Signs are pointing to big opportunities, so position yourself to take action when investing in real estate. However, avoid mistakes that put you in the ‘big house’ wearing an orange jumpsuit. For example, do you know how to put together an operating agreement to buy an apartment complex? Today, Clint Coons of Anderson Business Advisors talks to Dugan Kelley, a securities attorney and co-founder of Kelley Clarke, PC. As chairman of the firm’s securities and real estate practice group, Dugan assists clients in all phases of multifamily, commercial, and residential acquisitions and sales. Also, Dugan serves as a mediator for other attorneys or settlement counsel for complex litigation matters that require unique solutions.
Highlights/Topics:
- Should you partner with friends/family on real estate investments? Manage expectations. Anytime you take money from someone, they expect a return on that investment.
- What’s the difference between raising capital as a security versus a capital contribution? There’s no friends or family exemption to securities. Contributing equal shares is a joint venture and involves an active role in buying/managing the entity/asset.
- What are the penalties for legal mistakes? Avoid being cheap by taking short-cuts on the legal side. There’s potential for severe/massive fines, penalties, and criminal charges.
- What is the purpose of a Private Placement Memorandum? Protect yourself as a sponsor or syndicator and your investors by identifying potential real estate risks.
- When and who should create a Letter of Intent (LOI)? After a property is under contract and through your entity, not your individual name.
- When should new operators/investors call a securities attorney? After conducting due diligence to determine the possibility to raise capital on property.
- What information needs to be provided to the securities attorney to set up a syndication or transfer entity to start raising capital? LOI and Private Placement Memorandum.
- Is public registration necessary for private placement offerings? Two exemptions: 506b (pre-existing, substantive relationships) or 506c (restricted to accredited investors).
- Should an individual manager create a separate entity to be responsible for the debts and obligations of the syndicated entity? Anybody can be sued for anything. Securities is not something that you want to mess with—cover your assets.
- How to vet deals and investors by identifying red flags? Know what you are buying, your rights and obligations, and who gets paid what and when.
Resources
Kelley Clarke, PLLC: Legal Services
U.S. Securities and Exchange Commission (SEC)
Anderson Advisors Tax and Asset Protection Event
Full Episode Transcript
Clint: Welcome, everyone. Hi, it’s Clint Coons here with Anderson Business Advisors and this is another episode of our podcast. When I started going into this podcast, I was thinking about a topic that is relevant, that is on everyone’s mind right now or a lot of people’s mind who invests in real estate. This matter came up when I was dealing with a client that has to do with putting together an operating agreement where they are going to go out and buy an apartment complex and they’re going to bring in investors.
You’ve all heard about that. Everybody talks about the potential there, but let’s face it. With what’s going on right on in our society, in the United States, most real estate investors can agree that there are going to be some opportunities out there that if you’re a serious real estate investor, you can see the signs and you have to be positioning yourself to make sure that when those opportunities present themselves, you’re ready to take action.
Many times that means putting together the right operating agreements or right documents, corporations, LLCs. Let’s say if you’re buying single-family homes, you heard me talking about land trusts before, limited liability companies, but if you’re going to go bigger. A lot of people want to get that economies of scale, you can make more cash, now you’re going to move into a different realm. When you go big and you start working with other people, it’s no longer, you make a mistake, you just lose the asset. Now you make a mistake, they cannot possibly throw an orange jumpsuit on you and you get to live in a big house for a while. We don’t want to see that happen to you.
That’s why in this episode, what we’re going to do is bring on a good friend of mine, Dugan Kelley of Kelley Clarke PC, who is a securities attorney. They do the whole gamut; they help people set up the right docs, they handle the transactional side, as well as putting these together. He has over 20 years of experience. When I first ran into him, it was through an introduction from other individuals in the space that are buying properties and syndicating, “This is the expert, Clint. You got to meet this guy. He knows what he’s doing.” I thought, perfect. Let’s bring him on. With that, Dugan, how are you doing?
Dugan: I’m good, Clint. Thanks for having me. Hey, everybody, glad to be here.
Clint: That’s great. Just so everyone knows, you’re down in Texas. You’re right outside of Dallas?
