This article advises syndicators on the securities risks created when fractionalizing the purchase of REOs for rent and resale. For more information on REO rental syndication and Frannie’s REO Initiative, see the companion March 2012 first tuesday article, Syndicators, schemes and scams: the business of REO rentals.

Issuing securities, a risk created

Syndicator dealings in real estate owned property (REO) rentals present the classic securities risk environment – an investor is first mined for cash then  the syndicator has free reign to choose which properties and on what terms to purchase with the cash. This is called a blind-pool investment.

The investors then rely upon the syndicator to:

  • select suitable properties;
  • add value to the property through renovation; and
  • stock the properties with tenants (or rent-to-own buyers) to maintain the elevated property value.

Although finding tenants and/or buyers does not in and of itself produce a securities risk, a syndicator’s public declaration of his own expert acumen in doing so creates a heavy reliance on the promoter’s special individual talents in creating value for profit on a resale, rather than relying on the marketability of the properties themselves. [For an excellent discussion of how securities risks can turn into fraud, see the January 2012 Economist article, Fleecing the flock.]

Protection under the nonpublic exemption

So what happens when a securities issue exists for a group investment in which ownership is fractionalized? Syndicators experimenting with their own REO rental schemes are best served by seeking an exception to securities registration by limiting themselves to qualifying conduct, then filing for a nonpublic offering exemption.

Under the nonpublic offering exemption, also known as the 35-or-less interrelationship rule, an investment which poses securities risks is exempt from state and federal registration as a security if:

  • the investors do not number more than 35 (husband and wife counting as one);
  • all investors have a meaningful, pre-existing business or personal relationship with the syndicator;
  • the investors will not resell or distribute the interests they acquire; and
  • the solicitation of investors does not involve public advertising. [Calif. Corporations Code §25102(f)]

Editor’s note — We wonder: How does public exposure play into how “nonpublic” advertising is?

The REO Initiative announced by Fannie Mae (Fannie) in January of 2012 poses such a 35-or-less interrelationship rule for syndicators. Fannie is still in the process of pre-qualifying investors, but aside from large Wall Street Banks and established asset management companies, very few syndicators will have the resources to play in this REO bundle game alone.

Syndicators will need investors with deep-rooted prior relationships with the syndicator to prequalify for the program, and, of course, to financially back these blind-pool purchases. Syndicators will want to stick to the protection provided by filing for the nonpublic offering exemption, and take care how and whom they solicit for funds. [The People v. Humphreys (1970) 4 CA3d 693]

Their alternative to creating a securities risk is to first select the properties to be purchased with investor funds before soliciting investors. Here the syndicator completes a full due diligence investigation and compiles documentation on the properties specifically identified to be purchased and then discloses this information and data to investors before accepting their funds, a fixed-asset acquisition which is without any construction or other value-adding conduct promised by the syndicator.

Fannie’s disclosures — so far

As far as up-front property data from the REO Initiative, Fannie released a preliminary summary of its first bundle of REOs for sale to rent in late February of 2012. The summary includes a count of properties in each of the sub-pool regions, whether leases exist for those properties and the number of vacant units available. The same breakdown is available sorted by property type, i.e., single family residence (SFR), condo, duplex, etc. [The Preliminary Summary of Assets can be found on Fannie Mae’s site, Structured Sales – Investor Pre-Qualification Process.]

As yet, no specific details on the properties have been released. However Fannie’s REO homepage,, is sporting an ambiguous yet all-encompassing disclaimer about its potential securities offering:

“This is not an offer for the sale of securities or a solicitation of an offer to buy securities in any jurisdiction. Any such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such jurisdiction. In the event of a commencement of an offering of securities, it is anticipated that an offering memorandum or other materials describing fully the details of such offering will be made available to certain Pre-Qualified potential investors. Participation in any future offering may also be conditioned on the investor’s satisfaction of additional criteria.”

Disclosure of the risks is key: syndicators must be aware of what they are investing in, and disclose what they know (and should have known) to their investors.

In the end, it’s about disclosure or avoidance

Clearing out REO inventory is a good thing. No argument there. It is a commendable gesture that the Federal Housing Finance Agency (FHFA) wants to allow Fannie to sell the REOs to syndicators (although the REOs should have been sold and stricken from their books the moment Fannie acquired them.)

73% of voters in a first tuesday poll were in favor of private banks and lenders pursuing REO leasebacks to homeowners who remained in possession as an alternative to foreclosure. However, the issue at stake with foreclosure relief ideas such as REO rental schemes is not whether they’re a good or bad idea. What we’re concerned with is the action which will take place after Fannie passes the REOs into the hands of a syndicator. [To view or vote in the poll, see the January 2012 first tuesday The Votes Are In, It’s time lenders allow investors to leaseback to shortsale sellers.]

Sure, Fannie’s pre-qualification process is supposed to be a bulwark against the gamut of real estate scams, but after a syndicator signs the form, is qualified to bid and acquires the REO asset, Fannie’s hands are clean of the asset. What happens after is historically patent with these syndicated ventures and should do more than worry brokers and agents and the renters and homeowners they represent. [For more information on the pre-qualification provisions, see Fannie Mae Pre-Qualification Request Form.]

As with all investments, disclosure of the risks is key: syndicators must be aware of what they are investing in, and disclose what they know (and should have known) to their investors. Investors, in turn, must be aware that when investing in real estate, they are in it for the long haul. The idea of turning a profit quickly will not survive the reality of today’s market with its zero-bound interest rates and inflation-free government austerity spending.

The coupling of the disclosure of securities risks and responsible syndicate management will provide a shield against the “misunderstandings” which become the stuff of lawsuits demanding a return of the invested funds.

Of course, there’s an irony to this discussion of syndication and securities risks: in the end, it’s basically a very trouble-ridden, convoluted way for the government to get qualified owners into homes — which Frannie could have effected simply by saying, “Yes, we’ll grant you a principal reduction.” [For more information on Frannie’s policy decision against principal reduction, see the February 2012 first tuesday article, Cramdowns shot down: another missed opportunity and the November 2011 first tuesday article, Surprise: Frannie says “no thank you” to cramdowns.]

For more information on REO rental syndication and Frannie’s REO Initiative, see the companion March 2012 first tuesday article, Syndicators, schemes and scams: the business of REO rentals.