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Editor's Note: The following was written by Laurie Thomas Vass, a registered investment advisor, regional economist and licensed real estate broker in the State of North Carolina. Vass manages The Private Capital Market, a crowdfunding marketplace. Guest contributors' opinions are their own and do not necessarily represent the views of Crowdsourcing.org.
In either a Reg D or Reg A offering, a real estate development company can offer to investors any form of securities that suits its goals. The strategy for the company is to structure the terms and conditions of the offering that are attractive to potential investors, and competitive with the offerings of other real estate development companies.
The recommended strategy of The Private Capital Market is to create a subsidiary legal entity called a “Special Purpose Entity,” (SPE), that raises capital, and afterwards, pays out dividends and interest to investors, for each capital project undertaken by the real estate company.
1. The Value and Benefits of the SPE To Both Investors and the Real Estate Company
Special Purpose Entities (SPE) are legal business entities formed to insulate investors from the threat and risk of bankruptcy, if the parent real estate development company fails. The stream of benefits from the investment securities issued by the SPE are secure, even in the event of the bankruptcy of the parent real estate development company.
Investors can reduce risk, and gain more security in the future payments from the SPE, because the future payments are guaranteed and insured by the parent real estate development company. The real estate assets of the capital project are segregated from other assets of the company, and generally, the payments are secured by the investor’s direct financial interests in the real estate assets that are transferred to the SPE.
This direct financial interest in identifiable properties of the SPE is in contrast to the older real estate investment model of REITs, or the newer investment model of many real estate crowdfunding websites, where investors have an undifferentiated interest in the underlying blind pool of real estate assets.
In the older model, and in some of the newer real estate crowdfunding platforms, an outside financial firm or investment banker creates the SPE and manages the stream of investment payments generated by the SPE, on behalf of the issuing real estate firm. In exchange for the management of the investments, the outside managers obtain about 20% of the profits, on an annualized basis, commonly called “carried interest.”
In the newer crowdfunding version of the SPE, the real estate company creates the SPE and directly manages the real estate properties, after the capital has been raised. In addition to managing the real estate properties, the parent real estate company also manages the investments of the SPE.
The real estate company, in exchange for the management of the investments, obtains the 20% carried interest.
In other words, in the new model, the parent real estate firm gains profits from managing the underlying real estate, and then makes a capital gain by selling the assets in capital transactions in the future, while the SPE subsidiary gains the on-going 20% carried interest each year for managing the investments in the SPE.
The company can use the same legal form of the SPE entity over and over again for each new future project, and can place different types of properties into one SPE, which adds investment diversification for investors in a specific SPE.
In other words, the real estate company can have as many SPEs as it needs, and can create a new SPE whenever the company needs to raise capital for a new project.
In the future, under Reg A, and possibly Reg D, the investment units of each SPE may become eligible for trading among investors in the “not-yet-created” secondary private markets. This new type of trading of private securities would offer investors a path to liquidity if they needed to sell their securities.
In addition to liquidity of the underlying units, the entire portfolio of debt obligations inside of the SPE would be eligible to be sold or exchanged as a package, to larger investment firms and banks that may be attracted to adding investment quality commercial debt to their funds and portfolios.
2. Establishing the SPE As A Subsidiary Limited Liability Corporation
The SPE is formed as a limited liability corporation, with the executives of the parent company acting in the capacity as the general partners of the LLC, and the investors acting as limited partners. The general partners make decisions about the real estate assets that are transferred from the parent firm to the SPE, and also make decisions about the form of securities to be issued by the SPE.
The general partners obtain management guidance from an independent Board of Directors of the LLC. The members of the Board are authorized to represent the financial interests of the limited partners.
In the sequence of events leading up to the creation of the LLC, the parent real estate firm would first identify the real estate assets that it intended to transfer to the SPE. The parent firm would obtain clear legal authority to transfer the assets to the SPE. The real estate assets, and the subsequent investment offerings of the SPE would be directly secured as a pledge of collateral for the entire assets of the SPE, not just to the individual notes, or bonds, or stock that are issued bythe SPE.