Dugan: Yeah. We have brick and mortar offices in the Dallas Fort Worth area. We’re in what we call North Texas quarter. We’re up here on the edge of Frisco, Texas where new cowboys practice facility is built by Jerry Jones out here. The other location is in Santa Barbara, California.
Clint: Yeah. Santa Barbara’s a beautiful area. If I had a ton of money, I wouldn’t mind having a second home there.
Dugan: It is definitely beautiful. It is like an adult Disneyland for people for properties and everything.
Clint: Yeah. And there’s a great wine. The Pinots up there is phenomenal.
Dugan: For sure, absolutely.
Clint: When it comes to this type of investing, you have a tremendous amount of expertise. You work with real estate investors all over the country. I’d like to start off, is just laying the groundwork for people because it happens so much in what I do that an individual will call me up and they’ll say, “Listen, I want to go out and I’m going to buy this piece of property, but I’m going to bring in a few friends and we’re going to joint venture on it.” There’s this gray area. People always want to win this and go beyond, just a little partnership amongst friends and it becomes something more than you have to use someone like you. What would you say to that?
Dugan: Yeah. That’s a great question. I get asked about it a lot, as I know that you do from people throughout the country that are looking to invest in real estate or are looking to essentially figure out how to buy an apartment building or something more than just with their own money. The rule of thumb is that at any time that you’re taking money from someone and they are expecting a return on that money.
In other words, they’re not going to share in the downside or necessarily have any obligations in the entity that owns and operates the asset, and your purpose is essentially to raise capital. Meaning, if you’re asking somebody for money, they are expecting a return on that investment and you’re raising capital, that is a security. Unfortunately, there’s no friends and family exemption, there is no I got money from my dad or my mom, so, therefore, it’s not a security. It doesn’t matter if you call it a joint venture or anything else that is a security.
That is different than if you and your two buddies went and said, “Hey, I found a dry cleaner we want to buy and the purchase price is $200,000. Each of us is going to contribute an equal share to buy that dry cleaner’s business.” That’s a true joint venture. Small enough so that you and your buddies can use your own money and you’re going to have an active role in the entity and managing that business, then you can avoid this whole issue of securities. But if the person that you’re taking the money from in order to buy the asset is expecting a return of that capital, that is a security and you really need to raise that money, that equity in order to acquire that asset through what we call a private placement memorandum procedure.
Clint: I’ve always looked at it that way when I meet real estate investors that want to do this and they’re just going to work with maybe four or five guys that they know. I always say, “Well, listen, you got to make sure that everyone’s a manager.” Is that what I’m hearing from you? The way to get out of this context of it’s just a few people together, just give everyone, make them a manager in the LLC, and be done with it?
Dugan: Simplistically yes, but they can’t simply be camouflaged. If it smells like a security, if it looks like one, and if somebody reading the operating agreement of the LLC couldn’t tell what each of the parties that owned the members of that LLC or the managers are actually going to be doing, and in practice, if they’re not really doing anything, then I would say you’re running the risk potential of engaging in securities without or any of the protections afforded to you that you get through that private placement procedure.
In general, yeah. If there are two or three friends and each of them want to put their money in and essentially buy their equity through capital contributions, they are not expecting any particular rate of return, they’re just going to share in the profits through distributions, there is no reason that they need to go through the process of syndication or the process of selling those interest to private investors.
Clint: But they still have to manage though, right? Is that correct?
Dugan: They still have to manage, they still have to have control, they still have to have a role than here’s my money. It really has to pass that smell test.
Clint: Real estate investors sometimes can be cheap when it comes to the legal side because LegalZoom and all these other internet places make it seem like just throw this together and you’re good to go. You’re protected. But in this area, more so than anything else, if you screw this up, what are the penalties? What could they be?
Dugan: It’s really shortsighted for people—as I’m sure that you see in your business—to take short cuts. There are all these things […] 2in a box that you see pop up on the internet, the next greatest template that people want to use or whatever. The reality is that you do so at your own peril. The peril can be significant, it can be massive. You can have fines levied against you by the Securities and Exchange Commission or other regulatory bodies, the State Securities Board in which you’re operating. You could be precluded in doing any other private offerings for the balance of your life. Your name could go essentially on a watch list for a no-fly list post supposedly on not being able to do business and raise capital.
