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How To Price Real Estate Notes Pt.1

How To Price Real Estate Notes Pt.1

Livecast #

4

Take a deep dive with this 5 part series on how to price your offer to purchase distressed mortgage notes.
Transcript

Ron Happe: Okay, we're live. Welcome to the Main Street Capital Partners live cast number four. Today I have Tyler Happe with me. Tyler is a California licensed attorney and also a partner in this business as well as being a partner in a law firm that is here in Sacramento, California. Tyler's very experienced in raising capital, doing SEC regulation law, doing real estate law, contract law and so on. We thought it would be a good idea to just sit down and discuss raising capital because that seems to be a hitch point in the note business for a lot of people and we've gotten a lot of requests that we sit down and talk to you about what we do, how we do it, what Tyler recommends to avoid the pitfalls and everything else. 

A couple announcements first before we get started this morning. We will not be having a live cast next week. I'm going to be gone on vacation, and we will be up and running the following Tuesday. Next week, we will not be on. The second announcement of course is that the disclaimer, this is a live cast for informational and educational purposes only, we're not giving legal advice nor accounting advice, and for that you need to seek your local counsel. Tyler, do you have something to say in the disclaimer also about your part in this?

Tyler Happe: As Ron just mentioned, I'm going to be providing you an overview of how we raise capital and some options on how to raise capital. Questions and concerns can obviously be directed towards my attention. I'm happy to fill those out. To the extent that we have some detailed information that you need and those types of things, it's best to have independent counsel go through and just verify that things are being handled correctly. 

Ron Happe: Great. Let's get started. Now remember, if you have questions, you can type them in the chat box and we will try to answer them. If after the session you have questions, send them to us and we will be happy to address them, and if they're pertinent questions to everybody, we'll bring them up the next time that we get together and answering them then. We've been raising capital for quite some time. We utilize both our own capital and capital from investors and the direction that we're taking or in addition to our business is that we're going to start teaching people how to raise capital and create their own investment funds and then we want to be your back office.

I think it's to our benefit as well as yours to give you as much information as we possibly can on what we've done, some of the things that we've learned and some of the things, probably mistakes that we've made so that you don't have to make them. Now as we go through this, Tyler is very experienced in doing private placements and doing capital raises and private capital and so on. At the same time, while he'll be happy to help you and maybe through his help reduce your legal costs, he's not going to be able to be your attorney. That would be a conflict of interest and we're not trying to set him up as your attorney to do private placements. Please use him as a resource. We'd be very, very happy to help you in any way that we can. 

To get started, let's just start a conversation here about first of all, Tyler if we just wanted to get started in this business and we wanted to raise some capital from friends and relatives, can you give us some insight on how you would go about doing that?

Tyler Happe: I think the first thing that we look at is how do we want to structure the entity. How are we going to raise money? A lot of times when we're talking about real estate investments, people are putting together LLCs, limited partnerships and corporations to do that. They typically work well. Number one is how are we going to structure our entity. The second question is how are we going to make sure that we have the appropriate management, and through LLCs and corporations we can create that. Another way to do it would be through the use of specialized trusts, where we put somebody in charge and through trust documentation, we have some other beneficiaries that are actually the settlers who receive a payout based on however that documentation is put up.

Now once we've got the entity in mind, the next thing is how do we actually raise that capital? There's a couple different ways to do that. When it comes to close family members, oftentimes debt financing works out really well. You can borrow from friends, you can borrow from family, borrowing from friends, IRAs, is definitely a way that works out pretty well. Friends typically have that kind of trust in you. They may or may not need the security interest in the entity itself or the assets that are being purchased, and it gives the investor quite a bit of freedom.

The other option then would be to do equity financing, which would be actually selling the portions of whatever entity is created, be it LLC membership or corporate shares. With friends and family, we're not as concerned with the SEC regulations that are out there that really limit us as small business from going out raising capital. Taking a step back, the reason that raising capital is one of those things that a lot of people try to avoid and end up getting in trouble with is because the SEC has rules and regulations that say you cannot raise funds unless it's registered with the SEC. Now we use these exemptions like Regulation D which a lot of people have heard of, or other private placement types of offerings, if you will. 

