JF1643: Unlocking Dead Money In Single Family Houses #SkillSetSunday with Matthew Sullivan

The Blockchain. You’ve heard of it, you may know a little about it, now how can it help us as real estate investors? Matthew has built a company that helps people invest in real estate all over the world without a third party. We’ll walk through a case study of what one can expect if using the blockchain to invest in real estate with his company. If you enjoyed today’s episode remember to subscribe in iTunes and leave us a review!

 

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

First off, I hope you’re having a best ever weekend. Because today is Sunday, we’re doing a special segment called Skillset Sunday. The purpose of today’s episode is to help you acquire or perhaps hone a new skill or hone an existing skill. Today, here’s  a skill – how to use blockchain to unlock dead money or trapped money in single-family residences. With us today to talk about that, Matthew Sullivan. Matthew, how are you doing?

Matthew Sullivan: I’m doing well, Joe. Thank you for having me on.

Joe Fairless: My pleasure, nice to have you back. Best Ever listeners, you recognize Matthew’s name because you’re a loyal listener and you heard that episode way back – it was over 1,000 days ago, episode 435, titled “Buying first and second mortgages and crowdfunding.” Matthew is the founder and CEO of QuantumRE, and he is the co-founder of a 50 million dollar Secured Real Estate Investment Income Strategies Fund. He’s based in Newport Beach, California, and we’re gonna be talking about blockchain and what QuantumRE is up to, and how that can help us as real estate investors.

With that being said, Matthew, will you just give the Best Ever listeners a brief background, just for a refresher, and then we’ll get right into it?

Matthew Sullivan: Of course. My background is finance, technology and real estate. My first venture was a real estate crowdfunding company, which I set up 4-5 years ago. Then as we saw the emerging technologies and blockchain technologies come into play, it seemed a natural fit to evolve our real estate crowdfunding business into something that has a much wider audience, by leveraging blockchain technologies.

Joe Fairless: Got it, okay. And for listeners who are familiar with what blockchain is but it’s still a little fuzzy, how is blockchain relevant to us as real estate investors?

Matthew Sullivan: It’s fine, the first time I heard the term “blockchain” was at a conference about five years ago. Like everybody else in the audience, we all googled this word blockchain, because the guy up on stage was saying how this is gonna change the world. And when we googled it, it said “distributed ledger technology.” We were all looking at each other, going “Well, what is this? It’s obviously the wrong blockchain, because this sounds really dull. How can this possibly change the world?” But what blockchain does is it introduces a level of trust that we don’t currently have with all of our databases and systems that are currently used on the internet.

In very simple terms, it’s a ledger that’s distributed across lots of different computers, and each one of those computers has their own copy, and it makes it very difficult, if not impossible, to make any changes to that distributed ledger or to that record of events or record of data without destroying the whole ledger. So if you’ve got a system which you can’t corrupt, you can’t change, you can’t edit, you can’t manipulate, then that means that people tend to trust that much more than other systems, and that becomes the foundation of being able to do things on the internet that we couldn’t previously do because we didn’t really trust it that much.

Joe Fairless: For example, as real estate investors, where would that come into play?

Matthew Sullivan: From a real estate investment perspective, what a blockchain enables us to do is to take an illiquid asset such as the equity in single-family homes and create liquidly-traded tokens that represent those previously illiquid assets. What that means is that we can take something like the equity in someone’s home, put it into a structure and enable people around the world to buy tokens that represent ownership interests in those equity investments. We’re creating the ability for people to invest in a much more liquid, low-cost, transparent and rapid way, without the need for bank accounts, or stock brokers, or settlement firms, or all sorts of other third-parties that add cost and time to any transaction.

Joe Fairless: Will you walk us through a typical use case, just to bring it down to the ground level with how this would work?

Matthew Sullivan: Of course. If you’re a homeowner and you’ve spent a number of years paying off some of the equity in your home, you probably still have the mortgage, but let’s say you built up a few hundred thousand dollars worth of equity. The only way currently that you can release the equity in your home is by going back to the bank and borrowing money secured against your equity. So you’re not actually tapping into your ownership, you’re just using it as security. That means that you’ve got additional monthly payments, you’ve got more debt burden, and you’ve got interest payments that are accruing on a monthly basis.

What we do is we enable you to sell us a percentage of the value of your home right now. So we’ll buy some of the equity in your home, you pay us back when you sell your house, but in the meantime there’s no interest, there’s no monthly payments, there’s no debt. The way we make our money is we share in the potential future appreciation. If your house goes up in value, because we own part of the rights to that appreciation, we share in that appreciation. So we get our initial money back when you sell your home, plus a share of the profits. That creates a real estate asset for us, which we put into a REIT structure (a real estate investment trust), but rather than issuing normal shares or LP interests, we issue tokens. Those tokens are digitized assets. That means that they are a certificate or a share, but it’s represented in digital form, rather than in paper form, or rather than held on a company spreadsheet somewhere.

That digital asset can be traded around the world in a number of exchanges that are beginning to emerge. That means that people that want to have exposure to that real estate asset, which is the equity and owner-occupied single-family homes, if they buy our digital asset, if they buy our token, then they can get exposure to that asset. The asset should appreciate over time. So that gives people exposure to real estate which they couldn’t previously have.

