Gap in cost of debt and equity capital narrows.

Market fluctuations of recent weeks have been bittersweet to the weary real estate community, another reminder that external economic and political forces (read non-fundamentals) can be punishing, this time to investors in the public securities markets. Real estate investors are wise to weigh for the future the lessons learned from these events.

It is clear that overheated (oversold) markets walk a tightrope from which they can easily fall. In 1987-91, over-leveraged real estate developers were wiped out overnight as the equivalent of margin calls were made by banks and other holders of soured real estate debt. Much the same scenario is being played out in the public markets as the hedge funds and small mutual fund investors bail out, further accelerating the drop in prices and the rise in volatility. Whether or not securities investors are now wiser, the real estate community has learned plenty and should be poised to avail itself of recent positive trends.

If past movements are a guide, bank financing will become more expensive as rates move upward, while availability oddly will increase. So long as demonstrable cash equity is invested (minimum 25 percent of purchase price or development cost), banks will step up their search for quality real estate loan business. Consequently, the astute real estate developer/operator, while needing the required equity, may simultaneously hedge his or her position by raising funds in the capital markets. The purpose of this article is to deal with the techniques available in the small-cap ($5 to $20 million) real estate market.

In assessing the cost of capital, it is interesting to note that the gap has substantially narrowed between the cost of debt and equity capital, equity investors being quite willing to accept the 8 to 9 percent preferential annualized returns which lenders receive in the form of current interest. Front end costs will, of course, be higher on the equity side, how much depending upon the size, type, and location of the assets involved in the offering, and upon the intermediaries involved. (Then again, equity carries no maturity date!)

What are these costs? Financial intermediaries (broker/dealers, underwriters, money managers, venture capitalists) will normally charge 5 to 10 percent of the total equity raised, depending upon the type of investor targeted and structure of the transaction. Where high net-worth investors are exclusively targeted, transaction costs will be reduced, if for no other reason than the ability of the high networth investor to persuade intermediaries (and sometimes professionals as well) to take less. Realistically, since the level of disclosure is lower and the time frames shortened, accountants, lawyers, appraisers and others down the line should be willing to accept lower fees. However, unless the property is of premium quality and the management team possessed of an extensive positive track record, it is our experience that the high net-worth individual, pension fund or other premium investor simply will not be interested.

But there is positive news - while real estate limited partnerships have in recent years been a difficult sale to the smaller investor in light of the adverse publicity of the Prudential and similar cases, as well as the 1986 tax legislation, the amount of good deals presently in the marketplace through reputable entrepreneurs willing to risk their own money has sparked interest among investors for many years on the sidelines. In terms of structuring, the initial question concerns the type of entity used to take title. Prudence and tax considerations would dictate use of a limited liability pass-through entity such as an "S" corporation or limited partnership. The taint which has surrounded limited partnerships since the 1987 crash would add lustre to other forms, but tax considerations and transaction costs still may indicate the partnership as the preferred vehicle. (Practice point: use the term "fund" in your offering materials where possible in lieu of partnership.)

Entering the market for real estate capital entails assembling a smooth running and effective team of professionals and money-raisers. While we like to think of the lawyers as the ringmasters, it is somewhat easier today to enlist a lawyer's services than to persuade a broker-dealer or other financial intermediary to support the project. Hence, a rigid economic assessment is paramount. The existence of steady cash flow, good location, quality tenants and good physical condition are threshold evaluations in all marketable real estate ventures - add good upside potential and seasoned management, and intermediaries will come. The next consideration is documentation - except in a "heads up" investment, where the level of participation in the investment is equal among all investors and no passive investor-promoter relationship is involved, disclosure documents must be prepared, fully notifying investors of all material risks related to the investment; describing conflicts of interest and related party transactions; setting forth a detailed use of the proceeds of the offering, and describing the tax implications. Care must be taken that all filings are timely and properly made.

Accounting requirements, while much less detailed for private placements than for public offerings, should be in the hands of an accounting firm experienced in the preparation of financial statements and forecasts, with a sense for the quality of information furnished by the sponsors and its acceptability in the capital markets. If the property is being acquired with the proceeds of the offering, an appraisal prepared by reputable MAI appraisers must be obtained, demonstrating the reasonableness of the purchase terms. Finally, thorough engineering inspections covering structural integrity, condition of basic systems and presence of any conditions constituting violations of environmental protection statutes and regulations must be carried out. Care should be taken to engage a firm of engineers fully experienced in the geographic area and with the examination procedures in all of the agencies having jurisdiction over the property. The engineer should be instructed to specify any deficiencies and to furnish detailed estimates of the cost of rectification.