Worst-case scenario, if you’re habitually about this or you’re intentional, depending on what the actions are that you do, you theoretically could face criminal penalties. Securities are not something you want to mess around with. It’s not something that I would ever advise my family, my friends, my wife, my sisters, even my children when they get older to do by simply doing some sort of template that they purchase over the internet. You really want to have a trusted team member come alongside you that you can work with, to make sure that your offering is compliant and that in the event that there are changes needed that you can do that.
You’ve hit the nail on the head, Clint. It’s really not a situation where you want to mess around in a chance that you’re going to be able to get through this without any problems on the backside. Because the problems are so massive, you never want to risk it.
Clint: Any real estate investor has experienced at some point in time—an experienced investor that is—an investment goes down and you can potentially lose money on it. But the problem that I try to explain to people is that in this context, when you’re working with third parties, you think, I’m just working with Joe. No. You’re working with Joe, yes, but you’re also working with his wife. If you lose money on this deal and that was the college fund that they’d set aside for their son that he thought he was going to invest with you and double his money and you lose it, that wife is going to be out for a bear. In that situation, people think the entity will protect me. This is a situation where the attorney is going to come and he is going to sue your assets off because the entity is not going to protect you.
Dugan: You’re right. You’re absolutely right. Those provisions in the operating agreement that may have defense or indemnity obligations, what happens if the entity itself has no assets? What if they claim alter ego liability, or they try to get to your personal assets involved in the entity? It’s really not something that you can mess around with.
Remember, the purpose of the private placement memorandum, in large part, one of the huge factors is for your protection, it’s for both. It’s for both to inform the investors of the potential risks associated with […] in this particular commercial real estate asset, but it’s also equally important for the sponsor or their syndicator—the person bringing that deal to the private market to protect them, their assets, and their family. You don’t really want to take shortcuts. It’s so shortsighted when people take shortcuts in connection with securities offerings.
Clint: One of the things that I often tell people is, you should get an entity set up before you go out and make your offer. You have that entity available, so if it’s possible you could take the title in the name of the entity, make the offer in the name of the entity, you do that. From a security standpoint, if I were considering moving to that next level because I see there are opportunities here and I want to ask you a little bit about that as well in a moment, but if I see that coming down in the next month and a half and I want to start doing these types of deals, when should I start exploring setting up something like this type of structure? After I’ve got the property under contract or is it beforehand?
Dugan: I’m a big believer, Clint, just like you are in that if you’re going to be in the real estate space and you’re going to be buying and selling real property, you need to do it not for your individual name. You need to be doing that through your own entity. Ideally, in a perfect world, you have your own entity that’s already set up, that is […] letters of intent. Those commercial real estate brokers that you’re developing relationships with, you’re firing out LOIs under your entity’s name.
When you have an LOI that’s accepted and you enter into that purchase and sale agreement, the key is really, your entity or it assigns. Remember, the entity that ultimately will be the borrower that you will raise capital out of, that will ultimately be the owner of the asset, and that you will sell off to passive investors. It’s an entity that is created after you get a property under contract and your entity assigns, meaning, it transfers ownership of the purchase and sale agreement to that entity.
That is the most common way in which these deals are structured. But it’s never really advisable for somebody in their individual name to go out and put a property under contract and then start to create entities because you already have that contingent liability that exists because you’ve already put something under contract in your own name. And now you’re trying to paper it up on the backside. Whereas on the front side, what we want you to do is put the property under contract in your own entity, hence […] be that you own, control, and then after you’ve kicked the tires on the wheel and you decided that you’re really going to […] for it.
That’s the point that you will engage a securities attorney. If you know that you get into due diligence, you see that the property has foundation problems or whatever it is, the service contracts are too expensive, or there are exceptions on the title policy that are prohibitive to meet your business plan or proforma for potential investors, then you would not want to incur the cost or fees associated with hiring a securities attorney before that. It doesn’t make any sense. You’ll be basically wasting money.