Joe Fairless: Thank you for talking about the structure and how that works. It’s clear in my mind how it works, so let’s dig in a little bit and just talk about perhaps some questions that I’m sure have come up before. One is if I were to buy some tokens in the REIT in order to get access to buy people’s equity ownership in their primary residence, then the way I make money – and I think the only way I make money – is if the market continues to appreciate, and then they sell their house. Is that accurate?

Matthew Sullivan: Exactly. You’ve gotta imagine over time there will be hundreds and thousands potentially of different properties within that single fund. So you’re not exposed to one property, you’re exposed to lots of properties over time. Over time, people move in and move out of homes; as each person sells their home, if the house has appreciated from the time we bought the rights to the house, to the time that they sold it, then the profit that we make goes back into the fund, and the value of the fund increases. What that means is that the secondary market value – in other words, the value of the tokens – should also increase, as the value of the underlying pool of assets increases as well.

Joe Fairless: Got it. And if the value goes down whenever they sell, how does that work?

Matthew Sullivan: We have that exposure. As we are an equity participant, we are exposed to the value of the house going up or going down, and that’s why it’s very different a debt. If it’s a debt instrument, then it doesn’t really matter if the house goes up or down, you still owe us the money. But if our ownership or if our returns are tied to the equity component, then it’s much more like a partnership, so we’re also exposed. That’s actually quite good for the homeowner, because that means they don’t have that additional exposure to compound their worries if their house is going down in value. Our job is to make sure that we buy homes in places where over time they’re likely to appreciate.

Joe Fairless: And how do you determine where those places are?

Matthew Sullivan: That’s the hardest job on earth, really. What helps though is we focus to start with on California. We know that historically, California is a high-performing real estate economy/marketplace. The other thing is if we look at a longer-term view, we know that residential houses are cyclical, but over time they tend to outperform inflation. So we know that if we get a big enough sample of houses in the primary residential areas, then there’s a very good chance that over time our investments will perform in line with or will perform better overall than the general house price index.

Joe Fairless: That makes sense, because I was wondering if you’re buying all across the country… I was born in Flint, Michigan. My grandma is 103 years old, and she lives in Flint, Michigan, and she has lived in the same house for 70 or so years, and the house is worth less today than it was 70 or so years ago. Do you have an idea of how Flint, Michigan — I mean, perhaps there’s some good things ahead, but at least for the last 70 or so years her house has gone down in value… So I was just wondering ways you protect against that.

Matthew Sullivan: You’re right. And again, I think what we do is we underwrite the asset, primarily. This is another reason why it’s so very different to debt. With debt, you’re underwriting the person’s ability to pay your mortgage or your HELOC. What we’re doing is we’re saying, “Well, let’s look at the asset primarily. Let’s focus on assets in areas where we think that there’s a very good chance of appreciation.” That does mean that we’re targeting specific regions in the U.S, but again, that’s very similar to any other type of fund that would be looking for performance in that same asset class.

Joe Fairless: Do you have a certain loan-to-value that you adhere to, so that you’re not over-leveraged?

Matthew Sullivan: Yeah, and again, these are all critical components. The maximum that we will advance is 90% of the combined loan-to-value. That means if you take the existing mortgage and all of the other debt that’s associated with the property, and if you add the equity that we release, there has to be a 10% cushion. What that does is that gives you as the owner — you need to have some equity in the house as well, otherwise you’ll wake up one day and feel that this house is no longer yours. But also, it’s important for us to have some level of cushion in case that there is a downturn. The maximum equity that we will release is 30% of the value of the home. So there are limits.

And my last point is that our team has carried out over 300 transactions in the last few years in this space, so we do have some good experience in understanding where the wrinkles are and where the roadblocks or the humps in the road could be.

Joe Fairless: What’s the smallest transaction amount that you all do? I’m thinking of homes that might be purchased for $5,000 and they’re worth $15,000, and someone wants to do this…

Matthew Sullivan: Yeah. Again, we don’t see a lot of those houses in California…

Joe Fairless: Oh, right, right. You’re only in California now?

Matthew Sullivan: At the moment, we’re only in California. And that’s for a number of reasons. First of all, because each state has its own intricate web of regulations around this type of product, and we have experience in navigating those waters in California. Also, of the 15 trillion dollars’ worth of equity that’s currently available in single-family homes, about 40% of that is actually in California, so there’s an enormous potential marketplace for us. So that’s why we’re here, that’s why we’re focused on the West Coast.

Joe Fairless: What are you doing to gain more traction with this business? Because it’s gotta be challenging to increase adoption when you’ve got to explain a lot of things before you even get to the business model… So how do you go about doing that?

Matthew Sullivan: You’re absolutely right. The challenges are — there’s all sorts of buzzwords like cryptocurrency and blockchain floating around… The important thing is when we speak to a number of different audiences, the first audience is the homeowner. So the way that we communicate with a homeowner is really — you don’t need to know anything about blockchain or cryptocurrency, or funds, or REITs, or tokenization. So we try and mention as little as possible about that, and we lead the homeowner through a journey on our website that enables them to put their home details in and apply in a very simple way for us to be able to take them to the next stage.

