This article distinguishes the co-ownership acquisition of an existing income producing property as a fixed-asset syndication typically organized by a broker, in contrast to the co-ownership investment in a real estate development, mortgage lending or business operation which is a promotional syndication augmented with value-adding risks of loss controlled by securities laws.
Part II applies the protections provided by state and federal securities laws for investors who risk their capital in value-creating investment schemes generally offered by unlicensed promoters.
Economic risks in the real estate market
A group of investors is brought together to collectively invest and benefit from the co-ownership of real estate, called members. The members are solicited and organized by a syndicator, preferably a broker or agent with practical experience in ownership and management of income-producing property.
The ownership by the members is documented as percentage shares of participation in a limited liability company (LLC), or another less effective form of co-ownership for vesting title to the property, such as:
- tenancies in common (TICs);
- a corporation;
- a limited partnership (LP); or
- a general partnership.
A syndicated real estate investment program group comprises two or more people, to fund all or part of the purchase price of a property located by the syndicator and controlled under contract, called syndication. The syndicator’s share ownership is a percentage received in exchange for locating the property and subordinated as promotional to give cash investors priority and the syndicator income tax benefits.
The alternative is an individual purchasing a property they have located and will manage, with or without the help of a broker. Essentially, one buyer instead of two or more as with a group.
The syndicator soliciting investors to form the group investment needs a general understanding of:
- state and federal securities laws;
- the types of real estate investment programs containing a securities risk, and
- the underlying social purpose intended by the securities laws.
Without elementary knowledge of securities risks in real estate transactions, syndicators might offer investors promotional value-adding activities with uncertainty of achievement to enhance value in a real estate investment. But on the investors’ release of funds, these yet-to-be-completed activities place the group investment within the control of securities laws.
To be clear eyed about group investing, most real estate syndication programs are excluded from all securities laws. Most group investments do not include activities that present securities risks for a return of the investors’ funds, just economic risks in the marketplace of real estate controlling the level of income and profit (or loss). An operative distinction is:
- a program without a securities risk is the ownership of a fixed asset; and
- the other program with a securities risk is ownership of a yet-to-be-completed acquisition with a post-closing, value-adding enhancement activity without which the asset’s full value is not attained.
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The securities characteristic unpackaged
The classic federal definition of a securities law relationship with investors comprises three conditions, all of which must exist:
- an investment of money;
- a common enterprise based on the mutual success or failure of the group in its investment goals; and
- an expectation of wealth produced by the efforts of others, not just by the property itself. [Securities and Exchange Commission W. J. Howey Co. (1946) 328 US 293]
In application, the purchase and ownership of real estate by any group of investors always involves both the first two elements of an investment and a common enterprise. Without more, the group investment program is excluded from the securities law; no securities law risk is involved.
Thus, with these two elements in every syndicated investment property, the syndicator’s formation of a group for an investment in real estate has the potential to be designed to include activities which are a securities risk. It is the addition to the investment program, an activity within the third element — the further development of property value by other than the investors after acquisition of the property — which creates a securities risk.
A securities risk arises when an investor releases control of their cash contribution, shifting control over the use of the funds to the syndicator or someone else before the promised value-adding activity is completed.
The syndicator’s real estate investment programs is always distinguished as either:
- a pre-selected, fixed-asset investment program without an after-closing, value-adding activity; or
- an investment program which, after an investor’s funds are released for use by the syndicator, requires someone to perform an activity that creates the property value needed for the investor to recover their investment.
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Expectation of a return of invested cash
A syndicator offering a group real estate investment program to purchase and operate an existing income-producing property, or hold land for profit solely from resale, is the acquisition of a fixed asset. The program does not include activities that present a securities risk.
Here, the investor’s expectation of a return of the investment is based on and limited to the performance of the pre-selected property’s operations in the local marketplace. Thus, the investment is subjected to only the economic conditions and financial risks which the ownership of any parcel of real estate is subjected to.
Conversely, the addition of an event described in the third element of the securities definition establishes a securities risk. The risk arises on release of the invested money from the investors’ further control coupled with the investor’s reliance on the efforts of the syndicator or another person to:
- determine what property to acquire, a blind pool deferring asset selection;
- produce further value-adding improvements;
- develop a higher and better use for the property;
- produce and market goods in a farming operation;
- collective post-acquisition coordination with others (rental pooling); or
- investing in trust deed notes.
Critically, and due to misconceptions about co-ownership, any vesting for co-ownership is merely a static business structure. A vehicle such as an LLC merely holds vested title for the fractional ownership interests of members and the syndicator as in any common enterprise, with no role in any operation of the property.
Thus, soliciting and offering cash investors fractional membership interests in an LLC — or as tenancies in common (TICs) or partners — to hold title to an existing income-producing property does not create a securities risk. The type of ownership selected for the group without inclusion of a promotional after acquisition value-improvement activity is of no concern to securities laws.
Further, a guarantee of a minimum profit by a syndicator does not create a securities risk. The investor’s capital is no more at risk of loss after a property is acquired than had they purchased the asset outright, with or without a promise of profits. Again, it is the forward market that sets the earnings and any return of capital. [Hamilton Jewelers v. Department of Corporations (1974) 37 CA3d 330]
Further, a syndicator’s solicitation of investors by public advertising is not a value-creating activity which places the investors’ funds at risk. This observation is true whether the group investment program is a fixed-asset acquisition or actually contains a post-closing value-creating securities risk activity.