You want to be able to know that you have enough due diligence to know that you are going to go for it, you’re going to try to acquire this and you’re going to raise equity. Before you start raising equity, before you start taking money from investors, you need to have your entity that you’re going to syndicate up, means to be live, and your offering needs to go live. I tell clients, “Do not take somebody’s money. Do not take their money into your entity or into your own bank account unless you’re doing it through the entity that is ready to be syndicated unless your offering is live and all of your documents are in order.”
Clint: There are a couple of things there that I want to go a little deeper on. I have an entity, just an LLC set up. What you said was make the offer. I talk about this all the time. I say and/or designated entity or you said and/or assigns. In a commercial context, that’s fine because they expect this to happen on a commercial property that you will typically assign it over to that ultimate closing entity that you’re going to take title in.
But how long does it take? I mean, if I have this property, I get passed my due diligence, my money has gone hard, and let’s say they have a 60-day closing set up after that. How do I thread the needle and get this entity set up, the PPM, the LLC that’s going to hold the title? I lend in and bring all that together. Is that enough time? What should I tell people?
Dugan: Most syndications or private placement offerings throughout the United States, the typical raise period on a commercial period on a commercial asset is anywhere between, 30, 45 days, 60 days to be a lengthy raise. I […] tell clients, “Listen, you’ve gotten a property under contract. It’s not like you’re calling up your attorney cold and saying, ‘I need all of these in 24 hours.’ Typically, the turnaround you should expect somewhere in the neighborhood of a week from the moment that you tell your securities attorney, ‘Go, get me a draft. I want something. I want to go live, I want to start raising capital.’” That process typically should be a week, maybe sooner so that you maximize the time that you have in order to raise.
I have lots of clients that they know going into it. If their LOI is accepted, they’re off to the races because they know they’re going to go for it, they know they’re going to acquire the property so they’re not going to wait. But for most new operators or people that would like to scale up, get a larger acquisition and use other people’s money to do that, they need to get through some portion of due diligence in order to really determine if this property is something that you could raise capital on.
At that moment, when you decide that or whenever that is for you is the moment that you should call a securities attorney and say, “What information do you need from me, Mr. Securities Attorney, in order to set up the entity that I’m going to syndicate or that’s going to ultimately own this? How do we transfer this from my entity that has this under contract to that entity? And how do I get my hands on those documents, the private placement memorandum in order to start raising capital?” It’s not a one-size-fits-all for a client, it’s really a what is your situation, what does the deal look like and are you really prepared to go for it?
Clint: Let’s say I haven’t found a property yet. Can I start having conversations with people, like my friends […], I’m looking to do one of these deals, who might be interested in coming in if I find something like this? Is that acceptable or not?
Dugan: Very common for people to speak with people that they know, like, and trust. Most of these syndications that take place are what we call private placement offerings under Reg D and there are the two big exemptions from public registration of your private offering are either a 506(b) offering or a 506(c) offering.
Most people in the United States are still doing 506(b) offerings. What that is that means that it’s everyone that you have a pre-existing substantive relationship with. It is not uncommon for people to tell people, “Hey, I just started an entity. I have a property under contract. I’m thinking about raising capital. I know that we’ve been friends for a long time. I know that you’re interested in investing in real estate. If I were to think about raising capital on this thing, would you be interested?” Those types of conversations, that’s fine.
But I would not blast […] because these are securities. You cannot publicly solicit investors to invest in your deal unless you’re going to do what we call a 506(c) offering. But the downside for people that do 506(c) offerings are you’re restricted to accredited investors only. If you want to blast your offering out via social media—Instagram, LinkedIn, Facebook—put it on a billboard, put it on radio, whatever you want to do as long as it’s not fraudulent, it’s accurate, transparent, authentic. If you intend to do that, then you’re restricting yourself to accredited investors only.
Think about that, though. If the vast majority of investors in the United States and people, in general, are not accredited investors, that means that the likelihood of your Rolodex and anyone else that is your partner on that deal, their Rolodex is filled with people that are likely not accredited investors. An accredited investor is someone most typically whose net worth is something north of a million dollars, backing up the value of their primary residence or they have made $200,000 in the past 2 years or $300,000 with their spouse’ income and with a reasonable expectation of making that same amount in the future. That is a set criterion. It’s not a fuzzy slide rule that you can move up and down, it’s set.