The education process is really about getting them to understand that this is not a loan, and that they have the ability to raise capital that’s theirs, they can take some chips off the table, they can spend the money on whatever they want. So the education process for homeowners is really about the asset class itself, about how we’re releasing the money, and we absolutely avoid referring to tokens and that sort of stuff.

From an investor’s perspective, our focus is really on liquidity and explaining to investors that you get the same rights with this investment as you do with a traditional investment; in other words, you get ownership of the pool of assets, but it’s better because there’s a much greater chance of you being able to sell your certificate, or your token, or your asset, rather than having to sit on it and wait for the sponsor to sell the property, which normally happens in smaller real estate transactions.

So you’re absolutely right – education is one of the many challenges that we face, but we are making some real inroads, and we have hundreds and hundreds of people that have contacted us and expressed their interest to be part of the program.

Joe Fairless: What else haven’t we talked about as it relates to your company and the value proposition that you all have that we should talk about?

Matthew Sullivan: I think really just the asset class itself is incredibly interesting. I know we have talked about it, but it’s such an untapped, disregarded asset class, the equity in single-family homes… And the ability to release value that people own without getting them to take on more debt is a really interesting conversation. We talk about changing home owners — or rather, let me rephrase that… We talk about home owers and home owners. Most people want to be home owners, but the reality is that they are home owers, because they owe so much money to the bank, and their mortgages are so great. So our objective is to change that, so more and more people can actually be home owners.

I think the interesting conversation as well is what happens in an economy if you start moving money out of equity, into the economy as a whole, without increasing debt? How does that help? That’s a much bigger conversation, but that could be something that could be quite material if we do as well as we hope we’ll do.

Joe Fairless: How can the Best Ever listeners learn more about what you’ve got going on?

Matthew Sullivan: We have a website, which is quantmre.com. We have a lot of information, videos, articles, pieces that we’ve written over the last year… We’d be delighted if you go around and take a look. You can contact us on all the usual social media channels, we’d be delighted to answer any questions you have.

Joe Fairless: I love learning more about this space. It’s educational, it’s exciting… I am glad that there are people like you, who are on the frontlines, because there are people like me who do not want to do that at the beginning, but we’ll be happy to jump on board once you figure things out and you’ve established a path… So thank you for helping establish the path, on behalf of everyone who will benefit from…

Matthew Sullivan: It is a fantastic front. It is really exciting being at the front. I appreciate your words, and I very much appreciate what you do, as well.

Joe Fairless: Well, I hope you have a best ever weekend. This is educational, as I mentioned, and we’re looking forward to staying in touch and talking to you again soon.

Matthew Sullivan: That’s be wonderful, Joe. Thank you very much.

JF1426: Counsel For Real Estate Syndication #SkillSetSunday with Mauricio Rauld

We have one of the foremost experts on real estate syndication law on the podcast today! Mauricio was nice enough to do an interview and help us all learn more of the technical side of a syndication deal. One huge takeaway: are you offering a security and not even know it? You may be surprised by the answer.

 

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Mauricio Rauld Real Estate Background:

  • Founder of Premier Law Group, specializing in counsel to real estate syndicators
  • Nationally recognized expert on real estate syndications
  • Takes complex matters and makes them simple to understand
  • Based in Newport Beach, CA
  • Get your free 8 Critical Steps To Practicing Safe Syndications Report by emailing team@premierlawgroup.net and typing “Fairless” in the subject line
  • Say hi to him at http://www.premierlawgroup.net/

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TRANSCRIPTION

Joe Fairless: Best Ever listeners, how are you doing? Welcome to the best real estate investing advice ever show. I’m Joe Fairless, and this is the world’s longest-running daily real estate investing podcast. We only talk about the best advice ever, we don’t get into any of that fluffy stuff.

First off, I hope you’re having a best ever weekend. Because today is Sunday, we’ve got a special segment for you called Skillset Sunday, like we usually do… And with Skillset Sunday, you’re gonna come away with a specific skill that you either didn’t have before, or that can be honed based on our guest’s expertise.

Our guest’s expertise is securities, and specifically helping counsel real estate syndicators. How are you doing, Mauricio Rauld?

Mauricio Rauld: I’m doing great, Joe. Thanks for having me.

Joe Fairless: My pleasure, nice to have you on the show, my friend. A little bit about Mauricio – he is the founder of Premier Law Group. It specializes in counsel to real estate syndicators. He is a nationally-recognized expert on syndication; I’ve seen him be included in a whole bunch of conferences, and I’ve heard a lot of good things… Mauricio, this is the first time you and I have had a chance to connect, but I’ve heard a lot of good things about you and I’m looking forward to our conversation.

Mauricio Rauld: I appreciate that, and same with you.

Joe Fairless: How about a little bit about your background, just for some context, and then we’ll get into three things that we should know prior to doing a syndication?

