have some questions in the Q&A, but in case anyone has to drop off early, I do want to say if you’d like to make an appointment with us, please go to www.syndicationattorneys.com. You’ll see a “Schedule a Consultation” button. You can either schedule a pre-call with one of our staff or you can schedule a call with me. Just make sure that you’re ready.
We’re happy to talk to people even before you have deals under contract. We do have something called a pre-syndication retainer that allows you to engage with us and get on our weekly Masterminds that I usually lead or Mola Bosland, our other attorney, leads, where we’re going to help you guys get really comfortable with all these rules and how to structure your deals and all the questions that you’re going to have as you’re growing your syndication business. So anyway, syndicationattorneys.com is the way to reach out to us.
So hey, Art. Art is on the call. “Good morning,” Cammy says. Thanks, Art. Happy to see you. Hey, Chris. Chris says, “Great call. Kim, thank you for all the information. A couple of questions. What are your thoughts on doing a development/value-add fund if you’re going after family offices who are more familiar with both types of investment strategies?”
Well, the family offices are only going to invest with you when you have a track record. So once you have a track record of doing four or five deals, fine. Go ahead and see if you can get family offices to invest with you. I will tell you of the hundreds and hundreds of clients that we’ve helped, very few have worked with family offices, and there’s a reason for that. Also, don’t go after just what they want. Go after what you have experience with. It’s more about your experience than it is about what they want. So happy to answer followup questions on that one, Chris, if you have anything else you want to add to that.
Then, “What are your thoughts on utilizing T-bills as a way to take a fund fee until capital is deployed?” I have no idea what T-bills are, so I would not be able to respond to that.
So that’s all. If anybody else has any other questions, happy to answer them. Anybody got their hand raised? I’ll go look. Nope. Looks like you guys are all good. So I hope I didn’t scare you. I hope the information was valuable, and looks like we did get a couple more questions.
Hey, Rod says, “I missed the first part due to work. Is there a replay available?” Well, we are livestreaming right now on YouTube, so you should be able to go YouTube right after this call and get this.
David asks, “I’m looking at single-family residence, two-to-four-unit, and five-plus-unit residential/apartment deals. What’s the minimum and maximum deal size for someone who’s just starting for a single-family two-to-four-unit and an apartment?”
So this is maybe one exception where I would say start with a fund if you have experience with those kinds of asset classes. Again, if you don’t, then you should bring somebody into your management team that does have experience. I’m not sure whether you’re going to be doing fix-and-flips or buy-and-holds, but find somebody else to bring your team that has some experience with 10, 20, 30 doors of that nature and has done what you want to do. Then you would be able to do a … we’ll call it a little mini fund, where you’re going to go out and you’re going to raise a couple million dollars, and you’re going to buy six or 10 of them, right?
The reason I say that is because with syndication, you should be budgeting somewhere around $15,000 for that — $15,000 to $20,000. That’s a very conservative estimate. It’s probably going to cost less, but you’re going to have some legal fees. Then you’re also going to have some LLC formation fees and some fees for filing securities notices. So those can add up to a few thousand dollars. So budget 15,000 to $20,000. That’s a big ask for somebody who’s only raising $200,000 or $300,000, but it’s not a big ask if you have a fund where you’re going to raise a couple million dollars and you’re going to be able to go out and buy multiple properties.
So when I’m saying don’t go out and do a fund, I have a lot of people that come and say, “I want to do a $50 million fund,” and they’ve never raised money before. Had somebody come to me that said, “I have a ski resort under contract,” who’s never raised money before, and my recommendation is don’t get too far afield from what you know. If you do, make sure you’ve got people on your team that have that direct experience. It’s going to be critical, critical.
Then Hector says, “Thank you, Kim.” So I think that’s all the questions that we have today. I have sure enjoyed talking to you. Hope I didn’t ramble on too much. Well, wait. We’ve got one person with their hand raised. David. Hey, David. Hey, David, you wanted to ask a question?
Yeah, yeah, I do have a question. One was how do we use IRA funds for syndication?
Oh, you can. If you’re buying direct real estate and more than 50% of the assets in your fund or your company are going to be real estate assets, then you are not limited in the amount of IRA money that you can take. So what happens is that your investor will read the offering documents. They’ll say, “Yes, I want to do this.” They’ll send the subscription agreement and a buy direction letter to their IRA custodian, who will then fill out their portion of the subscription agreement.
