[Editor’s Note: This is part 3 in our real estate private placements series. This particular post is a continuation of parts 1 and 2, also written by Mark Reynolds, a real estate investor who offers privately placed investments. We have no financial relationship.]
My Background
I’ve been developing Real Estate for over 20 years now. I have done a number of Private Placements. In some the investors have made terrific money (annual returns in excess of 20% for 10 to 15 year periods). In some the investors have lost all their investment (fortunately not that often– but the real estate crash of 2008 came earlier than I expected). In addition, I know a pretty fair number of other syndicators, some of which have made and lost money and some of which have done jail time for SEC violations. In addition I screen investments, investors and credit on a daily basis. I think I am pretty good at detecting fraud and deception. So I think I’m reasonably qualified to explain how to investigate a private placement investment opportunity without a lot of costs. In other words, how do you tell a scam from a goldmine?
How to spot Scams and Losers
With that preamble let me start off saying that most private placement operators do not qualify, in my way of thinking, as “scammers”. A scam is a conscious attempt to get money out of investors by fraudulent means. When you divert money from later investors to give fraudulent high returns to early investors that’s a scam. But most of the “bad deals” I see don’t look like scams– they look like bad business decisions.
So, I have a friend who did “three to five” at the Federal Prison Camp in Terre Haute Indiana for securities fraud. Now surely that guy was a scammer, right? No, I don’t think he was. An idiot? Yes. A scammer? No. But he was convicted of fraud and surely that makes him a con artist? Well, maybe not. For starters the SEC always charges everybody with fraud. The reason is that fraud is the only count they can actually send you to jail over. So in the SEC book all sorts of compliance issues get charged as fraudulent.
Now I don’t want to imply that my friend’s business practices were OK, they clearly were not. But it wasn’t a scam– it was incompetence. He didn’t set out to steal the money which his investors gave him– he was just incompetent at the kind of business he attempted to run with the money. Now this may not seem like a critical distinction– after all the investor’s money is just as gone– but it actually is a vital difference.
Many people who are considering investing private placements start off trying to determine whether the investment opportunity is some kind of scam so they begin by looking at the organizer. Pretty quickly they can figure out that he is not a con artist (or at least doesn’t appear to be one). So they assume that the investment must be OK. But there are lots of ways to lose your money in businesses that are not fraudulent at their core.
So instead of starting off by examining the organizer on the assumption that he’s a con man (which means you concentrate on the person) one should start off trying to examine the business. This method will generally reveal the scam artist, since at the core the business model of a scam is unworkable. But you will also have a pretty good idea of whether the organizer you are talking to is going to actually be able to operate the business in question. And that information may be more important in the long run since there are many more legitimate businesses that fail than there are con games.
That said, as I was working on this article, an investor sent me a press release from the US Attorney General’s office announcing indictments for securities fraud against two men who live in my area for having “scammed” at least $5 million out of $9 million raised to develop condominium conversions at the height of the real estate boom in 2005-2010. According to the indictment the two perpetrators told people the money was going to go into the purchase of apartment buildings to convert to condominiums but actually about half the money went to the organizers who used it to pay living expenses, buy cars and go on trips.
The conclusion, of course, is that fraud is a real concern and the wise investor will look for it and attempt to protect himself from it. That said, had the investors in these transactions followed the advice below I think it unlikely that they would be hoping the SEC can get their money back today.
5 things to look for when considering a Private Placement:
1) What documents will actualize the transaction?
It’s perfectly reasonable to ask to review the documents. Documents typically include some kind of offering memorandum. Here there tends to be two extremes and both are wrong. First, there is the encyclopedic Offering Memorandum. Attorneys love this. It warns you in a hundred and one ways that this investment is a crap shoot and you could lose all your money and if you do you cannot sue “our guy” (the organizer who paid for this tome with your money). Frequently it tells you that everything not in the memorandum itself doesn’t count and whatever you heard about this investment outside the offering could be a lie, shouldn’t be trusted and if it turns out to be false don’t say we didn’t warn you.
Yet it tells you almost nothing important about the actual business plan. What little it does tell is squirreled away in financial statements and footnotes in the back of the book. So the only possible motivation for buying the investment has to be something you understood from outside the memorandum– which information the memorandum has already disclaimed as useless.