Mauricio Rauld: Yeah, so I founded Premier Law Group about 12 years ago now, and currently all we do right now is real estate syndications. That’s what we do 100% of our time, primarily Reg D offerings… But I started my career now almost 18 years ago; I worked at a law firm that specialized in litigation and specifically securities litigations, so I was kind of on the other side of the table. I would represent the big brokerage houses – J.P. Morgan, Credential, Schwab… Kind of all these litigations.

So I did that for a while, but realized that’s not really what I wanted to do, even though it was a great law firm, so I went off and worked in-house a little bit for the real estate guys who did a lot of real estate syndications; I did all of their work, and then kind of from there spun off my own law firm and started helping some of their guys, and that’s kind of grown and blossomed now; it’s been 10 years since I’ve been doing it on my own, and I’m just really happy to be able to travel the country and sometimes the world teaching real estate investors how to scale their businesses and how to get to the next level via syndications and raising private capital.

Joe Fairless: On that note, raising private capital and scaling our business, what are some things that we should know prior to doing that?

Mauricio Rauld: Yeah, the first thing we always have to think about is whether we’re even dealing with a security… Because it’s one of the big misnomers. Some people think “Hey, if I structure my real estate deal this way or that way, somehow we can get around the securities laws”, and a lot of people don’t realize that they’re actually involved in issuing securities when they don’t think so.

What I tell people, kind of like my little cheat sheet that I give people is that, look, anytime you’re taking people’s money, where the returns are generated primarily from your efforts, then you’re dealing with a security. So it doesn’t matter if it’s a TIC arrangement, a promissory note, a joint venture, profit-sharing agreements, handshakes, high fives, whatever you wanna call it. The actual structure doesn’t matter. If you’re taking people’s money, you’re generating the return, it’s a security if your investors are simply passive and cutting you a check.

So that’s probably the first, most important thing to realize, because a lot of people out there I think are raising money illegally, because they think, “Hey, I’m not doing an LLC, I’m not doing a company. I’ve got some creative mechanism that I come up with and I can get around the securities laws”, and that’s obviously not true.

Joe Fairless: I love that you’re mentioning this, because I interview a lot of people who if I stop to mention this during all the interviews I do, we’d be talking about this for half the conversation, for probably a large percentage of the people I interview… So let me ask you some examples. One, if I’m a fix and flipper and I need money to fund a fix and flip, and I reach out to my uncle’s best friend and she says “Yes, I’ll fund your fix and flip. Here’s $100,000. Just pay me 12%, and maybe 10% of the upside after it sold” – is that a security?

Mauricio Rauld: You know, we can probably structure that as not being a security. Again, if they’re just simply passive, if they write you a check and go home, then it’s gonna be a security. So it depends on how we structure that particular one. If you have a note that’s actually less than nine months, that’s by definition not a security.

So when you’re doing a fix and flip and if you’re talking to just one person, you get one investor and you do a note for less than nine months, that’s not gonna be a security. Or if you even have any kind of structure and you make that person active – again, it’s all about whether your investor is an active participant or passive. So if they’re active and they’re co-managing the LLC, they’re co-managing the project, they’re involved with you, then we can get away with not calling it a security.
But to the extent that they’re just writing you a check and going home, even with one person, that’s gonna be considered a security if they’re just passive.

Joe Fairless: I’d never heard of the nine month thing, so thank you for mentioning that. That’s the first time I’ve heard that mentioned.

Mauricio Rauld: And Joe, you’ve gotta be careful with the nine-month — again, the specific example was one person. So if I pick up the phone and call my buddy Joe, or in your scenario, somebody’s uncle, and don’t do any of the marketing and we do an 8-month note, that’s gonna be fine. The challenge is gonna be a lot of people wanna go out there and market their deal to their list, or reach out to many people, and in that case we can get into issues, because it’s not only a note, but it can be called an investment contract, which is, again, a type of structure that can be considered a security.

Joe Fairless: Got it. So if I’m a fix and flipper and I have a fix and flip which generally they don’t take more than 9 months (knock on wood), then what I could do is I could find an investor that I have a relationship with, or I know someone who knows them, I could reach out to that person – not put it on Facebook, but just kind of reach out directly to individuals and say “Here’s what I’m working on. I’m offering 12% on your money, and I’ll give you 10% on the upside. You will be active, but your role is going to be very minimal in the deal.”

Mauricio Rauld: Well, if you’re going the active route, they’ve gotta be active… So if we’re gonna make these guys active, let’s make them active. What I’m suggesting is if you have one person identified and you just pick up the phone and call them, or have a meeting with them and have them invest with a 9-month note or less, they’re gonna be fine… But if you send out a blast to your investor database saying, “Hey, I’m looking for one individual to do a loan for me”, that’s probably gonna be considered an investment contract, because you’re marketing it to more than one person.

The promissory notes are very tricky. You really need to speak with experienced counsel when it comes to promissory notes, because even [unintelligible [00:07:41].12] promissory notes, essentially it boils down to “if the promissory note looks like a security, acts like a security and quacks like a security, it’s probably a security”, so there’s not a great deal of guidance on that. But certainly, if it’s nine months and you just picked up the phone with one person, I think you should be fine.