When there is a close relationship, when there is family members involved, or when there are friends or business associates that you've got a longstanding relationship with, the need to prove to the SEC that this is a private placement is a little bit less. Your burden of proving that your father-in-law is invested in your company is a little bit less than the burden of proving that somebody outside of your sphere of influence invested in your company and that still is a private placement.

Ron Happe: If I could answer your question here, let's say that my father-in-law did invest in the business and of course I know them and we've had a relationship for a long, long time, but my father-in-law has a friend in let's say Arizona that I don't know, I've never met, but my father-in-law is talking to that friend and says, "Hey, my son-in-law is doing something that you might be interested in," and he turns that person onto us, how would you as an attorney interpret that and how should I handle that relationship with that person?

Tyler Happe: I think in situations like that, it requires then face to face communication and a degree of involvement on that end. A number of communications with that person, if there is any way to get face to face with them so that you can develop that trust, it does help. Now when we start talking about moving up friends of friends and we go a little bit farther than that, what becomes really important is the disclosures that the SEC requires. Putting together good disclosure packages that set forth the investment, set forth expectations, put out all of the risks associated with the investment, all the risks that are associated with the company, the illiquidity of the shares or the ownership interest or the lack of control that a passive investor would have are things that need to have some pretty good discussion.

When we're putting together private placements under Reg D, those are all things that we write down. We put these into a private placement memorandum and we provide that to our investors that are a little bit outside of our typical sphere of influence. What it becomes is it becomes good practice to have something that is a very broad and very detailed disclosure package that you start preparing for just about anybody at this point once you've reached outside of your friends and family.

Ron Happe: We often hear about something called the three touch rule or something like that. Can you give us an idea of if I am talking to somebody that I don't know that I've introduced, all of us go to a lot of networking events and so on, and we may run across somebody that wants to get involved in this, but they wanted to do it passively and they just want to invest some money with us. How do we go about handling something like that where it's a brand new introduction?

Tyler Happe: The brand new introduction, and this idea of the three touch rule is not a hard and fast rule. A lot of SEC attorneys will talk about it as being, okay, once you've had the three touches, then you can be more proactive in your offering of sale or solicitation of an offer to purchase ownership in whatever entity it is. It's not a rule. There's nothing in any SEC documentation that says three touches is enough or three touches is not enough. It really comes down to that relationship. How does it work? It basically boils down to developing a relationship where there is a degree of trust and I guess honesty between the parties so that at some point in the event we're challenged by the SEC, we're able to go back and say we're going to take a step forward here and say we have now sold a certain percentage of the outstanding shares of this company.

We need to be able to go into the SEC and say that our offering of these securities was a private offering. It was not a public offering. We didn't just go to everybody that was at one of these events and say, "Here, I have this for sale." It is one of those things that's very vague and nebulous, and I think that that's the intent of the legislation for it to be something where if it looks like it was a public offering, it's going to be a public offering. That's the thing that we want to avoid. We don't want to have to register these securities with the SEC because that becomes something that's extraordinarily costly and cumbersome and in our industries it just doesn't seem to work very well.

Ron Happe: A lot of times when I'm talking to some people that are interested in raising capital and they're really neophytes or their beginners at it, they're very concerned about the definition of a security and they don't really understand what's a security and what isn't it because almost all the laws are written about selling securities. Now I understand that even a promissory note that I would get from my father-in-law is a security. Can you give us some guidelines on what's a security and is there anything in this business that's not a security?

Tyler Happe: I believe that the SEC extended that intent of being vague and nebulous to its definition of a security. Securities do encompass pretty much anything and everything that we deal with in our industry. Obviously stocks of company, shares or membership interest in LLCs, the limited partnership interest and the limited partnership. In fact, promissory notes can and oftentimes are securities. Now what a security is, how I've tried to interpret it is if there are two people involved in a business and one person is the management and another person is the funds, the person who has the funds, that money part of it where they're not involved in the ownership or in the operation or management of the company, that's kind of where that security definition comes into play.

Really the idea of if there is a distinction between ownership and control, we end up with a security. Now there are a plethora of exemptions to the definition of security, and in some cases promissory notes secured by real estate fall outside of that definition. At the end of the day, we are playing with this definition that encompasses a lot of what were dealing with in our industry.