In other words, the credit worthiness of the pledge of real estate collateral inures to the benefit of the SPE.
The SPE obtains certain legal rights in the real estate property, and legal authority to manage the investment assets, after the SPE has raised capital. The SPE is the issuer of the 3 types of securitized investment securities, as described below. The different securities have different benefits to suit the needs of different types of investors.
Created as a pass-through entity, some tax benefits of the LLC may be passed through to certain types of investors. All investors in the SPE would obtain the limited legal liability that shields investors from liability beyond their capital investment in the investment securities.
In the second step of LLC creation, the general partners buy and own common stock shares of the LLC equal to 10% of the entire net asset value of the real estate of the SPE, on the day of transfer from the parent to the SPE. The general partners transfer the capital to the LLC, which acts as seed capital for operating the SPE, and tends to establish the benchmark market price of the SPE, on the day it is first created.
The other 90% ownership in the LLC interest resides in authorized, but non-issued common share units, sufficient to cover all future convertible securities issued by the SPE, in the event of a contingent convertible event.
While the SPE may issue debt or debt instruments to investors, the SPE as an entity is prohibited from borrowing funds, which would act as leverage for the underlying securities. The main function of the SPE is to own and manage real estate and investments.
In creating the LLC, the documents that created the entity would prohibit the entity from voluntarily filing for bankruptcy, or be forced into bankruptcy if the parent firm filed for bankruptcy. The attorney who drafts the organizational documents would prepare a nonconsolidation opinion letter stating that there is no reasonable likelihood of substantive consolidation of the assets of the SPE with those of the parent real estate firm in the event of a bankruptcy.
In the contingent event of a bankruptcy of the parent firm, the LLC would create a “Springing Trust” arrangement with an outside trustee to manage the real estate and the investment assets of the SPE for the benefit of the limited partners.
3. The Form of Securities Issued By The SPE
Real estate investors like the merits of investing in real estate through 3 main forms of securities:
Investors like to lend money to the real estate company in exchange for future interest and repayments of capital, amortized over a finite time horizon.
Investors like to loan money to the company, but also want to participate in capital gains if the underlying properties are sold.
Investors like the upside capital gains of equity ownership, along with the pass-through of tax benefits associated with owning real estate.
The SPE can accommodate all three forms of securities, and can provide the potential investors with a choice of investing in any one security or all three securities. The investors would make their selections at the time they signed the online subscription agreements in the online escrow process.
The revenues from the real estate assets that are transferred to the SPE are used to repay the investors, and to pay for the SPE’s operation and maintenance costs. The parent real estate firm guarantees the payments to the investors, if the real estate revenues are not sufficient to make payments.
One of the reasons why investors like the SPE arrangement is that it provides them a convenient way to invest in the diverse portfolio of real estate assets of the SPE, without incurring the costs of purchasing and operating the individual types of real estate properties.
The first type of security issued by the SPE is categorized as Corporate Senior Debt. The investors who buy the notes receive a security interest in real estate assets of the SPE. The SPE creates the notes as senior securities to all other securities issued by the SPE. The senior securities have the right to priority of payment over the other securities.
The interest rates payable on each note is fixed at the time of issue, and the notes mature in a fixed period of time. In the event of pre-payment of the loan, the investors would be entitled to obtain their pro rata share of the prepayment.
In the event that the entire portfolio of notes is sold to an outside bank, the investors are guaranteed their pro rata share equal to at least 110% of their capital investment.
The second category of securities issued by the SPE is called convertible contingent bonds. The interest and principal payments on the convertible bonds are subordinated to the senior corporate notes, but are senior to the convertible preferred stock issued by the SPE.
The investors in the convertible bonds have a junior secured interest in the real estate assets of the SPE, but have a guarantee of payment by the parent real estate firm. In addition to the guarantee, the parent is obligated to buy and transfer to the SPE, an insurance policy, so that the convertible bonds are both insured and guaranteed.
The interest rate payable on the convertible bonds is fixed at the time of issue, with a fixed conversion price into the authorized but not-issued common shares. The right of conversion is contingent upon a future event, such as the sale of the real estate by the SPE.
