CAPITAL MARKETS: TAX EQUITY INVESTMENT

APARTMENT FINANCE TODAY • OCTOBER 2007

Growing Your Own Equity

By Jerry Ascierto

As the availability of debt financing continues to tighten in the wake of the subprime mortgage industry meltdown, a greater degree of equity will be required to get multifamily deals done.

But for smaller developments, or developers just starting out and hoping to get their first project off the ground, access to equity can be a challenge.

Joint-venture equity investments are common vehicles for larger developments and seasoned developers, but for deals in the $10 million to $15 million range, those funds are often out of reach. Mezzanine loans are another traditional source of funds, but many mezzanine lenders don’t lend below $3 million, precluding smaller deals.

Additionally, as the capital markets continue to experience volatility, equity providers are growing more cautious.

“We’re starting to see return expectations from equity investors go up, just like spreads have on the debt side, though not as severely,” said Chris Feeley, senior vice president and managing director focused on equity investments for NorthMarq Capital, Inc. “They are getting more conservative as to how they underwrite deals.”

However, several strategies for raising equity are available for beginning developers, including “friends and family” investments, and preferred equity placement.

Friends and family loans

The most common equity strategy for a developer just starting out is the friends and family approach, where the developer taps personal networks to raise funds.

Developers can use their local bank, many of which now offer to administer “friends and family” investments by drafting the paperwork and processing the collections for a fee. A more common approach is when a group of such investors is syndicated into a limited liability company (LLC).

The advantages of an LLC include allowing the developer to retain managing member authority, a higher level of control than would be available in an equity joint-venture arrangement. Another advantage is that investors are shielded from personal liability. LLCs also enjoy “passthrough taxation,” meaning that profits and losses pass through the entity to the owners’ personal income tax returns, instead of being taxed at both the entity- and personal income-level.

But this method is fraught with potential pitfalls. Developers would do best to retain a lawyer skilled in the area to avoid running afoul of Securities and Exchange Commission (SEC) and related state regulations.

If the amount raised through the LLC totals more than $1 million, the SEC treats it as an offering of securities, which must be registered with the agency. However, Regulation D of the Securities Act of 1933 provides an exemption, allowing an LLC to privately sell its securities to “accredited investors,” or individuals who have earned $200,000 or more for the last two years ($300,000 if married with a joint income), or who have a net worth of more than $1 million (excluding a personal residence).

Developers looking to syndicate an LLC typically produce an offering document that outlines the risks involved in the investment, and shows the tax implications of the deal. Industry experts caution that the expense associated with such a structure can be significant.

“These offering memorandums tend to be multiple pages in length, and they can cost $30,000 to $50,000 or more,” said R. Lee Harris, president and chief operating officer for developer Cohen-Esrey Real Estate Services, LLC.

Harris advises that offering memos should include worst-case scenarios, or “opportunities to fail,” and ways of mitigating each potential loss. “Before you start looking at all the money you’re going to make, look at all the money you could lose,” he said. “That demonstrates a prudent approach as a sponsor of an investment opportunity.”

Other “accredited investors” include employee benefit plans and trusts with assets of more than $5 million. Many small pension funds and retirement plans, particularly professional corporations like those for doctors or lawyers, often seek to diversify their accounts by making local real estate investments.

But the laws governing retirement plans, such as the Employee Retirement Income Security Act, can be stringent and complex, so developers should proceed cautiously if going this route. “Those relationships can really be beneficial, but as the developer, you better make sure that they as the retirement plan group are doing it the right way,” said Harris. “You could be an unwitting participant in something that doesn’t meet the test.”

Preferred equity

Some investment management funds and financial institutions that provide joint-venture equity also provide “preferred equity.” These equity providers often look for opportunities with smaller apartment developers as a way to establish relationships with a burgeoning company and in the process get attractive yields on their investments.

Several such investors offer “90-10” preferred equity programs, wherein the investor contributes 90 percent of the equity required to green-light a deal, and the developer is on the hook for the other 10 percent.

Preferred equity is similar to mezzanine financing but offers a higher return for the investor. Whereas joint-venture equity assumes equal partnerships—everybody gets paid back pro rata—preferred equity providers receive a weighted, fixed return.

The relatively high price of that money comes in the form of priority rights over other investors in the property, most importantly the right to receive a preferred distribution, usually around 15 percent, on the invested amount. After that return, there may be a disproportionate split of other financial benefits on the back-end, such as cash flow or sale proceeds, favoring the preferred equity provider.

Preferred equity providers often seek a higher degree of due diligence up front—and a larger percent of the preferred return—when dealing with inexperienced developers. “You’re going to give up some more to these institutions early on until you build that track record,” Feeley said.

Best practices

When ZOM, Inc., began developing and managing properties 30 years ago, founder Joost Zyderveld sourced equity through a close-knit group of private “friends and family” investors from his native Netherlands.

Since 1977, ZOM has developed about 65 syndicated projects and raised more than $350 million in equity, according to Samuel “Trip” Stephens, chief investment officer for the Orlando, Fla.-based firm. ZOM’s investor base has grown through the years, and now includes both U.S. and foreign-based private and institutional investors.

One practice that helped guide the company in the early days was underpromising and over-delivering. Developers should be conservative in their projections of what an investment opportunity will yield, Stephens said. A 19 percent return will be a nice surprise to an investor expecting 15 percent; but if you promise 20 percent and deliver 15 percent, relationships can sour.

Stephens also advises developers to update their investors regularly, and report bad news early. Being open with investors “always serves you well, even if you have to report difficult news,” he said.

Additionally, experts warn against staying with a deal long after it appears infeasible. New developers sometimes invest too much time, effort, and emotion in trying to make that first deal work since it offers the promise of cash and proves credibility. “But if you’re too eager, you will make mistakes,” Harris said. “You can get in deeper and deeper and rationalize that you can make it work. But you have to be willing to walk away and move on to the next deal.”