Joe Fairless: Okay. Then really the question becomes “What is active?”

Mauricio Rauld: Right. When I do an active deal, I want them to be co-managers of the LLC and I want them to be involved in the decisions. Again, they can’t just write you a check and go home, because if you’re generating the return, then that’s gonna be a passive investor. They’ve gotta be involved in the flip and you guys have to make joint decisions, from hiring the contractor and getting the project done. It’s almost like you’re starting a business, as opposed to just having a passive investor.

Joe Fairless: Okay. And then one slight variation to this scenario and then we’ll move on – I have a pre-existing relationship with someone, I’m doing a fix and flip, eight months; I reach out to that one person and I say “Do you want 12% on your money, and 10% on the upside when we sell, and you’re gonna be completely passive?” Is that a security?

Mauricio Rauld: If it’s less than nine months, it’s not gonna be considered a security.

Joe Fairless: Got it. So they can be completely passive, and it’s not considered a security if it’s less than nine months.

Mauricio Rauld: Correct.

Joe Fairless: What if that project extends unexpectedly from eight months to ten months?

Mauricio Rauld: Well, you can’t extend it. You’re basically at that point in breach of your note, and you’ve gotta proceed with the consequences of the breach… So whatever the [unintelligible [00:09:07].10] in there, you don’t wanna be extending it at that point, because then you’re running the risk that you’ve gotta prove now that you didn’t intend from day one to really make it 10, 11, 12 months… And that’s why it gets tricky with the promissory notes.

Joe Fairless: Cool. Alright, well you’re welcome, fix and flippers. I don’t fix and flip, but we have a lot of fix and flippers. We’ll move on to number two, but to summarize – if you have a pre-existing relationship with someone and it’s less than eight months and they’re passive, then that is okay to do.

Mauricio Rauld: Yeah, and for your show notes I’ll get you the statute that shows you that the promissory note that’s less than nine months is not considered a security. Again, the note may be considered an investment contract, which is a security, and that’s where it gets a little bit complicated.

Joe Fairless: Number two.

Mauricio Rauld: Number two, let’s talk about — once we’ve identified that you’re dealing with a security, then I always tell people it’s really only three things we need to worry about. Number one, we need to register that security with the Securities and Exchange Commission (SEC), or number two, we have to find an exemption to registration, or number three, it’s illegal. Those are really the three things. You need to register your security, you have to find an exemption, or it’s illegal.

Usually, I go with the assumption that you’re not in the business of doing an illegal offering, but illegal doesn’t necessarily just mean you’re committing fraud, and you’re trying to defraud your investors; obviously, at least in your world, nobody’s trying to do that… But illegal offerings can be as simple as omissions, failing to put some disclosures in your documentation, it can include things like over-promising on your returns… If you suddenly tell people “Hey, look, I promise you a 30% return” – they call that kind of a blue sky representation; it’s kind of out there. So anything that breaches the securities law in that sense would be illegal.

You never really want to register your security, the reason being that it usually takes  a couple years to do. I mean, you’re dealing with the Federal Government, so it takes a while to get it through the process, and it usually takes six or seven figures to get that through the process. So if you’re an investor and you’re in a contract to take down an apartment complex, for example, you just don’t have a year or two years to wait for the SEC to approve your syndication… So typically, we look for an exemption, and that’s really where I live, that’s what I do 100% of my time – finding the appropriate exemption to the registration… And fortunately for us, there’s a couple of exemptions that about 95% of the people use, because they’re popular and they have a particular function, which I’ll go into… And that’s probably the ones that you’ve heard of before, Joe, which are these Reg D offerings, specifically 506(b) and 506(c). Those are, according to the SEC, the most popular exemptions, and the reason for that is quite simple.

Number one, they provide us with what’s called the safe harbor, which means if we comply with all of the rules of 506(b) or 506(c), then we’re assured that we’ve complied with the exemption and we’re clear. Other exemptions don’t have that safe harbor, so we have to start making arguments, we have to convince the regulator that we comply… But with these 506 exemptions, if we hit these five or six items, then we’re good to go.

Then the other big deal with these is that they pre-empt state law, which is just a fancy way of saying we don’t have to worry about the state laws, as they pertain to the registration of the securities laws. We still have to worry about anti-fraud provisions, so we still can’t obviously commit fraud, and that’s what the states really are focusing on right now, but we don’t have to go and hire an attorney in every single state and make sure that we’re complying with the securities laws of that particular state, because the Federal rules will pre-empt the state law. So that’s primarily why these two exemptions are the most popular out there.

Joe Fairless: You said they provide a safe harbor if we complied with them and are in the clear on five or six items. What are those five or six items?

Mauricio Rauld: Well, let’s go through them. The first for both of these is that you can raise an unlimited amount of money, which is one of the reasons you’ll see a lot of these even huge brokerage firms like the Charles Schwabs of the world, and Goldman Sachs and J.P. Morgan – they sometimes raise billions of dollars under this 506 rule, because you can raise an unlimited amount of money… So that’s a nice thing.

