We know that when you are just starting to learn about real estate investing, it can be difficult to understand all the new vocabulary and learn about all the little, but crucial details that can help you make it or break it when investing in real estate. In this article, we will discuss SEC compliance for passive investors and what you can expect to see in an SEC PPM.
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Three ways to invest in multifamily properties
There are three main ways to invest money in multifamily properties. You can be a passive investor, a deal sponsor, or a so-called individual investor. You can also be two or all three of those simultaneously, like our Founder, Perry Zheng, who invests passively and sponsors deals as a GP.
Group purchasing of real estate involves passive investors (LPs) and deal sponsors (GPs). There is usually one deal sponsor (sometimes with one or more co-sponsors) and a group of passive investors.
The individual investor model usually involves one person or a couple buying a property with their own funds without raising money from other people.
What is group real estate investing?
In the real estate industry, group purchasing is called a syndication. A syndication is a group of people who form an association to undertake a business transaction. This group of individuals forms an LLC to purchase an apartment complex.
What are the benefits of being a passive investor in syndication?
- A potential to earn double-digit average annualized returns.
- Most of the time, minimal effort is required from your side.
- Passive investors benefit from leverage. You can have partial ownership of an asset that you would not be able to buy with the same investment amount entirely. Therefore, you are leveraging other people’s money and the deal sponsor’s time and experience.
- Real estate syndications are an excellent way for passive investors to diversify. Some passive investors put $100K-$200K into real estate depending on their net worth and invest some % of their money somewhere else.
- Multifamily syndications are an appropriate investment for the self-directed IRA.
- Many people use passive investing as a stepping stone, meaning that they start as passive investors and progress to deal sponsors when they have more time and experience.
Passive investors’ responsibilities in a multifamily syndication
Passive investors are similar to shareholders, and they have some responsibilities and roles. They include:
- Passive investors need to be sophisticated or accredited.
- They must find a deal sponsor and evaluate the deal, including the projections, to understand if it fits their criteria.
- They should be able to read and understand the financial projections that the deal sponsor provided to them.
- Before committing their money, they need to understand the PPM, the subscription agreement, the property package, and the company agreement.
- Once the passive investors are in the deal, they need to attend regular meetings organized by the deal sponsor.
Passive investors can use cash or other liquid assets or IRA funds to invest in multifamily syndications.
Things to consider when investing passively in a multifamily syndication
You need to consider a few essential things when you decide to invest passively in a syndication. They include:
- Your investment is illiquid once you complete the subscription agreement and wire your money to the deal sponsor, which means that you can’t just call the deal sponsor and get your money back. Your investment is now in the form of a piece of real estate owned by the LLC. So you need to understand the business model and the holding period before putting your money in.
- You have minimal day-to-day control over your investment. Meaning that unless the majority of the passive investors want to change the deal sponsor to be the managing member, you can’t decide on that. So ensure that your company agreement has a paragraph that gives passive investors the right to do that. When passive investors need to change the managing members, they might become more actively involved in the deal. Sometimes one of the passive investors takes on the management.
- It’s also possible to lose your entire investment. There is no guaranteed return as part of being a sophisticated investor involves a certain level of risk.
- There is a minimum investment amount, which is usually $50K. Sometimes deal sponsors allow for lower investment amounts, as low as $10K.
- You need to understand the exit strategy, financing, experience, and track record of the sponsor. We’ve written an article on evaluating the deal sponsor that can help you dig into more detail.
Best practices for real estate syndications
Best practices can vary from country to country. However, in this post, we will be talking about the USA-specific standards for multifamily syndications.
- In the USA, syndications are usually registered as LLCs, because it’s a pass-through entity. It means that a CPA does tax return for the entire LLC, while each individual investor has a schedule K1 generated from the LLC tax return. Then each investor takes that K1 from the LLC tax return and attaches it to the individual tax return.
- A syndication must have a company agreement and a managing member.
- The deal sponsor has day-to-day control, so other members of the LLC have limited voting, with a few exceptions, like replacing a managing member.
- The deal sponsor should be able to estimate how much money they need to close the deal and raise an additional 10%-15% to cover unexpected expenses.
- Professional property management is necessary for a multifamily property. Sometimes deal sponsors have the proper skillset, attitude, passion, and experience to manage properties. However, most of the time, they hire a professional management company.