On the other extreme is the “offering” where the paperwork is almost non-existent and everything is a verbal presentation. The problem is that both of these end up being the same thing. The guy selling you the “full blown” offering memorandum knows that you are not going to read the entire thing. So he recommends that you have your attorney and accountant review it. So you dutifully drop off a copy at the attorney and the accountant’s offices and wait for their review (and their bill).
But the attorney and accountant are not looking at the basic business plan of the business. They are reviewing a document– the attorney has a checklist of things that he includes when he writes one of these documents and he’s making sure that all of the parts are present. Likewise the accountant. He is making sure that the financial statements are in the correct form, that the columns “foot” and that it looks like the guys that put the document together knew what they were doing. But of course all the boxes are checked and all the financial statements foot– the organizer paid a lot of money to HIS attorneys and accountants to make sure that they would.
So after a week or two the accountant and the attorney come back to you and say, “Well the documents appear to be in order but I am not giving you advice about whether this is a good investment or not.” They are practicing law the same way you practice medicine when you are concerned that this patient may be litigious by nature: yes, you would like to cure this patient but just as important is to make sure you’ve got your ass covered when his attorney comes knocking at the door. This is, of course, exactly what the offerer is expecting. This “attorney’s review” is supposed to convince you that the DEAL is OK but the only thing the attorney has actually signed off on is that the Paperwork is OK.
Alternatively, the attorney and the accountant come back and say, “I never recommend these type of investments.” Why? Well because nobody ever sues you for the things you advise them not to do. If the client doesn’t buy then they cannot lose money and they cannot sue you for the losses. On the other hand they also fail to realize the gains– but it’s pretty hard for your client to sue you over gains he didn’t make on an investment you advised him to stay out of.
The medical analogy would be off-label uses of a prescription drug. Your attorney will tell you to never do this. Only your professional judgment and Hippocratic oath tell you that this is the most cost-effective treatment for this particular patient. Still, if things go badly the MD who followed his JD’s advice and avoided the off-label prescription is going to be in the better position in court. So what’s a busy professional to do?
Lets look back at the fraud case discussed above. These investors made personal loans to one of the scammers. He told them he would buy apartment buildings with the money but, of course, there was nothing in the organizational documents that made it impossible for him to divert the money to other purposes.
The rule here is to make sure that the documents do what you were told they were going to do. If you’re investing money to buy real estate make sure you have a mortgage in the documents. Make sure that there is a mechanism for the money to go directly to the seller of that real estate without the organizer having the opportunity to divert the money elsewhere. That mechanism is generally called a Title Company.
“Lend the money to Bob and he will take care of you” is a very bad idea. Even if Bob is a deacon at the church, won last years golf tournament at the club and has never been seen to spit on the sidewalk he is, in the end, just Bob and given a way to pocket money he may be tempted to do so. Make sure the documents don’t put money in Bob’s pocket until he has earned it.
2) What is the business plan?
At the heart of any Private Placement is a very simple question– what business are we in? In other words– how does the entity make money? The answer to this question has a lot to say about the risks and the returns of the investment. When analyzing a business plan I have two questions I like to ask to get to an understanding of the business– 1) what do we do to add value? 2) what is our competitive advantage over the other businesses that do this?
The more the business does to add value the more the returns on investment should be. Thus, a private placement that starts a new restaurant takes more risk and does more work than one that buys and operates an existing restaurant. So the start-up should (must?) pay a higher rate of return than the ongoing operations partnership. Businesses with competitive advantages also have a better opportunity to succeed than those where the “barriers to entry” are low.
So if you are looking for safety you’d like an on-going operation with lots of competitive advantages over the competition. Does that sound a lot like the kind of stock you’d like to buy in the public market place? See, I told you that you already had the critical skills to manage this. With the public stock, however you are competing with a lot of other investors who have access to the same basic information that you do and while the competition for the business may not be intense the competition for the stock may be. At the very least you can assume that this stock is “fully valued”.
But private placements are just that– private. You will not have a lot of competition for ownership of the company. In all likelihood only a few other people will even know the opportunity exists and, as discussed above, that gives you an opportunity to increase your rate of return without unduly increasing your risk.