Number two, on 506(b) you are allowed to accept a limited number of non-accredited investors. And so that we don’t leave anybody behind, an accredited investor is essentially anyone who has a net worth of a million dollars of more excluding their primary residence, or earned $200,000/year for the last couple of years, with a reasonable expectation of earning that amount this year.

A lot of first-time syndicators tends to go out to their friends, their family, people in their network, and a lot of them tend to be non-accredited, so 506(b) allows us to take up to 35 non-accredited investors, as long as they are sophisticated.

506(c) does not allow us to take any non-accredited investors, and there’s a reason for that, which we’ll get into next.

The limitation on 506(b) is that we are prohibited from advertising or generally soliciting. We have to essentially stick to people that we have a pre-existing relationship with, a substantive pre-existing relationship. With the 506(c) we’re actually allowed to advertise. Really, the 506(c) was kind of the new rule that came out and implemented in September 2013, that lifted that prohibition of advertising, so now it is possible to go out — if you wanna put an ad in the Super Bowl, knock yourself out… If you wanna do a podcast, a radio show, a webinar, Facebook ads – you can do that under 506(c), but again, your limitation on 506(c) is you cannot take any non-accredited investors; all of your investors must be accredited. Furthermore, you must take what’s called reasonable steps to verify that your investors are accredited. That’s not a requirement in 506(b). And in 506(d), which is the old rule, which still is in existence today, and actually is still way more popular than 506(c), we can rely on their representation. We prepare a questionnaire; it’s basically a check-the-box, they tell you they’re accredited or non-accredited, and you can rely on the representation.

But when we’re talking about 506(c), where you’re allowed to advertise, we cannot rely on check-the-box verification; we must take what’s called reasonable steps to verify, which generally means looking at tax returns. If you’re claiming that you’re earning more than $200,000, you’re looking at either a W-2, a 1099, your tax forms… And there are other ways to do it as well, but that’s what I think most people rely on in terms of verifying your investors.

With either one of these, you cannot accept what’s called “bad actors” as sponsors. So if you partner with someone who’s had some kind of a history of a violation, or sort of  a slap on the wrist for some securities violation or something to that effect, you will either be prohibited from being a sponsor in that deal, or if it happened before 2013, you have to disclose that.

I think those are kind of the main ones…

Joe Fairless: Okay. Not to take this off-track, because I do wanna continue on one and two, but one question that I get a lot is “If I don’t have a deal, what can I say and can’t I say about my business?”

Mauricio Rauld: Great question. If you don’t have a deal, it’s not impossible, but it’s hard to really make an offer… Because when you have a security, you make an offer sale – but if you don’t have a deal, it’s hard to make an offer, unless you’re what’s called “conditioned to market.” So you can definitely talk about your company and what they do, the kind of investments that your company invests in… What you wanna avoid a little bit is talking too much about your prior returns, and also just “Hey, this is what we do – we invest in multifamily and we tend to give investors a 10% return.” That’s the stuff you wanna avoid because of what’s called conditioning the market, which is very similar to making an offer.

So talk about your business, talk about the people – which is probably one of the most important things anyway – talk about your team, talk about what you do, but don’t talk about the types of returns that you anticipate giving investors… And I would probably be staying away from talking about prior deals, because again, it might be viewed as “This is the type of deals we’re doing in the future, and these are the kind of returns that we’d be expecting to give you”, which is conditioning the market.

Joe Fairless: Well, does that mean you should not have case studies in your company presentation?

Mauricio Rauld: No, case studies are fine. What you wanna stay away from is showing people what the returns were for your investors. If you wanna say “Hey, I’m in the business of investing in multifamily” – and again, when you say case study, I presume that means something that you haven’t done; it’s sort of an example…

Joe Fairless: No, sorry – let me clarify… Case study meaning a property that that company has done previously, and the results of that from (I was thinking) a returns standpoint, plus just overall business plan that was implemented successfully.

Mauricio Rauld: Yeah, I would stick to the business plan that was implemented successfully. “Hey, we bought this building at X, we spent X amount of money on cap-ex, we increased the occupancy, we increased the rents, and it was a very successful execution of the plan.” What I would stay away from is “Hey, if you invested $100,000 in that deal, you would have made 12% cash-on-cash, and then a 30% IRR” or whatever, because that could be viewed as conditioning the market.

Joe Fairless: So that was number one, “Is it a security?” Number two, well, if it is, then we need to register the security, find an exemption, or just do something illegal… So either register the security or find an exemption. Anything else on two?

Mauricio Rauld: I think the one thing — I think I’ve mentioned it, but just to kind of tie it all together – in both 506(b) and 506(c) they do pre-empt state law, so we don’t have to worry about the states too much regarding the securities laws. But the states get a little bit neglected, because think about it – their powers have been stripped quite a bit with these new rules… So I kind of joke around that they’re kind of sitting around, twiddling their thumbs; they don’t really have too much to do over the state side, so when they do get something, when there is some kind of impropriety or somebody that’s claiming some kind of fraud, they tend to jump all over it… So really the states are really what we’re usually worried about when it comes to securities violations. I’m not saying it never happens, but it’s very rare for the SEC itself at the Federal level to get involved with these — most people are raising a million, two million dollars… I mean, that’s not where the SEC plays. They’re looking for the Bernie Madoffs, they’re looking for the Ponzi schemes, they’re looking for the people who are out there intentionally defrauding investors.