If your Rolodex is not filled with those types of individuals, then I would tell you, you do not want to engage in pushing things out on social media to people. It is not an improper solicitation to talk to people that you know, like, and trust, people that you have a pre-existing substantive relationship with.
Think about this: the vast majority of people that invest in real estate, they invest with people they know, like, and trust. You’re not investing a large part in seeing some offering on a bus bench, or listening to it on the radio, or seeing it in the sky by some plane that wrote something. That’s not how people invest, they’re not investing. The conversion of stranger investor to actual investor in large part in the United States does not take place through advertisements.
Unless you have a large social media following like a Grant Cardone or eyeballs are always on you day in, day out and you can push something out with a tweet or something and you’ve got tons of action, the reality is, most people, even seasoned syndicators, I’m talking about people that are doing massive deals, they’re still doing 506(b) offerings. Which means they’re not advertising, they know that they’re not going to convert a stranger investor to potential investor, and they’re only engaging in raising capital inside of the people that they actually have that pre-existing substantive relationship with.
Clint: So, what you mean there is it’s okay to talk to people, but you can’t get any money from them until you have all the documents in place to cover your ass.
Dugan: That’s right. Absolutely.
Clint: If I was going to be an operator, if I was going to put this together, then if I wanted to manage the investment, since I’m going to be the one buying and finding the property, can I have a separate entity manage it or does it have to be everything run through the syndication that was created by the LLC to own it?
Dugan: No. That’s a great question. In fact, most common structures of the syndication, the sponsor or syndicator forms their own entity to manage that entity that owns the asset. In other words, it’s not advisable for you to be an individual manager. Even though the operating agreement says that you as individual manager are not responsible for the debts and obligations of the entity, the reality is, where Clint never had talked to that, anybody can be sued for anything.
This is America. God bless us, but the reality is, you don’t want to be individually managing the entity that is syndicated. You want to operate if you’re going to be the manager, oftentimes the sponsor, the person that finds the deal, that gets it under contract […] as well. Makes sense. You’re going to stay with the asset through the life cycle, you’re the one that’s raising the capital, you’re the one that’s forming the entity that’s going to be sold off to investors that’s ultimately going to be the borrower, that signs the loan docs, that gets the loan proceeds in order to acquire the keys to the asset. That person is not doing that through their individual capacity, they’re often doing it through a separate entity. That is the manager of the LLC.
The most common structure that you’re going to see for syndicated commercial real estate assets around the country are manager-managed limited liability companies. The limited liability company that will own the apartment building, that is a manager-managed LLC. What do you think the manager is? The manager is another entity. That other entity is often an entity that is owned and controlled by the sponsor or the syndicator. All of that stuff has to be set up.
Remember, these are best practices. I see people do things that are crazy all the time. But they’ve often decided that they are going to just risk it. Many people that ask for help at the 11th hour, unfortunately, they die at 10:30. The reality is, you’re going to get sued at 10:30, and at the 11th hour, you’re going to ask for help. Often, it’s too late to help, or at that point, we’re just bringing our dumpster along and sweeping as much of it into it as possible.
What we want to do is we want to make sure that your entities are up, that you’re protected, that you understand the structure because you’re going to be essentially raising capital from people that you have this pre-existing relationship with that you’re going to be able to explain it to them.
You want to be able to do all of that in a timely manner because remember, like Clint said, you’re going to have a very short time frame within which to do all this stuff. You get a property under contract and the likelihood is, the seller is going to have an expectation that you close within 60 days or sooner. And while you’re dealing with the seller, the lender is pressing on you for items because you’re raising debt. Most people are syndicating equity, meaning they’re raising the capital necessary for the downpayment in order to get that loan to buy the apartment building or the commercial real estate asset.
You’re doing all of these things. It’s often confusing, it can seem overwhelming. That’s why you want to have a good team around you to make sure that your structure is sound and that you’re compliant at all times.
Clint: Just yesterday, one of my clients sent me over for the syndication that he’s going to be investing in, the attorney that put together the operating agreement, I don’t know if this is his specialty. I don’t think it is because I’m reading through it, it’s member-managed. As you just described, they’re always manager-managed typically.