Finally, can you, as the investor, understand the business? You should be able to understand what the business does and why its a good deal for its customers and for its owners (you). A business model that is based on either the customers or owners doing things that don’t make sense is a bad plan in the long run (not withstanding the strong returns of tobacco stocks).
Personally I like simple business models. Not only are they easier to understand but they are less likely to fail because step 47 in the 98 part transaction suddenly fails to happen. In other words the true basic core of the business plan should be explainable in no more than 2 to 5 pages. More than that and the plan is going to get lost in the legalese. Less than that and you don’t have enough detail to understand how this business is unique and different from its competitors.
3) How is your investment secured?
As a general rule hard assets tend to correlate with safety. Placements that are used to buy land, equipment, natural resources, etc. have hard assets to liquidate in the event that something goes wrong in the business plan. Collateral is a good thing. It means that while you may lose some of your money you are unlikely to lose it all.
On the other hand, collateral that is already pledged to other lenders doesn’t count. “Underlying” debt is particularly common in real estate transactions in the form of mortgages. As we pointed out above, this increases the rate of return for the “equity” investor if things go well but that “leverage” dramatically increases the risk in a transaction. A securitized lender in front of you when it comes times to dispose of assets in a worst case scenario dramatically increases your risk. In fact, in the event of a default, an underlying lender practically guarantees the loss of your principal. Real estate in particular tends to have a lot of debt in it. The key to analyzing the risk of that debt is a ratio called the Debt Coverage Ratio. The higher the DCR the safer the investment.
The other thing that increases your safety is the presence of some reserves. As every emergency physician can tell you, the unexpected occurs all the time. When the broken leg happens to an otherwise healthy young adult they will probably recover. When the fall happens to a geriatric patient with osteoporosis the recovery is much more uncertain. Likewise in business, the presence of some reserve to carry the business over in the event of the unexpected makes the long-term prognosis much better.
In my opinion unlevered real estate with cash flow (i.e. not vacant land) and some reserve is an extremely safe investment. Most of the time when a real estate investment based business (as opposed to a real estate brokerage company) fails it is because there is too much debt. So if your investment is secured with real estate without debt you are in a very secure position. The organizer of that Private Placement may have a business model that allows a higher rate of return but that doesn’t mean that the investment has a disproportionately high risk level.
4) Who handles the money?
The heart of a good accounting system is that no one person has enough access to the money to make off with it. A good business plan must have appropriate safeguards to keep the money from disappearing. Likewise in private placements. Your money should not go directly to the managing member and there should be accounting safeguards in place to guarantee that nobody’s fingers get “sticky”.
5) When does the Organizer get paid, how much and what for?
If there is one “short cut” to understanding the likelihood that a given offering will work it’s when the organizer gets paid. If the organizer is getting paid before you do its a pretty good sign that he thinks the business is not going to work and since he has more information than you do I think you should trust his valuation. That said it is not unusual for a private placement to have some fee structure on the front end. The justification for this is that the manager must make a living somehow and he is doing all the work. As I get older I am less and less convinced by this argument.
When I was a young man I typically took a small part of the “back end” (typically 15 to 25%) and a number of fees on the “front end”. These fees were usually related to some specific activity (typically managing a construction project or property management) and were related to the “market” rate for those services. While nobody ever accused me of running a scam with this organization and I honored my duties to the investors I can say that I’m not sure I’d buy one of those offerings if I saw them offered by somebody else today.
As I got older I took a larger piece of the “back end” (typically up to half) and subordinated my “fees” to a base return to the investor (typically 10% per year but that was in a high-rate environment. If I were doing the same structure today I’d make the base rate between 2% and 4%). The theory is that the investor should get something akin to the “risk-free” rate before the organizer sees any cash. But after that base rate is paid then the organizer might charge some reasonable fee for the work he has done. After that both investor and organizer should participate in the profits approximately equally.
Now I’m doing a series of transactions where I take all of the “back end” after the investor has a fixed rate of return (10% per year) plus their principal and I take no up-front fees. Coupled with the fact that all the funds are handled by either a Title Company or an accounting firm with a license to lose if money goes astray I can legitimately tell my investors that I do not get paid until they are paid off. Obviously I have a great deal more incentive to get the investor paid if my reward comes after his than if it comes before. I believe that this says to the investor that I am committed to their return and that, as a result, they can be confident that the business is not a scam.
