[Editor's Note: This week we're going to take a look at Real Estate Private Placements. We've discussed these on the blog in the past, and in fact one of the blog sponsors, Dennis Bethel, MD of NestEggRx also works in this field. There will be a total of 5 posts in the series, some longer than others. The first three are written by Mark Reynolds and were originally sent to me as a 6000 word guest post after a long email conversation about real estate private placements. Mark has spent his career putting together real estate private placements and is currently seeking accredited investors for his current offering. The fourth post is also a guest post, written by Jilliene Helman, who I met at Fincon 13. She is a blogger and the CEO at Realty Mogul, a company that puts interested investors together with private placement sponsors. I wrote the final post in the series with some of my thoughts on a subject I am clearly not an expert at. I have no financial relationship with Mark or Jilliene. All of these guys would love to have your business so I hope the financial conflicts of interest in their writing are obvious. Nevertheless, I think the material is really worth spending some time on, and they know a lot more about it than I do.]
What if I told you that in addition to all the public market investments you know about there is another, secret, market where almost every vehicle you are aware of is duplicated (stocks, bonds, mutual funds, etc) but that in this “secret” market investors have a lot more room to negotiate terms, there is less governmental regulation (but still a long way from none), and the underlying businesses are much easier to understand? Some mythical investor fairyland of higher returns and less regulatory burden? No– just the world of Private Placements.
Now what if I told you that there is nothing to prevent you from investing in this secret marketplace except that you may not hear of the opportunities and that a LOT of advertising dollars and government expenditures are spent convincing you that this market 1) is not there and 2) is VERY scary and dangerous and that you shouldn't go there? You'd at least want to investigate the “secret” market and look at whether it looks like it might produce some superior returns and whether it is as scary as they say. After all, it doesn't cost anything to shop– its only buying that's risky.
Finally, whether you are interested in participating in this market or not you might want to learn more about this “Private” marketplace because changes arising out of the JOBS Act are about to make this private market a LOT more public and at the very least you should develop an understanding of how it works and how to avoid losing your money there.
A History of the “Public Market”
Most modern regulation of securities goes back to the Securities Act of 1933. The Act, of course, was drafted in the shadow of the 1929 collapse. Like the current administration the political leadership of the time believed that “no good crisis should be wasted”. Although most modern economic theory believes otherwise, there was a lot of sentiment at the time that rampant fraud on “Wall Street” was one of the causes of the crash. While there was certainly some fraud in the pre-1929 Wall Street boom, the current consensus is that it was relatively minor and not the cause of the crash.
As always, however, a theory does not have to be correct for the government to act upon it. The belief that fraud was the cause of the crash empowered Congress to pass legislation intended to make stock fraud both more difficult and more expensive for the perpetrators with penalties up to and including substantial amounts of jail time in federal prisons. The motivation here was to protect “small investors”, hundreds of thousands of which had been lured into the market in the booming 1920's and had subsequently lost most of their savings in the crash. By 1932 the Dow was down to just 11% of its 1929 high. Pressure on Congress to protect the amateur investor was intense.
The result was the Securities Act of 1933, the Securities Exchange Act of 1934, and the Glass-Stiegel Act (actually the Banking Act of 1933). The provisions of these acts created the post-Depression securities market in which we have lived ever since.
The Private Placement Market
In the midst of this fervor (in the 1930's) it was pointed out that the proposed legislation would have deleterious effects on the ability of small businesses to raise capital, and so the distinction between the “Public” markets and the “Private” markets was invented.
The essence of the distinction was that Private Placements could only have a small number of investors in any one company and that these investors must be personal friends and acquaintances who, it was assumed, the organizer would be unwilling to scam. Again, the motivation came back to the belief that the pre-crash run-up was based on getting lots of small investors to buy into an essentially fraudulent market. Congress apparently believed that running stock scams on small groups was not worth the effort for the fraudster nor worth the effort for the newly formed SEC to chase them (the Congress did make room for the states to regulate these small players). The main rule in Private Placements was that they needed to be Private– issuers were prohibited from advertising to find Investors and only a handful (originally 25, later 35) of investors were allowed in any one company. The idea was to allow small companies to raise money from “friends and family” without having to incur the expenses of SEC registration and compliance.
The restriction on the number of investors was later (1974) amended to allow an unlimited numbers of “Accredited Investors”. Although the designation of an Accredited Investor now includes income and net worth qualifiers, the original and most important qualification to be an Accredited Investor was that one must have the financial sophistication to evaluate the risks involved in a business opportunity. In essence, an Accredited Investor is one with enough wealth and sophistication not to need government protection and is therefore able to “fend for themselves”.
Obviously there are advantages for the issuers in avoiding the level of regulation required to do a public offering. Especially if the issuer, for whatever reason, doesn't need millions of dollars to fund their business plan. Less obvious are the advantages to the investors to moving in the less regulated Private Placement marketplace. As readers of the Whitecoat Investor are well aware, fees, costs and regulatory burdens get paid before the investors return so if such costs can be avoided investors' return should improve.
The JOBS Act.
All of the above is about to change, however, as a result of the JOBS Act of 2012. Among other things the JOBS Act has lifted the rules on the general solicitation of the public for investments in private placements. The idea was to make it easier for startups to raise money without the burden of a public offering or other costs associated with the SEC.
Theoretically this change is minor, since the first thing the issuer must do after an initial expression of interest from a potential investor is ascertain that the investor is an accredited investor. It remains illegal to attempt to sell private placements to non-accredited investors via advertising.
Practically, however, it opens a whole new field of endeavor for small companies to advertise for investors and raise money to help their business grow. Clearly high income earners who are likely to qualify as accredited investors (like doctors) can expect to be deluged with offers for private placements of every sort.
This is complicated, however, by the fact that the SEC doesn't really seem too thrilled with these Congressionally mandated changes. One SEC commissioner voted against the regulatory changes required to implement the law. In addition the SEC seems ready to prosecute private placement fraud cases energetically in an attempt to prove that the entire direction of this regulation is mistaken.
Quite frankly I have no idea where this is going to shake out, except that in the short run advertising for private placements is likely to increase and that investors (accredited or not) should develop the skills to evaluate such offerings.
In part 2 tomorrow, Mark will discuss concerns about fraud and some thoughts on the return on investment available with private placements. You can make comments as we go along this week, or save them all up for Friday. I would also recommend checking out our No Hype Real Estate Investing course. It will give you the foundation you need to learn about all the different methods of real estate investing.