- Deal sponsors must send monthly reports to passive investors and schedule quarterly or semi-annual meetings. The more stabilized the property is and the better the communication – the fewer meetings you need to have. As a passive investor, if you are not getting monthly reports for several months in a row, it is your responsibility to call the emergency meeting with the sponsor and figure out what’s going on.
What you need to know about SEC
There is no way we can cover everything you need to know about SEC in this article. However, we will give you an overview of what to expect to help you become a sophisticated investor.
What is security, and what does it have to do with an apartment building?
SEC stands for Securities and Exchange Commission. A security in this context involves an investment of money into a joint enterprise with an expectation of profit. The anticipation of profit comes from the deal sponsor, meaning that passive investors trust that the deal sponsor will control the assets making day-to-day decisions. As a result, the profit will depend on the skills of the sponsor and how they make these decisions.
It means that the deal sponsor sells securities when raising money for a deal, and passive investors are buying securities. In the USA, you need to have a securities license to do this with a few exemptions.
- Reg D 506. Under this exemption, there are few rules that you need to follow. First, you can have a maximum of 35 sophisticated investors in your group and an unlimited number of accredited investors. It’s up to the deal sponsor to determine if the investor is sophisticated.
- Reg D 505
- Reg D 504
Whether you are a passive investor or a syndicator, you need a specialized SEC attorney who advises you on all these details. Another important document you need if you are a deal sponsor is a PPM from your SEC attorney. Do not reuse or recycle PPMs from other properties because raising money with a plagiarized PPM is illegal.
Solicitation is not allowed under SEC law
Another critical point in the SEC law is that you aren’t allowed to do general solicitation or public advertising when raising money for your deal as a deal sponsor. It means that even soliciting investor information via your website is not permitted. A deal sponsor can’t ask strangers for money either because it’s considered a general solicitation.
The first step in building your investor database as a syndicator is to create “substantive” relationships with your investors. It means you need to have a detailed conversation to get to know some details about this person, their goals, what they do, their business, etc. Once you have substantive relationships, you can start soliciting. That’s why our real estate investor portal allows only for one-way discovery of syndicators so that they cannot solicit investors or poach other syndicators’ investors.
As a syndicator, you need to have a record-keeping system to track when you meet your passive investors, discussion notes, and meeting minutes.
Four key documents that SEC attorney prepares
- Private Placement Memorandum (PPM)
- Company agreement
- Investor Questionnaire
- Subscription agreement
How a typical SEC PPM looks like
An SEC PPM is a legal document that companies file to describe a private offering of their business. The documents normally include detailed financial statements for the offering, any third-party due diligence and analysis, and background information on the company’s officers and directors.
The first page would usually look like the one below. It will have the name of the LLC, the number of units offered in each class, the minimum investment (in this case, it’s $50K), and the total capital investment.
SEC PPMs are 50+ pages long, and here is what they usually contain:
The risk factors section is a mandatory requirement by SEC, and it demonstrates all the risks that investors might face by investing in this property. This section can be anywhere from five to thirty pages. As a passive investor, it is your responsibility to familiarize yourself with these risks before making your investment decision.
The first and essential part is the summary and terms of the offering. It contains information about the deal, the Manager, the Manager’s fees, minimum investment, and the number of unaccredited investors to which the company can offer this investment. The Manager, in this case, is not the property manager. It is the Manager of the LLC (typically, the deal sponsor).
Steps a passive real estate investor should take before investing in a syndication
- Define your acquisition criteria & set your goals. You can read this article about acquisition criteria for deal sponsors, which will give you an idea about what you should be looking for on a more high level. Ask yourself if you are willing to be a guarantor and how much money you want to invest. The business model, holding period, etc., are also part of your criteria. Remember, there is an additional liability when being a guarantor, but there is also a benefit.
- Get to know the deal sponsor and understand if you can trust this person. Ask them for their investor package, including their resume, property package, projections, the business plan, acquisition criteria, etc. For example, if your criteria are to invest in a value play and the sponsor’s is to invest in a yield play – your goals do not align, so you should not invest with them.
- Read the SEC PPM and the Company Agreement. Being a sophisticated investor means that you are responsible for your decisions, and the PPM will outline all the possible ways you can lose your money.
- Review and complete the investor questionnaire that the SEC attorney prepares. The investor questionnaire is part of the subscription agreement.
- Complete the subscription agreement and return it together with the check. The check should go into the company name, not the deal sponsor’s name.