Now these “rules of thumb” should not be construed as definitive. I think that all of the above methods of organization are legitimate– what is important is that they are clear, that the investor knows what he/she is getting into and that the organizer does what he says he is going to do. Again, in my opinion, the only way to insure that is to have some third party who handles the funds and pays the appropriate person at the appropriate time. Personally I prefer that third party be a CPA but there are alternatives.
I think you can see that if these safeguards are in place the opportunities for even the unscrupulous to run a scam are pretty limited and in the end that kind of restriction is more valuable than a lot of background checks, etc. which will not uncover the not-yet-criminal.
Conclusion
I hope you have found this series helpful. Of course I’d love it if you chose to get in touch and talk about your financial goals and how we might structure something that would help you meet them. Whether you choose to do any business with me or not I’d like to think that this has opened your eyes to some of the opportunities in private placements and how to evaluate the risks when you see such opportunities.
The changes that are coming about as a result of the JOBS act are going to cause you to see more private placements one way or another. Hopefully this article will cause you not to turn away from such opportunities on principle and will give you some tools for deciding to invest or not based on reason and analysis and not just instinct.
Mark can be reached at mark (at) blackhallpartners (dot) com with any questions about his three posts. Tomorrow will be another guest post from a professional working in this field. Comment as we go along, or save your comments for the final post on real estate private placements.
I understand that the fees will be significantly higher than mutual funds, however, the fees he mentions here are significantly higher than what I have seen in other similar private placement real estate offers.
There is no doubt that these fees are high in comparison to a mutual fund ER. Keep in mind these deals tend to be much smaller than a mutual fund. This isn’t a trillion dollar Total Stock Market Fund. There isn’t quite that kind of an economy of scale. Put yourself on the other end of the deal. What would you be willing to do the work for? Also, consider that we’re not talking about large cap US stock mutual funds where there is zero alpha. A skilled manager may have a much easier time earning his fees back for you in the relatively illiquid, inefficient real estate market. Fees still come straight off your return like with any investment of course, but the goal is a diversified asset with acceptable returns after expenses.
Well, these fees don’t exactly come “straight off your return” in the current case because the return is preferred to the fees.
The other thing is that these “fees” are not exactly like mutual fund fees, as you point out, because they are operational expenses of the company, not the fund. If one were going to compare these to the costs in a mutual fund they would be more like the executive compensation of the companies underlying the fund. Since there is no middle man (the fund manager) there are no “fees”.
While you could still argue that I am being extravagantly compensated it would not be entirely accurate to call this a fee for 2 reasons, 1) it is subordinate to the investors return and 2) it is not a determinable amount– I only get what’s left after the investors preferred return.
Now there are lots of Private Placements with other organizational structures and “fees” and some concern that the fees are reasonable is appropriate but in my old age I’d rather borrow the money (even at a high rate) than charge a bunch of fees to “partners”.
I agree it is an issue of semantics. The point remains that whatever return/salary/income the manager is paid does not go to the investor. That’s not semantics, it’s just math. The more you make, the less I make. The hope is that by offering the manager a nice level of compensation, the manager can “grow the pie” even if my slice of it doesn’t become any larger, or even becomes smaller.
Keep in mind you can get a very low maintenance office warehouse unit that yields a 7 1/2% cap rate. In order to get a similar return based on his formula he would need to garner a 14% return. In order to get a 14% return he would likely need to take on much more risk than what you would need to take on for a 7 1/2 Cap rate office warehouse building on your own. Add a little leverage and you can increase your return to 10 to 12% with a relatively low risk. In order to get a10 to 12% return with him he would need to get about a 20% return which would be less likely and higher risk. Granted he is doing all the work, but if you settle for a low cap rate commercial property it wouldn’t require that much effort or risk.
Not at all clear where these numbers are coming from. My current offering is a fixed 10% return to the investor for 5 years. These are refinancing of condos I bought on about 35% cap rates and have sold on long-term land contracts. The investor return is a preferred return and I get no cash until the principal is returned and that rate is achieved.
This doubling the rate assumes that I’m taking half of the profits but that misunderstands the offering. My return is actually higher (over about a 10 year period) but the investor return is first.