However, when a securities risk exists as with a yet-to-be-completed, post-closing value-adding activity, no advertising can take place under exemptions, whether state and federal, and only as allowed when a DFPI or SEC permit is obtained to solicit investors, the tombstone advert situation.
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Protecting the investor
Investors who risk their capital in asset-creating investment schemes offered by others are protected by state and federal securities laws. The social purpose is to give investors a reasonable opportunity to realize profits on their investment as permitted by the local economy.
A securities risk is created under California securities law whenever an investor:
- places their funds at risk of loss;
- assumes a passive role, and
- gives control of asset selection, development, pooling or resale decisions exclusively to the syndicator or others.
When the syndicator or others promises to perform an activity that creates value in the acquired property after the close of the purchase, a securities risk is created. Unless the promotional activity is completed successfully, value will not be added to the property as expected for the return of capital.
In essence, the investor did not invest in a fixed asset, but in the skill of someone else to create future value in the asset acquired. The future expenditure of invested funds — or borrowed capital — is no longer controlled by the investor, but by the syndicator or others.
Fixed asset vs. a securities risk
Consider a group of investors who purchase a newly constructed apartment building that is unoccupied by tenants. The syndicator solicited the investors and serves as manager for the group and the property.
The local economy — population density, wages, competition — and marketing efforts by the syndicator do not produce enough tenants to occupy the property. Thus, the amount of rental income received is insufficient to pay operating expenses and mortgage installments. The investment fails and is sold by foreclosure.
The co-owner investors make a demand on the syndicator for a return of their investment funds, plus the legal rate of interest (10%). They claim the purchase of the existing unoccupied complex, when coupled with a property management agreement, creates a security that was neither exempt from securities law nor qualified by the DFPI (or SEC).
The co-owners claim they relied on the syndicator’s management expertise to locate tenants and rent out units in the newly constructed building and through those effort create value sufficient to recover the capital they invested.
Does the syndicator, who merely manages property in competition with other like-type properties, impose a liability on themselves for the return of the co-owner’s capital under any securities law?
No! The existence of property management activity or the promise or expectation of an annual rate of return on their investment does not create a securities risk. Members of an LLC, TIC or other entity always retain control over the management of the property.
Investor controls property management
The investors may terminate any property management agreement as well as the group manager by a vote of the co-owners. More importantly, they can locate and replace management with other management, a service readily available in the local brokerage community.
Here, the investors capital was not placed at risk in reliance on the skill and effort of another to create value in the property. Instead, they acquired a fully improved, existing asset in exchange for the funds invested, on the chance the local rental marketplace will allow their investment to prosper.
Further, investors retain the ultimate control over management since they may change management at any time. The investors buy property, not syndicate managers or the expertise of a manager. They periodically pay additionally for those services as an expense of operating the property — not as an investment. [Fargo Partners v. Dain Corp. (8th Cir. 1976) 540 F2d 912]
Promised returns without development
The first task of a syndicator is the selection and a due diligence analysis to prepare an investment circular used to disclose to the investors material facts about the specific parcel of real estate to be acquired. Then, the syndicator obtains the investors’ approval of the property selected for acquisition using their funds.
Until the approval, the investors’ funds may not be released and made available to the syndicator to fund the purchase. Even then, the only activities conducted after acquiring the property are either:
- the locating of tenants by marketing and maintenance of an income producing property; or
- the ultimate resale of the unaltered property at a profit.
In another example, a syndicator completes their due diligence investigation on a property they locate and determine it is suitable for syndication. A detailed investment circular (IC), also called an offering memorandum, is prepared. The IC states no development or improvement of the real estate is to take place. The property will be owned and operated for what it is — a rental income property. [See RPI Form 371]
All money invested in real estate is, to some extent, at risk of loss due to fluctuating property values brought about by economic conditions, natural hazards, etc., called marketplace risks. However, marketplace risks merely affect the level of income, profit or loss. Income and profits (or losses) from ongoing rental operations in the local economy are not the concern of securities laws.
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Parcels in a subdivision sold to groups
Now consider a developer who acquires undeveloped real estate and subdivides the property as a planned community. The developer sells unimproved parcels within the planned community development to groups of co-owners.
The parcels are advertised as being suitable for development as part of the planned community.
The developer does not promise:
- to develop or provide offsite infrastructure for the parcels sold to the co-owners
- to produce profits for them based on any development of the entire planned community, adjacent parcels or off-site infrastructure, nor
- to operate any profit pooling arrangements.
One group of investors who acquired a parcel makes a demand on the developer and their broker for a return of their investment, claiming a security was created since they relied on the developer to complete the development of the planned community, which did not occur.
However, the group of investors had complete control over the parcel it acquired from the developer. Nothing remained to be achieved under any obligation imposed on the developer after acquisition. The investors simply had to wait for the local real estate market to deliver a profit or loss.
The transaction was merely a sale of real estate to the group to hold for a profit on resale or later development as the group saw fit. The only investment risk remaining on acquisition was the economic risk existing in the local real estate market. No securities risk was created. [De Luz Ranchos Investment, Ltd. v. Coldwell Banker & Company (9th Cir. 1979) 608 F2d 1297]
To read about the application of the protections provided by state and federal securities laws for investors who risk their capital in value-creating investment schemes generally offered by unlicensed promoters, see Part 2 in next week’s firsttuesday newsletter, Quilix.