Ron Happe: I think from our perspective, we've always said lets err on the side of safe. We don't want to be surprised at some point where the SEC comes to us and says that is a security when we were under the assumption that it wasn't. We're basically treating everything that we do as a security, and we're very, very careful in doing all of that. Even if you're just raising money from a friend or relative that you've known for all your life, you probably should treat that participation from that person as a security. Now let's just broaden our talk a little bit about Regulation D that you pointed out. Now my understanding is that Regulation D is a regulation that allows us to work outside of getting securities exchange that we don't have to get approval from them to do it, that we can do it outside of the Securities and Exchange Commission. 

Can you go through the different Regulation Ds that are available to us that we can use to raise capital and how we have to go about it?

Tyler Happe: Absolutely. It starts with the Securities Act, which has a couple rules and one of them says every security must be registered unless it's a private offering. The definition of a private offering is an offering that is not public. We end up with this circular definition at that point. What the SEC has done is they created this scheme, Regulation D, which we've heard of, which is one of the ways that we can avoid that registration of the securities. Regulation D has four main rules to it. It's actually got I guess six rules, but four of them are the rules that we really care about when it comes to deciding how we're going to raise funds, and those are rules 506, 505 and 504. 

Rule 504 allows you to raise $1 million. There is no advertising allowed. There is no limitation on who can invest, but the concerns aren't there as much. If you're raising less than $1 million and you're going to do a 504 offering, your disclosure requirements are a little bit less. Rule 505 allows you to raise up to $5 million. Now there's a limitation on the number of people, be it accredited or nonaccredited, that can invest, and you have this stepped up disclosure requirement. Rule 506, there's actually two parts. There's 505b, which is kind of what we've done in the past, which provides for an unlimited amount of capital being raised, but we can only have 35 nonaccredited investors. We can have as many accredited investors as allowed, but only 35 nonaccredited investors in that fund, if you will. 

The disclosure requirements are fairly significant and that's where rules 501 and 502 come in. They actually tell you what you need to put forth in your private placement memorandum. It's effectively the same thing you would have to put into a registration statement with the SEC. However, it doesn't get filed with the SEC or approved by the SEC, it just is there for your safekeeping. The new rule in 2014 is this 506c, which allows for some advertising. Now 506c is something that, it's still very new. I don't know exactly how it's going to play out. It's not one of the schemes that I've dealt a lot with, and the reason being is that though you have the ability to advertise, those advertisements have to be given to the SEC. 

Maybe not so much approved, but at least filed with the SEC, and then the number of nonaccredited investors at the end of the day, if you're under 506c, you can sell to an unlimited number of accredited investors but absolutely none of your purchasers can be nonaccredited. 

Ron Happe: Can you identify, before we go any further, what exactly is an accredited and a nonaccredited investor so that we have a clear understanding of who we can go to and who we cannot?

Tyler Happe: Yeah, an accredited investor is somebody who, there's income thresholds or asset thresholds. An accredited investor is a person who makes over $250,000 per year for the last two years or $300,000 as a husband and wife or spouses, or they have a net worth of over $1 million. That excludes your primary residence. Now one of the things that is calculated in that calculation of net worth however is any upside down equity that you have in your primary residence. If your house is worth $1 million and you owe $1,200,000, that $200,000 actually counts against whatever your net worth is.

Ron Happe: All right. I know that when this Jobs Act took effect, and I think it was July 1st possibly or maybe January 1st, I'm really not sure of the date that it took effect, it made advertising allowable, but you had to have an accredited investor. In the past, if we were doing a raise and we needed to have accredited investor, it was a simple matter of having the investor fill out a statement that says, "I am accredited investor. I have either a net worth of $1 million or I have an income of $250,000 a year," and that was that. However, those laws changed too and can you take us through what we have to do now if we're going to raise money from an accredited investor?