I may be mistaken, but my initial reply is consistent with what your article states. You state “As I got older I took a larger piece of the “back end” (typically up to half) and subordinated my “fees” to a base return to the investor (typically 10% per year but that was in a high-rate environment. If I were doing the same structure today I’d make the base rate between 2% and 4%).” To me that says that you used to give a preferred investor return of 10%, but now only 2%-4%, “then the organizer might charge some reasonable fee” (presumeably 2-3%), then “both investor and organizer should participate in the profits approximately equally”. So doing the math from my reply example: 20% total investment return=2-4% base to investor + 2-3% to mananger leaves approximately 15% return to be split equally (7.5% each). Thus the total investor return is approx 10.5% and manager gets the remaining 9.5% profit (the investor is essentially paying half of the potential profit in fees while fronting 100% of the financial risk). My point is that it’s just a much higher fee structure than I have seen with other syndicated/private placement deals. You also mentioned another scenario with a 10% preferred return, but this is a max return to the investor: “I take all of the “back end” after the investor has a fixed rate of return (10% per year)”. This is essentially a high risk, non-recourse loan that you are taking out that you could never get from a lending institution. In your reply you state that this deal was bought with a 35% cap rate, I hate to say it, but it appears that you structure the deals to maximize your return, not the investor. If you have a routine deal, then you split the return evenly with the investor (1st example), if you have a killer deal (35% cap rate, but I’m sure extremely high risk), then you give the investor a fixed rate, but take all the upside–it’s essentially a high risk, high reward scenario where the investor carries all the financial risk and you get a non-recourse loan that you walk away from if it flops, but allows you huge leveraging power with no risk other than your time. Good structure for manager, but I’m not sure if the investor is being appropriately compensated for his capital/risk.
Sorry to be so long in replying to you Jon, I got busy with the holidays and didn’t feel like I had the time to give your thoughtful comments the attention they deserve.
First I’d like to respond to “I hate to say it, but it appears that you structure the deals to maximize your return, not the investor.” In one way this is certainly true. I do a certain kind of real estate transaction because I make money doing it. That’s how I make a living. In the process I must pay my investors enough money for them to be happy. If they are unhappy they do not invest with me in the future. If they do not invest I do not do more transactions– i.e. I no longer make a living. On the other hand if I pay all the profits to investors then I do not make any money and will not stay in the business long. Does that mean that I always make more money than the investor? No. Frequently they make more than I do.
The other comment of yours that I think deserves a response (probably because it hit a nerve since I hear it frequently) “this allows you huge leveraging power with no risk other than your time”. The problem I have with this is that implies that my time is not as valuable as your money.
Obviously I have a lot of trouble with this implication. Lets start with the source of your “investment”. In the end the source of this money was your time– spent practicing medicine, acquiring the skills and the licenses to engage in that practice, etc.
Now, I am willing to concede that your time and expertise are worth high rates of compensation, i.e. that trading your time for money was a legitimate economic transaction.
So why is it hard for investors to recognize that trading my time and expertise for money is also a legitimate economic transaction?
“AH,” you say, “But I am a highly skilled professional with years of training and experience in a complex field.”
So am I.
In addition, my compensation is performance based. How many physicians do you know who are willing to get paid only if the patient improves? If my performance does not produce a rate of return in excess of the “risk free” rate I earn NOTHING. If I am no better than the average real estate manager (who gets paid regardless of his performance) then I deserve no better than his rate of compensation. But my contract with the investor compensates me ONLY if the investor first gets the agreed preferred return.
So in a private placement we both, in essence, invest our time. You invest your PAST time as condensed and crystallized in the form of money and I invest my CURRENT and FUTURE time. We both invest our expertise– you in the form of medical training which you converted to cash in the past me in the form of real estate development expertise which I plan to convert to cash in the future. Since we have contributed equivalent resources (cash, expertise, time) we should participate in the gains in some equitable fashion (i.e. we split the cash in one way or another).
So my next point in response to your thoughtful comments is that the compensation that a developer/syndicator/manager/offeror of a Private Placement deserves is a function of the value that he adds.