But this is member-managed and they said the managing member. I thought, if they’re all members, how you’re going to sign out one managing member because it references the statute and the statute said if it’s member-managed and all the members have authority over the entity. They’re trying to do this weird hybrid structure and I was going through it and I was just, “Okay. We got issues here, we got issues here, it doesn’t address this if you’re going to refinance the property.”
If you know what to look for, you can spot these issues. If I’m an investor like my client is, they don’t have access to someone like myself or you. They’re listening in on this podcast. What are some of the red flags? Let’s take the other side now. If somebody wants you to invest in their syndication, you get these documents, what should I be looking at and say, all right, this doesn’t pass the smell test. I’m sure you’ve seen it.
Dugan: Oh yeah. We vet deals as you do for passive investors throughout the United States and we often get offering docs or the investor likes the deal. They like the asset, but they don’t know what to look for. Many of these private placement memorandums are a couple of hundred pages long, maybe even longer.
There are a couple of key things that you always want to look for. One is, what am I buying, and is it the market in which I expect? You would think it’s basic common sense, but if you don’t look at the details, often you can miss it. What am I buying? And then two, what are my rights and obligations? Meaning, I know you want my money, but at what point do I get my money back? Those are preferred returns. What is that waterfall? You might have heard that word waterfall or plan of distribution? Who gets paid? What? And when?
Those are key things that are going to be set forth and both the offering, meaning your PPM, as well as the operating agreement or the limited partnership agreement. Remember, once an offering closes or the acquisition of the property actually consummated, the PPM gets thrown in the trash in many cases because the only governing document that exists between passive investors and the sponsors or the managers of these things is the operating agreement.
Clint’s actually right. You’re looking at the operating agreement to see who gets paid what and when and how long. What’s the exit strategy? I don’t know too many of my investor clients that are going to want to give you capital so that you can buy an asset and that they never get a return on a timely basis. What’s the exit strategy? All of this needs to be laid out in the operating agreement. If it’s not there, it’s a major red flag.
We’re in a time right now where there’s a lot of unrealistic fear in the commercial real estate space. I got passive investors calling me saying, “What happens if there’s a cash call? And what are my obligations? Do I have to give them more money even if I don’t want to give them more money? What happens if I don’t give them more money? All of those things, if they’re not set forth in the operating agreement, that’s kind of a red flag.
Just this deal that you just got presented with, that somebody says they are a member-managed LLC, my first question will be that’s not going to get through underwriting. Meaning the lender is not even going to allow that. The lender likely is not going to loan millions of dollars—depending on the size of the acquisition—to an entity that is member-managed because the lender doesn’t want to deal with 50 passive investors, 50 members, 100 members, or 150 members.
Remember, the lender is going to want to have a uniform one voice, that’s why the lender and the people that are seasoned commercial real estate professionals on the legal side are setting these entities up in large part to be manager-managed so that the lender can actually yell at one person, or two people, or their entities. They don’t want to talk to all of the members that have to give you capital. They want to know who they are and how much capital they have in the deal.
Remember, the lender has the most at risk because you’re using the bank’s money, depending on the leverage meaning the amount that you’re able to borrow, the bank could have 80% skin in the game and your passive investors may have many 20% skin in the game. Who do you think has the bigger stick in that scenario? It’s the lender. Not even the investor. If I see those things, those are red flags.
It’s very difficult. It’s very, very difficult for an investor or even somebody as seasoned as Clint, for Clint to go back to the attorney that has prepared those documents and demand changes. Why? Because those documents have been shotgunned out to hundreds if not more people. All the people in the Rolodex of the sponsors and for them to begin to make changes, it has a ripple effect.
You want to make sure that your documents or entities you set up correctly ahead of time and […] because of the chances if you as a passive investor, one investor, being able to dictate changes in the syndication or the offering docs are very low. Very, very low.
Clint: I always tell people if you see the docs and these docs that I was looking at are more deficient than that, they didn’t even address the sale of the property, the refinancing, except there was one clause that stated if the property’s refinanced, then the company can redeem all the member’s interest for a dollar.
Dugan: Oh, wow.