The conversion price is based upon the price of the 10% of the capital in the common shares purchased by the general partners when the SPE was created. The conversion price is set at a discount to the common stock, providing an additional layer of security for the holders of the convertible bonds that they would obtain a capital gain upon conversion.
The same rate of conversion for the contingent event applies to the right of redemption of the SPE if the entire portfolio of convertible bonds is sold to an outside bank.
The LLC structure of the SPE allows it to treat interest payments to holders of the convertible bonds as an interest deduction applied against other income that possibly could be generated by the SPE.
The third category of securities issued by the SPE is convertible preferred stock. The holders of the preferred stock have certain rights and preferences over the common stock owned by the general partners bought the 10% of the issued common shares.
The Board of Directors of the SPE can vote to pay dividends to the investors, if there are sufficient revenues, after the payment of interest on the senior notes and on the convertible bonds. The dividend payments could be made in the form of cash, or in the form of shares of authorized but non-issued common stock, at the election of the holder of the preferred stock.
The SPE retains the right of redemption to redeem the preferred stock if the entire portfolio of preferred stock is sold to an outside bank, or if certain underlying real estate assets are sold during the SPE holding period. At the time of redemption, the holders of the preferred would also be required to convert the accrued accumulated stock dividends.
The SPE would be restricted in redemption to the payment of a premium on the conversion, based upon the price per share of the 10% of the common shares the general partners bought. In other words, the initial price per share of the preferreds is established with a “beneficial conversion feature,” that flows through to the conversion price at the time of redemption.
The SPE must always have the full number of shares of common stock potentially issuable on the conversion of the outstanding preferred stock and the convertible bonds. The shares must be reserved out of the SPE's authorized but unissued common stock. When issued on conversion of the preferred stock or the convertible bonds, the shares of common stock should be considered validly issued, fully paid and nonassessable.
Because the LLC is established as a pass-through entity, certain tax benefits would flow through to both the general and limited partners in the LLC who owned the preferred equity.
4. Transferring the Securitized Real Estate Assets to the SPE
The parent real estate company transfers real estate assets from the parent firm to the subsidiary SPE through execution of several different legal documents. The real estate could be office buildings, shopping centers, hotels, or any other type of commercial real estate that generates revenues through leases or operations.
One important legal document associated with the transfer of real estate assets to the SPE is the Indenture Agreement, that defines the legal financial interests in the properties held by investors who buy the SPE securities. The Indenture Agreement also describes the duties and obligations of the parent company for managing the SPE.
The Indenture Agreement makes reference to a related legal document called the Springing Trust, that comes into existence if the parent firm files for bankruptcy. The trustee of the trust, generally an institutional trustee, manages the real estate assets and the investment assets of the SPE, when and if the parent is not able to perform this duty.
The third important legal document related to the transfer of assets by the parent firm is the filing of the Uniform Commercial Code notice that alerts potential creditors of the parent that the underlying real estate have been transferred and pledged as collateral to the SPE. This filing acts as the legal notice to creditors, or potential creditors, that the assets of the SPE are not available to satisfy the parent firm’s debtor obligations.
The attorney who drafts the legal document to transfer the titles and interests in real estate is aiming at a legal concept called “ringfencing” the assets when they are transferred to the SPE. The type of documents used by the attorney to ringfence the assets may vary based upon the type of real estate, and how the title to the real estate had been held by the parent firm.
The main legal goal of the attorney is to show that all the formal legal protocols and procedures had been followed to create a legal separation between the parent and the SPE subsidiary.
In the absence of this formal legal documentation of ringfencing the transfer, the possibility exists that a bankruptcy court could construe the transfer as a secured financing from the parent to the SPE. If the transfer is deemed as a loan, then the securitized assets would remain the property of the parent, and be available to the bankruptcy court.
In making the transfer of real estate assets, the document describe that the parent is also transferring any related financial instruments to the SPE, such as property and casualty insurance that names the SPE as the loss payee. The parent firm is obligated to also name the SPE as the beneficiary of bond payment insurance that insures the future payments of principal and interest on debt of the SPE, if the parent files for bankruptcy.
