[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

medical student loan refinancing

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.