Clint: Yeah. I was just shocked. My client said, “Because […] some language maybe that should be in there.” I said, “Why do you even want to go forward with this? Because the sponsor that you’re dealing with tells me that they have uninvested themselves into what they’re doing. Because they try to go on the cheap. If they’re trying to go on the cheap here, they’re going to cheap other places and this is just going to be a snowball effect.”
Dugan: They may have had the best of intention, right?
Clint: Yeah.
Dugan: They may have had the best of intention, but the credibility. Their loss of credibility with you immediately when you looked at that impacted that potential investor and that potential investor is going to share that with other potential investors. The reality is, that sponsor’s credibility didn’t need to take a hit if they would have had a more professional understanding of the whole process.
Clint: Exactly right. All right, on different tact then, with what’s going on right now, what do you think commercial—when I say commercial, typical commercial property versus multifamily—what do you see with your client, where are they looking to make the moves in the next 2-3 quarters or up a year? Where do they see that investment play going?
Dugan: We talk with clients all the time and it depends if you’re the sponsor or the manager, you’re looking at what my cash reserves look like? What are my tenants looking like? What does my economic vacancy look like? Meaning, I know my properties have tenants in them. Are those tenants actually paying their rent? When tenants don’t pay their rent, your economic vacancy, meaning money that you’re expecting is not […] that goes up, that increases pressure on you. Many of these loan agreements with lenders will have covenants as to what happens on the property.
I was practicing in 2007, 2008. Twenty years of practice tells me that when there’s a crisis in the marketplace, the capital market starts to be sluggish and it’s hard to find leverage, you get unscrupulous lenders out there. They may be hard money, they may be somebody that you thought would never call the recourse events in connection with that, or you sign a personal guarantee on a commercial real estate asset, you never thought that your personal guarantee is actually going to come into effect. In times of crisis, those events often play themselves out in very, very bad ways.
I’ve seen equity theft, meaning lenders ability to declare what they perceive to be a default, even if it’s a non-monetary default in connection with the loan agreement to try the foreclose on an asset that has hundreds of thousands, if not millions of dollars in equity in it through a credit bidding in process. You want to be aware. If you’re a sponsor or manager of these entities that own commercial real estate assets, you want to be aware of what are your obligations under the loan agreement. You sign this in good times, you sign this with the best of intentions and you never thought that there would be a crunch or a downward turn in the economy.
Now, whether it’s realistic fear or not, there is fear theoretically in the marketplace. The question is, what do you do and how do you guard against theoretically losing the one thing that you cannot lose, and that is the asset? Because remember, as the sponsor or the manager, you have fiduciary obligations of care and loyalty to your passive investors and the number one rule is don’t let the asset go. Don’t get foreclosed upon.
Understanding your loan agreements, your operating agreements, we walk clients through that from the sponsor side to make sure they know what their obligations are in the passive investors that they have an understanding of their cash reserves, that they can meet their debt obligations. If they think that they cannot, then we try to grab the bull by the horns and engage with the lender immediately in order to get some sort of forbearance agreement put into place.
Forbearance simply means that we want the lender to push pause on its expectation of receiving rent or mortgage payments from us as the borrower, which in turn helps us manage expectations by the passive investors because then we don’t have the risk associated with the asset theoretically being foreclosed upon. While we might not have the cash available to pay distributions to our investors because our tenants at our properties, it doesn’t matter what the commercial […] as it is, could be multifamily, could be a commercial strip mall, could be a bowling alley.
If those places have tenants that are paying us rent and for whatever reason, they stop paying rent, they’re in default to us, yes, but that doesn’t help us in connection with our relationship with our lender. It’s not an excuse for you to go to your lender and say, “I didn’t make my monthly mortgage payment because the tenants didn’t make their rent payment to me.” They need to have a very solid understanding of those triggers that happen in those pitch points and seize the opportunity to engage with your lender for a different deal, for another deal if you need to. You got to do that early on, don’t wait. Remember, people that plead for mercy at the 11th hour often die at 10:30. Don’t wait until the 11th hour to […].
Clint: As far as investing then, if you’re looking to get into some properties now, what would you suggest? Commercial, multifamily, or just hold off for a while?
