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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.