If  you fail to disclose something, if you get too carried away with some of your projections, it’s the states that are really gonna jump on you, because that’s the only thing they have left to hang on to, is these anti-fraud provisions. So if there’s a complaint, it’s probably gonna be a complaint to your state regulator, and it’s probably a call that you’re gonna receive from the state regulator, versus the SEC… Because like I said, I think that they’re just a little bit bored over there, because they’ve had most of their power stripped away from them.

Joe Fairless: So let’s say you get that phone call from a state regulator… What happens?

Mauricio Rauld: I’ve gotten those a few times, and I’m happy to say we’ve passed those with flying colors… But the first thing a state regulator is gonna ask you is for all your disclosure documents that you’ve provided in this particular deal that’s at issue, and then most likely all of the prior deals as well.

We got a little bit ahead of ourselves, but once we’ve picked this exemption, what we typically do is we provide the investors with all of these disclosure documents. They typically include a private placement memorandum (some people call it a PPM), which is just where we put all the disclosures and all the ways that the investors can lose their money. They have an operating agreement that the investors are gonna be a member of, we have subscription agreements, we have investor questionnaires, and obviously the business plan.

So when a regulator calls, that’s the first thing they’re gonna ask for. It’s really powerful when you’re able to send over to the state regulator a package of 150 pages or however long your disclosure documents are, along with all the signature pages and you’ve got all your i’s dotted and your t’s crossed.

Typically, in my experience, at least with the ones that I’ve gone through, once we’ve provided them with all the documentation, they realize that this is not really low-hanging fruit for them, and that we’ve actually done our work properly, we’ve had sophisticated counsel, and they kind of move on.

What they’re looking for – and I’ve had this on the other side of the equation, is they ask for all the documentation and they literally get two or three pieces of paper because they didn’t really have any of the disclosure documents, or they had a two-page business plan and that was it… Or one of those scenarios we talked about earlier, where the person didn’t think they were dealing with a security, so they didn’t really worry about any of that stuff. That’s where the securities regulators get all excited, because now they’ve got kind of low-hanging fruit and it’s something easy for them to go after.

Joe Fairless: What’s the investment into the legal documents, so that everything is registered properly and disclosed properly?

Mauricio Rauld: When you say the investment–

Joe Fairless: How much does it cost? I think of it as an investment in peace of mind…

Mauricio Rauld: Sure, absolutely. I usually recommend putting a line item in your budget, because all of this is obviously reimbursed at the time of the close… But I usually put about $15,000 for what I call “Legal and Compliance”, and that’s a combination of the attorney fees, and also the state filing fees.

One of the things we have to do at the conclusion of the raise is we file with the states a notice filing; we file with the SEC what’s called a Form D, which is just a form that tells the SEC, “Look, I’ve just raised a million bucks from five non-accredited investors, or ten non-accredited–“, just basic information, and then we file a copy of that with the state… And each state, what they’re really looking for is their fee. Each state charges anywhere from a couple hundred dollars to $500 for that filing.

So depending on how many states you have in there, it will cost you probably another $1,500-$2,500 in filing fees. So I always recommend putting $15,000 in the budget for sort of a standard real estate syndication.

Joe Fairless: And just to make sure we clarify… That’s specifically for the securities aspect of the deal; that’s not the real estate attorney who’s working on the contract and other items.

Mauricio Rauld: That’s a great distinction. This is for the securities attorney. You will typically have a securities attorney, who’s dealing with all the securities work and drafting the PPM and all the disclosure documents; you might have a real estate attorney, who’s actually handling the purchase and sale agreement, that’s handling the loan, that’s handling the financing part, and if you’re doing a 1031 exchange you might be even handling it with a 1031 expert and you may even have a tax attorney. So there’s numerous attorneys; I’m specifically focused on the securities compliance part, the legal and compliance.

Joe Fairless: And what’s number three?

Mauricio Rauld: Well, number three… I guess the next step is once we’ve identified what exemption – let’s say we’re gonna go with a 506(b), because we don’t intend to advertise, we have pre-existing relationships with everyone… Then we go into actually drafting all the documentation – the private placement memorandum (PPM) is probably the most important one of those… Joe, I’m sure you’ve gone in for surgery before, and I’ve just had my wisdom teeth taken out a few years ago, and you know you go under for about 30 seconds to get those things off, and they give you that medical consent form, that yellow piece of paper that tells you all the ways that this surgery can go wrong, including death; I can die from getting my wisdom teeth out. Obviously, the chances of you dying are slim, but it’s in that paper, you sign off on that, and that’s the medical consent form. It’s very similar on the securities side, with the PPM – just all of the risk, all the ways you can lose your money, all the ways that this deal can go south gets put into that documentation… So it’s a little bit of a scary document for some.

