What are the challenges for a real estate owner/operator to enter successfully into the non-traded (aka “Alternative”) securities space?

Accessing equity can be the life blood to feed growth for a realty firm. Alternative broker dealers are a way to reduce entry costs and to gain (some) greater control of accessing equity.

The “all in costs” to successfully launch a Regulation D 506(B) fund can be (but often isn’t) much less than a $1,000,000. Compare these costs with the successful launch of a fully registered non-traded real estate investment trust (“NTREIT”) which can exceed $5,000,000.

Where does the money go?

LAWYERS – Anticipate legal fees from $125,000 to $250,000 for a Reg D offering and take 90 – 120 days start to completion.  Legal can easily exceed $500,000 for a fully registered non-traded offering and, depending on the response time with the SEC, exceed a year for completion.

CPA – Accounting work for most Reg D offerings is under $35,000. For a fully registered offering, assume accounting will be about 50% of what is paid for attorneys.

VALUATION OF ASSETS – Appraisals for all properties in a proposed offering will be required by most broker dealers considering distributing an offering.   The level of detail of the appraisal goes up significantly if the property being placed in the security comes from the inventory of the sponsor (perceived as “self-dealing”). Budget $5,000 – $25,000 per assets.

DUE DILIGENCE REPORTS – Almost all broker dealers (“BD”) will require a third-party analysis of the sponsor ($30,000 – $60,000) and of the offering ($15,000 – $45,000).  Why? FINRA, the regulator of broker dealers, require BD firms to complete due diligence on all offering, and allows a review of a third-party report substantially satisfies this requirement. 

MARKETING – Nothing happens until distributing broker-dealers are 

1. aware of an offering, 
2. conclude that it fits their risk parameters, and 
3. that it can sell in their system. 

With some broker dealers, where they permit access to their registered representatives prior to the signing of a sale agreement – a “cart in front of the horse” approach (aka “rep up”) – want to know there is RR interest before they spend money and time on due diligence.

All broker dealers, even when they like the sponsor and the offering, will require a financial commitment to support their sales effort, typically with a “contribution” to their meetings with their sales force.  Anticipate paying (at least) $10,000 per producing broker dealer and “supporting” 5 – 10 broker dealers.

SALES – Even once a broker dealer signs a selling agreement with a sponsor, it is up to the sponsor to drive sales from the registered representatives (“RRs”) of the broker dealer.  The sponsor engages a salesperson (a “wholesaler”) to repeatedly and effectively reach out to RRs to encourage their consideration and eventually placement of the offering.  

While (most of) the costs of marketing and sales are covered in the offering, these costs come upfront, and the coverage of these expenses is only paid to the sponsor with the completion of the offering.  To retain an effective wholesaler, assume $120,000 base plus travel expenses and production bonuses.

1031 DSTs – Alternatives are sold; they are not bought.  Meaning, no one is waiting for an investment opportunity. UNLESS they are selling real estate (held in a business or for investment purposes), and they are aware of the potential of completing a 1031 Like Kind Exchange to defer recognition of capital gains taxes (NOTE – think IRA and 401K; if you don’t gain control of the proceeds, tax recognition can be deferred). About 35% of eventual 1031 DST investors go online and look for sponsors (and find websites from registered representatives who sell 1031 DSTs). And those who place 1031 DSTs are generally easy to find online, and the time “market to close” is shorter (than with a fund).

BOTTOM LINE

Without a steady source of equity capital, most real estate owner/operators no longer grow.  And if they are not growing, they lose their top people to real estate firms which are growing (which can offer a way for their employees to earn greater incomes). 

The Alternative market, while expensive to enter, provides access to capital which is reasonably priced (versus hard money lenders), and this market (versus equity funds) tend to be loyal to sponsor which performs at or above projections.

Is the alternative space right for you? Contact Rick Chess at rick@chesslawfirm.com to consider your alternatives!