Tyler Happe: Absolutely. Exactly as you're saying, prior to this new Jobs Act, and even under the current 506b, the determination of accredited investor is left to the investor himself. We have them fill out an offering questionnaire, which sets forth their knowledge in investing in these types of investments and their net worth. Now under the 506c scheme where we're allowed to do some advertising, we have a higher threshold to meet to determine that it is an accredited investor, and that actually requires the issuer being the company that the people are investing in, looking into the either tax returns or getting a statement from the investor's attorney or CPA verifying that that person is in fact accredited. We as issuers can no longer lie on the investor saying, "I'm accredited," it has to be verified by an independent party effectively.

One other thing that I forgot to mention about rules 504, 505 and 506 is that there is also the definition of a sophisticated investor. In 505 and 506, all of the investors still have o be sophisticated. Sophisticated is more not net worth based, it's knowledge based. If it's somebody that has invested in promissory notes before or somebody that's done some private placement investing before, somebody that's maybe owned some businesses or invested in a lot of day trading or stocks or something like that. That gets them up to that sophisticated investor threshold. If we're looking at somebody who maybe is in a nursing home, and they've got $900,000 net worth, they're not an accredited investor because they don't have that net worth, they may not still be allowed to invest in one of our entities because they might not have the knowledge base, they might not be that sophisticated investors. 

That's just something that our offering questionnaire, and a lot of offering questionnaires also ask is give me some details. Prove to me that you understand finance, you understand investing, you understand real estate enough so that, again, we can go to the SEC and say, "Yes, this person understood what they were doing. They knew how this program operates."

Ron Happe: I guess that all of this really matters if something were to happen and somebody would be upset. I think the big point is if I'm not mistaken, get your input on this that now where before we relied on the investors to tell us whether they were accredited or not accredited, and if they were accredited, if they signed that said that they were accredited, then we pretty much done our duty and there was not much that they could say about us taking advantage of them at some point, but today them just saying it's not enough. We actually have to verify that they are accredited, and if we don't then we could be in for some trouble down the road. Is that correct?

Tyler Happe: Yeah, absolutely. If we actually end up issuing securities and don't have a registration statement and it turns out that we've run afoul of a couple things, being the accredited investor limitations or it becomes a public offering, then the SEC's going to get involved and it's not going to be fun for anybody. What we are always doing at this point is trying to stay as cautious as possible, putting together very detailed private placement memorandums, independently verifying statements about somebody's accredited status, and making sure that even if we have some technicality that takes us outside of our Regulation D offering, our private placement Regulation D, we can still fall back on the SEC's rules that this was a private placement.

That goes back to we just want to make sure that all of our I's are dotted and our T's are crossed because of the entities that we don't want to be on the wrong side of, the SEC is certainly one of them.

Ron Happe: The thing that intrigues me now is our ability to advertise if we are going to just use accredited investors, and I've heard a lot about crowdfunding lately. Can you give us an idea about what crowdfunding is? When I first heard of crowdfunding, I thought it was to go out and raise $100 from this person and $200 from that person, and raise small amounts of money, but now I'm seeing where there's actually crowdfunding to go out and raise $1 million. I just wanted to get an idea and maybe share those ideas on what crowdfunding is and what are our limitations on using crowdfunding?

Tyler Happe: Crowdfunding is a new beast. We've heard about it in the past with things where there was actually a good being sold. I think that's how it's sidestepped the SEC. The idea behind crowdfunding, again, is getting a bunch of smaller investments. Crowdfunding itself was allowed by this new Jobs Act for equity securities, so crowdfunding to invest in securities. How it works now is we have these regulations that require there to be a platform that is registered with the SEC and then going through that platform, going out and raising a bunch of money from a whole slew of people, however the case may be. It provides a very interesting and unique opportunity, and there are some companies out there that are doing it, but the initial infrastructure I think might be a little bit cost prohibitive if it's just going to be a single $1 million trench being invested. 

It requires more of an ongoing series of things because there is still a part of this project that does have to I guess surrender to the oversight of the SEC for reporting and for disclosure purposes.

Ron Happe: I think if you could just give me a little information about if I wanted to go out and raise some money to invest in notes and I wanted to be sure that I was in safe harbor, advise me on how to go about it.