5. Establishing the Seniority of the SPE Securities
The transfer of real estate interests from the parent to the SPE subsidiary is performed simultaneously with the subordination of the junior securities to the senior securities that are issued by the SPE. The two events, transfer of ownership interests, and security subordination go hand-in-hand because the real estate acts as the collateral for the senior securities.
In the chronology of legal tasks establishing the SPE, the attorney first creates the SPE, then transfers assets to the SPE, then drafts the documents that establish the seniority of the securities, and then drafts the private placement memo for issuing the securities of the SPE.
The documents related to subordination are legal agreements that one set of investors agree not to be paid until the senior security holders have been paid. In an investment risk analysis, the subordinated securities, or junior securities, are more risky than the senior securities, and consequently the subordinated securities are established with higher rates of interest.
While the SPE could possibly have title to just one real estate asset, it is more likely that the SPE would have several different real estate assets and classes of commercial property. In this case of multiple underlying properties in the SPE, the subordination agreements would act like pooled securitization, where the different properties secured the interests of the senior debt.
In establishing the “waterfall” of payment prioities related to subordination, the convertible preferred stock would rank as senior to all classes of common stock in the payment of dividends and the distribution of assets on any liquidation of the company.
6. Guaranteeing and Insuring the Repayment of Loans and Interest Payments to SPE Investors
At the time of the real estate transfer from the parent to the SPE subsidiary, the parent provides a written legal guarantee that investors will obtain their payments in the event that the revenues generated by the real estate are not sufficient to make the payments.
As a part of the guarantee, the parent pledges to use revenues from the other revenues of the parent to make the payments, and to buy and won bond insurance as a back-up in the event the parent does not have sufficient revenues.
7. Reg D or Reg A Crowdfunding To Sell The Securities of The SPE
The attorney who drafts the documents creating the SPE may not be the same attorney who drafts the securities documents related to the selling the securities issued by the SPE. Corporate finance and real estate are different practice areas in law than securities law, and it would be unusual to find an attorney who could draft all sets of legal documents.
Generally, the Reg A offering would be the best idea for a capital raise over $20 million. The legal fees to prepare the Reg A private placement documents would be around $75,000. The marketing and sales costs to sell the securities for a Reg A offering would be about $50,000. The commissions paid to broker/dealers to sell the securities would be between 5% to 10% of the capital raised by the broker.
The Reg D Rule 506(c) offering would be best for a capital raise under $20 million. The legal fees to draft the Reg D offering documents would be about $18,000. The sales and marketing fees of a Reg D offering would be about $15,000.
Unlike the required broker dealer underwriters in a Reg A, in a Reg D, there are 3 selling channels, two of which do not require a broker dealer to sell the securities. If the SPE retains a broker dealer to sell the securities, the fees and commissions paid to the broker would be between 5% to 10% of the capital raised by the broker.
The three selling channels for a Reg D private placement are:
The SPE’s own online, internet-based sales and marketing platform to find investors.
The online crowdfunding profile matching websites.
The use of private placement FINRA broker dealers, who sign a selling agreement with the SPE.
Each selling channel has its own costs and fees and the SPE is free to combine the selling channels to suit its goals in selling the securities. In both the Reg A and Reg D sales effort, the SPE is authorized to make cold calls to prospective investors, send blast emails, conduct internet and traditional radio and television advertising, issue press releases and write articles published in newspapers, magazines, or on the internet.
In addition to legal and marketing fees, the SPE may retain an investment advisor to provide guidance on issuing the securities. The investment advisory fee, paid at closing, would be about 3% of the capital raised.
No matter how prospective investors are identified, in the Reg D private placement, the ultimate sales of all securities issued by the SPE must be made to accredited investors. In the Reg A offering, the investors can either be accredited or non-accredited, with the non-accredited investors providing representations about their income levels and willingness to incur investment risks.
The legal life of the SPE ends when all the securities and all the underlying properties have been sold, or otherwise disposed of.