The Jumpstart Our Business Startups (JOBS) Act, a recently enacted federal law, amends the Securities Act of 1933. The amendment encourages capital solicitation and investment in small businesses. The JOBS Act allows promoters to solicit accredited investors by advertising to raise private capital.
Yet, the JOBS Act does absolutely nothing for real estate syndication in California, unless you are:
- a builder/developer who is locating investors to fund the development of property; or
- a syndicator who solicits and accepts funds to hold and invest in a yet-to-be-located property.
Furthermore, it is misleading to suggest securities laws are involved in the syndicated real estate transaction acquiring an existing income property – they are not.
Real estate syndication is the pooling of funds from several investors for the acquisition of real estate. Three to six cash investors are ideal. These investors become members of a limited liability company (LLC) formed to structure the ownership of the syndicated property.
Investing in a real estate syndicate is essentially investing in an existing property to be held as an income-producing property. A broker acting as a syndicator has a duty to inform each prospective investor of all aspects of the property and the investment program that might influence a prudent investor’s decision to contribute funds. To do this, a syndicator completes their due diligence investigation and provides a memorandum on their findings to prospective investors.
Here’s a checklist for forming and organizing an LLC for the acquisition and ownership of an income producing property:
- Research available residential or nonresidential rental properties and select one to investigate for investment suitability. [See first tuesday Form 185 or 279]
- Analyze the selected property, including its physical condition, the economic risks, environmental and natural hazards of the property’s location, personal security, title conditions and property operating data. [See first tuesday Forms 304, 314, 321, 324 and 352]
- Contract to purchase the property in the name of the syndicator under a purchase agreement, an option to purchase or escrow instructions with a vesting provision allowing the syndicator to assign their right to purchase the selected property to the LLC. [See first tuesday Forms 161, 161-1, 401 and 159 §§10.6 and 13.3]
- Open escrow, and name the syndicator, not the LLC, as the buyer. Prior to closing and after the LLC has been formed, the syndicator will assign their right to buy the property to the LLC. [See first tuesday Form 401]
- Complete a due diligence analysis and confirm the seller’s disclosures regarding the condition of the property’s improvements, operations, location and title.
- Apply for new financing or an assumption of the existing financing as called for in the purchase agreement.
- Review plans for the formation and management of an LLC entity with competent legal and accounting advisors.
- Prepare the investment circular (IC), subscription agreement, LLC-1 (Articles of Organization) and LLC operating agreement, along with their exhibits and addenda, naming the syndicator as manager of the LLC. [See first tuesday Forms 371 and 372]
- Deliver copies of the IC to prospective investors to solicit them to become members and fund the LLC so escrow can close and the property be acquired.
- Obtain the signature of each investor on a separate subscription agreement and the signature page of the LLC operating agreement, and deliver their funds to the syndicator or escrow. [See first tuesday Form 373]
- Enter into a property management agreement to employ the syndicator to manage the day-to-day operations of the property. This agreement must be signed by each investor-member of the LLC. [See first tuesday Form 590]
- Arrange mortgage financing and sign loan documents for an assumption of any existing loan(s) on the origination of a purchase-assist loan, either in the name of the syndicator or on behalf of the LLC, as demanded by the lender.
- File the LLC-1 (Articles of Organization), prepared and signed by the syndicator, with the California Secretary of State.
- Assign the syndicator’s right to purchase the property to the LLC in an amendment to the escrow instructions, vesting title to the property in the name of the LLC on closing. [See first tuesday Form 370 or 401-2]
- Fund the purchase price and closing costs from mortgage financing and cash contributions received from the members of the LLC.
- Close escrow and take possession of the property.
- Send copies of all closing documents to each member.
- File an LLC-12 with the Secretary of State within 90 days after filing the LLC-1 and biennially thereafter, and identify the name and address of the manager as the agent for service.
- Operate the property on behalf of the LLC during the LLC’s ownership of the property and distribute earnings to the members.
- Resell the property when ownership of the property no longer meets the objectives of the investment group or when the initial goal was to sell or exchange the property after a period of time. The manager will negotiate the sale and the net proceeds will be distributed to the members on closing.
Existing asset vs. securities risks
Under the California risk capital rule, a syndicator’s mere promise of future profits does not create a securities risk. A securities risk is created when that promise is accompanied by a promise to perform an activity that creates value after acquisition, such as development. Thus, the investors do not risk their capital in reliance on the skill and effort of the syndicator’s ability to create value in the property after delivering their funds. Instead, they are acquiring a fully improved, existing asset in exchange for the funds invested, on the chance the rental market place will allow their investment to prosper.
Also, the investors retain management control since they have the right in an LLC to change management at any time. What the investors acquire is a fractional ownership interest in real estate, typically indirectly through membership in an LLC. They purchase the syndicate manager’s expertise to oversee the ongoing operations of renting and maintaining the property under a property management agreement, not to create property value. [Fargo Partners v. Dain Corp. (8th Cir. 1976) 540 F2d 912]
In contrast to an apartment building managed by the syndicate manager and co-owned by investors through an LLC, a syndicated investment in a parcel of farm land contains a corporate securities risk. The investors rely solely on the expertise of the syndicator to create a return of their invested funds (capital) by producing a crop, then harvesting and selling it. As a further securities risk, these syndicators often agree to do so in cooperation with owners of other properties in a pooling arrangement.
Even though the transaction is structured as a sale of a parcel of real estate to an individual purchaser combined with a management agreement for their services, the series of individual transactions display the critical elements of a corporate security – a group investment with an expectation of profits and success inextricably interwoven with the efforts of the syndicator or others to produce a marketable item and then sell it to generate an income and, ultimately, a return of the investment. [Securities and Exchange Commission v. W. J. Howey Co. (1946) 328 US 293]
Likewise, when a developer sells memberships in a yet-to-be-built development to investors, the sale of memberships is coupled with a securities risk. The investors risk their capital on a “yet-to-be-built” project, relying on the developer to complete the construction of the development after the members release their investment funds to acquire membership in the group ownership of the property. [Silver Hills Country Club v. Sobieski (1961) 55 C2d 811]
Thus, when a syndicator locates an existing income property and prepares a full disclosure package to present to prospective investors, no securities risk or law controls their conduct. They have delivered their funds for a specific fixed asset – identified improved real estate – after the investor has been informed of the property involved. Hence, the syndicated project includes no promise to deliver anything other than direct or indirect (LLC) ownership of the property in exchange for funding the purchase of the property under an existing purchase agreement and escrow instructions.