Tyler Happe: I think the first thing that we do is we sit down with our attorneys and accountants and we tell them what we want to do. The idea here, number one, is we create an entity. The entity decision is going to depend on local laws wherever you're going to be incorporated and taxation, how you want that to be taxed. Then we're going to decide how we want those funds or the income to be distributed amongst the management shares versus the investor shares or those active managers versus the passive investors. Creating the entity and then drafting up those initial documents.

Now oftentimes in our practices, we'll start an LLC and create an operating agreement that has two classes of shares. Those two classes of shares then becoming the controlling management side and then the investors side. After we have the entity created and the whole time that we're working on that creation is we're putting together a private placement memorandum, and that private placement memorandum is going to have all of the disclosures. It's going to talk about the managers, it's going to talk about their experience, their relationship to this company and their relationships to other companies. It's going to talk about how people are paid. It's going to talk about the risks involved in notes and the risks involved in notes as we know are pretty high.

There are options. There are ways to make good money in this business, but there are also ways to lose the security in the note or whatever the case may be. Those are all going to be disclosed in that private placement memorandum. Once all that stuff is finalized, then we can start rolling it out and making these presentations to our close friends or the people that we've got that we have a couple touches with. Then once we've sold a security, we register with the, or we don't register with the SEC, we file what's called a Form D with the SEC, which is a form that talks about how people were paid, what the money is going for and those types of things so that the SEC has knowledge that this was a sale of securities and that the intent behind this sale of securities was for it to be under Regulation D and for it to be a private placement.

Ron Happe: We still are involved with the SEC no matter if we're operating under Regulation D or not. Is it possible Tyler for us to share with people a private placement memorandum that's been done for us that you've done so that they can just what one looks like? Certainly they would need their own attorney to do it for them, but this may help their attorney also that's maybe never done one before, and I'm sure that a lot of people that are on today have never ever done one, maybe never ever seen one. Is that possible?

Tyler Happe: Yeah, I think that that's something that can be shared. Of course, it does require sitting down with the attorneys with the document that we can share with you and saying, "Here's how somebody else has done it." One of the things about this SEC, about the Regulation D, about the law in general is that we are all individual attorneys with our own individual opinions. A lot of times there's going to be some minor differences. I won't take offense if I share something with you and your attorney says that, "Hey, I think that this should have been done a little bit differently." That's just how my industry works. 

I'd be happy to share that information and at least point people into a right direction to see where things go.

Ron Happe: That's one thing that I think would be very beneficial is that you can at least see what a private placement memorandum and an operating agreement look like. I will say that every one that we've done, and we've done a number of them, Tyler has done of course, and they have all been reviewed by the investors attorneys. There's been a lot of looking at these documents, so we're pretty comfortable that we have a good one, but your attorney certainly may make a suggestion to change it. The most important thing is that you seek local counsel, somebody that's done this or is interesting in this kind of work, and have them take you through it so that you cover all the bases and before you actually go out there and raise money. 

If anybody is interested in seeing a private placement memorandum, just send it to the email at info@mscpinc.com, and we'll email it back to you. We'd be happy to share that with you. Tyler, do you have any more input that you would like to give before we close this up?

Tyler Happe: Yeah, I think that the one thing that a lot of people forget about is we try so hard to avoid this registration with the SEC, but at the end of the day there are issues with securities and the SEC can and may get involved. The number one thing to think about is that when we're putting together disclosure statements and when we're talking to potential investors, when we're talking to anybody like that, we need to be completely honest. Honest with experience, honest with projections and those types of things because under the SEC regulations, any false statement is in fact fraud. There doesn't have to be the intent for fraud or anything like that.

All that is is we just need to make sure that we're honest. Putting together the documents helps us do that, but even just chitchatting with people about it, making sure that we're not making any false statements I think is paramount.

Ron Happe: Okay. I think we'd be open to answering any questions that you may have if you want to contact us. I think that the opportunities in this business are still huge. The more capital you have of course, the better job that you can do, the better prices you can get when you're purchasing, the more astute you become in your investments, the more that you make. We love this business. If we can be of any assistance at all in helping you raise money, we'd be more than happy to do that. Again, next week we are not going to be here. We'll be here the following week. Thank you for attending. We look forward to hearing from you and looking forward to seeing you again next week. Thanks a lot. Take care. 

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