Finding equity for a small apartment deal has always been a
difficult task. But it's particularly vexing
these days, when most equity investors are targeting only a handful
of the safest markets.
So, where can a small-market or new developer turn for financial
backing to get a project off the ground? In many cases, to
investors they know and trust the most: friends and family.
Nearly one of every two start-ups obtains initial funding from
friends and family, according to the Global Entrepreneur Monitor.
In fact, the lending environment has become so risk-averse that
raising capital from family and friends might be the best option
available to first-time apartment developers.
The November 2011 Real Estate Research Corp. (RERC)/Certified
Commercial Investment Member (CCIM) Institute Investment Trends
Quarterly survey revealed that return-versus-risk perception was
strongest among participants in the apartment sector at the end of
last year compared with the office and retail sectors. But deals
under $2 million still only make up a small percentage of apartment
transactions, as most big industry players and equity investors
won't pick up the phone for anything less than
$10 million.
So, family and friends represent a potential source of capital
that could come into play in some of the more overlooked apartment
markets.
Rather than searching in vain for a high-leverage loan, many
first-time developers offer equity positions to potential
investors. This way, the investor gets to own a stake in the
property and have a personal financial interest in its success.
Better yet, the developer isn't on the hook for
repaying the initial capital as he would be with a standard loan.
Instead, the transaction is considered the sale of a security. The
catch? That's where the Securities and Exchange
Commission (SEC) comes in and legal obstacles crop up.
Cover the Bases
One such obstacle is expense. In fact, an offering
memorandum—also known as a private-placement
memorandum—can cost upward of $30,000.
Because the investment comes in exchange for an ownership stake
in the company, legal considerations come with the turf.
That's why documentation is so important. If the
initial round of funding is handled improperly and
doesn't follow all applicable laws, it could
seriously compromise a developer's chances of
attracting other venture capital and angel investors in later
stages of fund-raising.
Friends and family partners often join to form a limited
liability company (LLC) as one solution.
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 “pass-through
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 levels.
But a family and friends round of investing needs to be
registered with the SEC once the amount raised reaches $1 million.
And the offering must comply with the security laws of the state in
which each investor resides. To ensure that all state and federal
regulations are met, each investor must meet certain criteria, as
well.
“The most common problem is finding accredited
investors,” says Arina Shulga, an attorney at the New
York City–based Shulga Law Firm.
“It's difficult and expensive
to comply with the securities laws if your family and friends
investors aren't accredited.”
For accreditation, each investor must have a personal net worth
in excess of $1 million or have earned $200,000 or more in each of
the past two years. If an investor fails to meet such criteria, the
developer must provide additional assurances and documentation,
such as the offering or private-placement memorandum, which is a
document describing all financial information associated with the
sale of a security, including the risk factors involved. This frees
the seller from liabilities. Another example of a qualified
accredited investor would be a trust with more than $5 million in
assets.
There are exemptions. Regulation D of the Securities Act of 1933
addresses the issue of partnering with nonaccredited investors.
Under Rule 506 of Regulation D, up to 35
“sophisticated” nonaccredited
investors are allowed a private placement of securities. (A
sophisticated investor is one whom the seller reasonably believes
has sufficient financial knowledge to allow the investor to
accurately evaluate the risks associated with the investment.) And
under Rule 504, deals with securities offerings less than $1
million are allowed to be made to both nonaccredited and
nonsophisticated investors as long as the securities are not
advertised to the public.
In short, developers would do best to retain a lawyer skilled in
the area, to avoid running afoul of SEC and related state
regulations.
Don't Forget the Little
Guy
The bottom line is that once a sponsor navigates the legal
hurdles, family and friends remain a viable source for
securing investments for mid-market deals at lower prices.
Right now, institutional lenders simply don't
want to take the risk on small deals in cooled-off markets. But
that might be exactly what's needed to stimulate
a recovery in these struggling real estate locales.
In small markets' favor, however, is the fact
that over the past year, more and more investors have been wedged
out of the booming metro markets by institutional investors,
creating more interest in smaller locations.
Cindy Chetti, the National Multi Housing
Council's senior vice president of government
affairs, is concerned that investor neglect could stifle small
apartment markets' rebound hopes.
“Private capital generally flocks to top-tier
markets and trophy properties. That's exactly
what's happening now: The new institutional
capital coming in is concentrating in a handful of markets and on
high-end assets, leaving vast amounts of the country
out,” Chetti said in a statement.
Despite meager institutional interest in properties outside of
major metro markets, transaction volume, and rent rates, has been
growing in those locations too. In markets like these, family and
friends could net high-yield returns while demand remains ahead of
supply.
After all the legal issues are sorted out, of course.