You almost have to oversell your on the front-end, with your business plan and your conversations with the investors, because no one’s going to invest in your deal based on the PPM. If anything, it’s gonna scare them off a little bit, so you almost have to oversell your deal, so that when they read the PPM they get a little bit concerned, but they’re still good to go because you’ve done such good job on the front-end.

Joe Fairless: Number one, is it a security? Number two, we need to register it or find an exemption, and number three is make sure all the documentation is in order?

Mauricio Rauld: Yeah, I call them the offering documents; some people call them some different things… But the offering documents, which are composed of a PPM, which has a disclosure, the operating agreement, which will be where all of your terms and conditions of the deal will be included… So what are the splits with the investors, are you giving them preferred returns, what are the voting rights, what if somebody wants to get out – all that information gets put into the operating agreement, because your investors (remember, they’re going to be a passive investor) are gonna be a part-owner of your LLC, or your LP or whatever the structure you’re using… So obviously the operating agreement is important.

There’s a subscription agreement, which is the document that actually the investor signs and puts in how much money they’re investing, and that’s the document that actually triggers the investment.

Then there’s an investor questionnaire, which if you’re doing a 506(b) and it’s check-the-box, we have several questions for the investors so that we can find out their level of sophistication, we can find out what their net worth is, make sure they’re accredited, and if they’re non-accredited we just keep track of it so we don’t go over 35.

If it’s a 506(c) deal, we also do a questionnaire, but I typically recommend — it’s such a  compliance nightmare… I usually recommend outsourcing the verification process. There’s numerous companies out there that will verify your investors and make sure they’re accredited, for a very reasonable price – somewhere around $80-$100 per investor – so you can just add that to your budget. That way, if you’re doing a 506(c), that means you’re advertising, that means you’ve got some investors you’ve never met before… It’s just not a great thing where you’re asking this new person for their financials and their tax returns and their property appraisals, and their brokerage accounts… That’s just not something you wanna be involved with, so these third-party companies – they deal with that, they go gather the information, and then you get what’s called a deliverable from that company that says “Hey, we’ve done our job, we’ve done the verification, and this person is in fact an accredited investor.”

Joe Fairless: Mauricio, how can the Best Ever listeners get in touch with you?

Mauricio Rauld: The best way to get in touch with me – actually, I’ve got a report, which is The 8 Critical Steps to Practicing Safe Syndications. If they e-mail me at team@premierlawgroup.net, and just put the word “Fairless” on the subject line, I’ll make sure you get that and we can then start a conversation.

Joe Fairless: Wonderful. Our team member Grant already has that in the show notes; I can see it right here, and it’ll definitely be in the show notes whenever we publish this episode.

Thank you so much for being on the show and educating us on securities as it relates to syndication. The three steps – one, is it a security? Two, we need to register it or find an exemption, and three is to draft the documentation… And typically, we do the exemption, which tends to be Reg D, a 506(b) or 506(c). There are some things that we talked about for fix and flippers and others in that scenario; if you have a relationship with one person, and they’re passive, and it’s less than nine months, it’s okay, it’s not a security.

A couple things that we also talked about – allocate about 15k for legal and compliance as a line item in your budget if it is a security, and also, when you don’t have a deal, it’s okay to talk about your business, about what you do, but there’s a phrase, “conditioning the market”, that you wanna be careful about, where you’re talking about what type of returns that you’ve done in the past.

Thanks for being on the show. I hope you have a Best Ever day, and we’ll talk to you soon.

Best Ever Show Real Estate Advice

JF621: He States that Buyers Should NEVER Buy On…#skillsetsunday

You’ll have to hear this episode to get the answer to the title. Today’s guest closes over $100,000,000 in volume in Orange County as a broker. He has experience investing and working with real estate professionals all over SoCal. Tune in!

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David Feldberg Real Estate Background:

-Based in Newport Beach, California
-Closes $100MM a month in loans as a broker
-At Coastal Real Estate group
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JF609: What Mobile Home Parks Can Yield in Cash Flow

Mobile home parks are very lucrative investments as they don’trequire as much maintenance as an apartment community. Our guesthas the experience in putting together mobile home park deals andhe is going to share how he closed on three worth approximately$1.5 million. Hear his advice and consider mobile homeinvesting!

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Robert San Luis real estate background:

  • Been an investor and entrepreneur for over 25 years
  • Focused on mobile home syndications and has owned 3 mobile homeparks in Texas worth roughly $1.5M
  • Author of Wealth Without WallStreet
  • Based in Newport Beach, California
  • Say hi to him at robertsanluis.com
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JF435: Buying 1st and 2nd Mortgages and…CROWDFUNDING!

President and founder of Crowd Venture, a platform geared to creatively purchase 1st or 2nd liens via crowd funding, Matthew Sullivan implements his technology background and builds a real estate investing system. He is highly enthusiastic about the crowd funding space, and has come from his home land of London to optimize his efforts. Hear his plans to grow via crowd funding!

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Matthew Sullivan’s real estate background:

  • Founder and president of http://www.crowdventure.com which is a crowdfunding platform
  • Based in Newport Beach, California
  • He used to be a director and trustee of the London Air Ambulance so he has a helicopter pilot licenses

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