So what we have is a subscription agreement that has a page for individual investors or husband and wife. Then there’s a page for people who are investing through an entity, for their signatures and all of their information. There’s one for self-directed IRAs, and so with the self-directed IRA signature page, they would send that booklet to the self-directed IRA company. They would fill out their portion of it, the investor would fill out their portion of it, and then they would go ahead and fund that deal. Just realize there could be a little bit of a lag time in doing that. So just make sure that you’ve got that time. You’re not trying to close on something next week.
So for a tax pass-through, like an LLC, you can have the depreciation on real estate pass through to the investors. I spoke to an IRA custodian, and he said that they could still use that if you’re getting financing on the property. So I’m planning to use financing.
Yeah, so there are some taxes that do apply to the financed portion of the asset. So it’s the at-risk funds that are considered non-taxable or where the tax is deferred. So you’ve got to just be aware of those rules. As far as depreciation, my understanding is that there are times when your self-directed IRA investors can’t use the depreciation. If that’s the case, we have clauses in our document that say that if it’s allowed by the IRS that that amount can be then disbursed amongst the other investors pro rata.
Okay … You said that it would be best to bring in somebody experienced for my deals. I’m just doing residential investment. It could be single-family, duplex, triplex, fourplex, and apartments, five and above. So you think somebody who’s already done these kind of deals and also maybe a property management company?
Don’t bring your property management company into your deal. You want to just hire them. You can identify them. You can ask them to give you their resume. When you do a fund, the investment summary is different than the one I described earlier, because that was for a specific offering. For a fund, you have a business plan that says, “Here’s the kind of properties we’re looking for. Here’s the geographic areas. Here’s the parameters they have to meet, and if they meet all that stuff, then we will go ahead and buy them.”
So it would be helpful for you if you’ve never done these types of properties on your own before to bring in somebody that has that kind of experience into your fund management. For you, I was saying for these small deals, you might need to conglomerate some of them together in order to be able to hit that critical mass number that makes it viable to do a syndicate. If you’re just buying them as one-offs, you might want to do them as joint ventures, or if you’re not getting bank loans, you might use private lenders on those smaller properties.
Yeah, we’re going to use private money for fix-and-flip. It’s basically hard money. Yeah, it might be starting off as a joint venture just with a few guys together who buy the deal.
Yeah, and you can do that on a per-project basis. Just realize that that’s not a scalable model. My rules for joint ventures are no more than five people, including you, because it’s really hard to get more than that to make a decision or to even show up. To be able to defend that it’s a joint venture and that you weren’t selling securities, every member has to be actively involved in generating their own profits. They shouldn’t be handing over the money to you and then waiting on you to generate checks for them. You should be asking them for money when you need it. They all contribute. They should be all being consulted on who you’re hiring for contractors and “Here’s the three bids. Which ones do you guys want?,” that kind of thing. So it gets a little bit more cumbersome to deal with joint ventures, and that’s why it’s not scalable, because you’re only really stuck with the amount of deal that four or five investors can buy.
So the scalability comes in the syndicated LLC?
With the syndicate. Yeah.
I’m seeing houses for even 300,000, and look, at what point does it become viable to invest in all the money for creating a sponsorship?
So we have clients that are raising $400,000 and above, that are syndicating $400,000 and above. Depending on what state you’re doing them in, we may be able to use a series LLC that would contain your costs on success of deals. We can do a master PPM, master operating agreement, and then just shorter series agreements and subscription agreements for each deal. So that’s another way that you can help contain costs on individual deals like the ones you’re talking about.
Well, what if the members are different on a series LLC?
You’re allowed to do that. So with a series LLC, you can have separate members and separate assets for each series. But part of the problem depends on where you’re doing it, because some states…
Yeah, some states don’t recognize series LLCs. I would have to do some research to find out whether Florida would recognize them. They may not. There’s still ways that you can do it. You can use a Florida LLC to take title to the property. It’s owned by a Delaware LLC Series A. We don’t like that. So there are ways that we can do it. You still end up with a Florida entity has to own the property, because otherwise, that entity is not allowed to do business or to enter into contracts in the state.
Okay? All right. Well, those were some great questions, David. Thanks for asking.
All right, everybody. We’re at the top of the hour. We always try to end on time. Please subscribe to our podcast, “Raise Private Money Legally.” Check us out on YouTube. Subscribe to our YouTube channel. We’re trying to get 2,000 subscribers. Anyway, we’re just happy that you all showed up today, and we hope to see you again in a couple of weeks. We’re now doing these two times a month.