Dugan: I still am a big believer, Clint, in the multifamily market. The reason why is a couple of reasons. One, in large part, the lenders that are lending, both at the agency level, meaning Freddie, Fannie, or HUD are your federal bank lenders, even at the bridge base, meaning private lenders, that debt that you’re borrowing is largely non-recourse. That means the lenders are not stupid. They know that it is non-recourse debt, in my opinion, is always better than recourse debt.
Investors that are looking to take cash, that’s just sitting in a bank account, it’s not earning anything. It’s not moving, it’s not generating any opportunities. […] I’m going to be looking for opportunities in the multifamily space to either invest or sponsor those deals and bring those and raise the capital necessary on this side of it. I’m seeing seasoned sellers in that space be more realistic on pricing and I’m seeing longer closing periods. So that sellers know that in order to get a property to the market, the raising of capital and raising of debt and getting through due diligence is taking longer than average because of what’s going on currently throughout the country.
When you have parties that want to get deals done, they will get deals done, but it’s going to take wisdom on both sides of the transaction, both of the seller as well as the buyer and if you’re the investor. It’s always better to have your money generating more […] in a bank account generating very little money.
I am a big believer, I am optimistic that in the next few months that the sluggishness that we see in the capital markets on the lending of debt is going to loosen up. There are still deals happening and there are still deals closing. People that are actively looking for deals right now are seasoned investors. Seasoned investors that have lived through several points in time like this know that now is the time to hunt, now is the time to actually be looking because there’s a lot of deal flow and there’s a lot of assets potentially up on the block to look at to potentially acquire.
If you’re an investor and if you’re thinking about investing, multifamily is one of the safest investments because it’s diversified. It’s non-recourse debt and in large part, you’ve got all these little tenants, those are all little contracts that are tied to those tenants, that’s diversified streams of income versus a commercial space where I’m relying on an anchor tenant. If I’ve got a commercial space and I’ve got one anchor tenant in there that goes belly up because its reliance upon customers to come into their store and for whatever reason, it could be a gym, it could be a business that’s not essential, that the state or the city in which you live is declared non-essential and as a result, they can’t maximize their business plan or carry it out. That impacts everything.
The reality is, think about this, we all have to live somewhere, but we don’t all have to work somewhere. If you’re an investor and you’re thinking about investing, my thing is to think about somewhere where people live and they have to live because we all have to live somewhere, but we don’t all have to work somewhere. The places that we work at or the places that we patronize are the first places, in large part, that have cash crunch, that are going to […] upside down and are going to be in trouble. If I’m an investor, multifamily in my belief is one of the safest places to put your money.
Clint: Yup. I would agree. This has been very interesting, especially on my side of getting this information out of you, and I want to thank you for taking the time to come on and share all of this. You gave me a document that we’re going to make available for download. It’s going to be in the podcast notes and it’s about the crisis with COVID and how it affects syndications in general and things that people should be aware of in the operating agreement.
I want to say thanks for that because I know this is going to help out a lot of people that are considering getting involved in these investments. As you stated, there’s going to be a lot of opportunity on the horizon here. Either you’re a syndicator or you’re just going to be an investor in it. You got to go in with eyes wide open, you have to be using professionals that know what to look for so you don’t find out at the back end that you have this huge cash call. You don’t have any cash to do it, you get diluted out, and you lose your money. I want to thank you for that.
Dugan: Thanks, Clint.
Clint: If somebody wants to get a hold of you, what’s the best way to do it?
Dugan: I’ll make it easy to get a hold of me. You can find me on the web, you can find us on Instagram @KelleyClarkeLaw. You can find us on Facebook at Kelley Clarke PC. We’ve got a YouTube channel up or you can […] my email is dugan@kelleyclarke.com. We’re happy to chat with any of you.
Clint: Perfect. Hey, who’s the Clarke?
Dugan: The Clarke is my partner. He’s one of my partners in the firm.
Clint: Is he in California?
Dugan: It takes a village, Clint. He splits time between our office in Texas and California. But he’s a California boy. Born and raised in Santa Barbara.
Clint: Oh, beautiful. Thanks for coming on and we’ll be in touch shortly.
Dugan: All right, thanks.
Clint: Bye-bye.
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