Lets start with your 7.5% cap rate “easy management” warehouse space. I agree that a 50% “management split” on such a property would be inappropriate. I have never syndicated such properties but if I did so, a management fee of more than one or two points would be excessive. In addition the syndicator of such properties would need to do two things, in my opinion, to “justify his existence” in the deal (1) he would need to pool a bunch of these in order to spread the risk of any one or more units going vacant and (2) he would need to buy them at a price that was way better than a 7.5% cap rate. I did see a bunch of these deals several years ago syndicated as TIC deals (these days they are Delaware Trusts) but the investor motivation to buy them was mostly to be totally passive and avoid capital gains taxes on the profits of other real estate transactions by doing “like kind” 1031 tax-free exchanges into this kind of transaction. One’s rate of return was low if you calculated it on the total investment but was much better if you figured that otherwise you got a big tax bill and had to get a higher rate of return on the after-tax balance in order to be in the same spot as the TIC put you in.
But that’s not exactly analogous to the kinds of transactions I engage in. My role is much more akin to the developer who bought the land, got the approvals, built the warehouse and leased it up (not necessarily in that order) and eventually sold it to you at the 7.5% cap rate. Now if he did a reasonably good job of that process his return was a LOT more than yours. Criticizing him for “maximizing his return, not the investor” makes no sense– maximizing his return is precisely what he was supposed to do. You can beef that his return was too high for the services rendered but the only way to act on this belief is to not buy the warehouse– in which case someone else will buy it because 7 to 8% cap rates are what the market has decided this kind of building is worth.
In my current offering I bought these condos very cheap (way under the 7.5% cap rate price). I took the “lease-up” risk with my money and am essentially “selling” the first 5 or 6 years of a 30 year contract cash flow. So your criticism that I am getting a lions share of the return while the investor takes the lions share of the risk does not quite seem correct to me in this case. If the buyer defaults it is still predominately MY risk to reclaim and redeploy the asset since I have another 25 years of cash flow after the investor is made whole and that “back end” motivation requires me to perform on the investors mortgage position so that I can collect. Essentially my motivation to place these private mortgages is to allow me to free up my cash so that I can do it again– exactly the same reason the warehouse developer sold to you at the 7.5% cap rate.
Now there is a difference– if the warehouse tenant files for BK and moves out is the guy that sold it to you going to roll up his sleeves, find you another tenant, charge you nothing for that service and eat your 7.5% rate in the meantime? Of course not. But that is what I agree to do in these condo transactions (except that the rate is 10%).
The point is that the key to a good private placement is not the costs (fees or otherwise) but the performance. If the syndicator gets paid before you, in my opinion, then that’s a red flag and analysis of what the fees are is appropriate. But if the syndicator subordinates his compensation then the conversation needs to center on the soundness of the business plan and the risks of the transaction.
In the real estate business we have an aphorism for this phenomenon. “Don’t count the money in the other guys pocket.” The point is that how much the other guy makes is not really the issue– the issue is whether the risk and return are appropriate to your portfolio.
In this way Real Estate is different than a Mutual Fund. Efficient Market Theory essentially says that the performance of the manager is irrelevant– nobody is any better at this game than anybody else. While that may be true in the stock market it is certainly not true in other businesses.
And that is the glory of Private Placements. They give the investor the opportunity to invest in places where superior performance is possible. Yes, you will need to compensate Management for being a scarce resource but Management will compensate you with superior returns.
Well, this is now WAY too long so I will pass on responses to other aspects of your comments. Hopefully your interest in this matter has not waned too much in the period where I failed to respond and we can discuss the matter further.
Correct me if I’m wrong, but isn’t Mark’s suggestion that the disadvantage with pubic stock, that “you are competing with a lot of other investors,” actually an advantage: competition or lack thereof can make a stock a growth stock or a value stock, for example. It seems that the real advantage to private placement is simply diversification.
An efficient and competitive market is, of course, a two edged sword. If you manage to time your trades well then the efficiency of the market should help you. But one of the principals of modern portfolio theory is that timing the market is essentially impossible and you are better off diversifying by asset class and ride the market good times and bad.
Personally I like to buy in inefficient markets and sell in efficient ones (that’s the point of the Goodwill story) but that kind of arbitrage is not viable in the public stock market because there is no corresponding inefficient market to buy in.