We now turn to a summary of the legal bases for the private offering of real estate securities. While certain other exemptions from registration are available in limited circumstances, the principal Federal exemptions are those arising under [section] 4(2) of the 1933 Securities Act, more specifically, Regulation D adopted in 1982 and amended in 1992 as part of the Securities and Exchange Commission's small business initiatives. Regulation D has been largely successful in achieving its avowed purposes of bringing uniformity to federal and state regulatory schemes and expanding the opportunities for capital raising by extending and simplifying the process, thereby reducing costs and shortening time horizons. It is noteworthy that issuers of all sizes may use the exemption and that there are no limitations on the amount of capital which can be raised.

Regulation D comprises five rules which are the warp and woof of the regulatory fabric of private offerings: Rule 501 sets forth definitions of terms used in the Regulation, most notably that of accredited investor, which for our purposes means individuals with a $1 million net worth (home and car included), or with consistent minimum annual income of $200,000. Rule 502 sets forth general conditions to the use of the Regulation, most notably simplified financial statement requirements and liberalized disclosure requirements. The Rule is clear that the issuer or affiliates must not be under any stop orders or similar restrictions by the SEC or state regulatory agencies in order to avail themselves of the Regulation D exemption. With regard to risks and financial statement disclosure, the disclosure latitude is keyed to the size of the offering and the net worth and sophistication of the offerees targeted in the offering. Notice requirements are set forth in Rule 503, which requires filing with the Commission five copies of Form D not later than 15 days following the initial sale of a security. We advise that filing be made as early as possible in the offering stage since it may be assumed, incorrectly, that until escrow is broken, no "sale" has occurred. The former requirement that an amended Form D be filed after each subsequent sale has been repealed. Issuers must remember that additional filings may be required by the securities commissioners of certain states in which offers or sales are made and, if filings are made under Rule 505 (see below), the SEC may request submission of copies of the offering materials.

Rule 504 provides a clear and formidable exemption for the small issuer, ideal in that the attributes of a public offering are available free of the registration process and of the high level of disclosure required in most circumstances. The 1992 small business initiatives further enhanced the attractiveness of Rule 504 by increasing to $1 million the limitation on the dollar amount of securities which can be offered by a single issuer in any 12-month period. This may be the favorite exemption for the entrepreneur seeking to syndicate a small multi-family project or neighborhood shopping center offering, for the following reasons: general solicitation, advertising, cold calls, mailings and the like may be employed, permitting new investors to be solicited and brought into the fold for this and future transactions; investors may be enticed by the prospect of acquiring a fully tradeable security not subject to the strict resale limitations of other privately placed securities, no limitation exists on the number of non-accredited investors which may be brought in, widely opening markets, and transaction costs should be reduced since the disclosure requirements are reduced as is the time involved from contract to closing.

What are the catches? First, anti-fraud rules apply, thus requiring a disclosure document, however brief. Second (and very important), not all states have received Rule 504 in whole, and disclosure requirements, offering procedures and the like may be stricter. Indeed, some states' limited offering exemption adopts Regulation D without Rule 504. (New York, incidentally, requires a full registration in order to use general solicitation and promotional literature, although it has shown a willingness to negotiate comprises in appropriate circumstances).

Rule 505 is available for offerings not exceeding $5 million with no express disclosure requirements if only accredited investors are admitted. No limitation on the number of offerees is imposed, but advertising and other means of general solicitation are not permitted. Additionally, the SEC may request review of copies of offering materials, posing confidentiality considerations to private issuers.

Rule 506 remains the rule most used in private placements as it is the broadest and most comprehensive, eliminating any ceiling on the amount of capital which is to be raised and any limitation on the type of issuer eligible to use the exemption. As in Rule 505, a limitation of 35 non-accredited investors exists, and no specific informational requirements exist if no non-accredited investors participate. No limitation exists on the number of accredited investors. Unlike the other rules, Rule 506 imposes a requirement on the sponsor that a subjective determination be made as to the sophistication of the investors - accredited investors are presumed to be sophisticated but non-accredited investors should be required to complete questionnaires and follow other procedures in order that this requirement be satisfied. As in Rule 505, if non-accredited investors are admitted, specific disclosure requirements apply.

Future articles will deal with state requirements, most notably those of New York and California where the bulk of private real estate equity capital originates.