What to Look for When Reviewing a Private Real Estate Investment PPM
Have you ever read the Constitution? The whole thing?
I got a booklet containing the Constitution in the mail as part of a political fundraiser…errr, I mean as a gift from someone I didn’t know last election season. I was surprised when I realized I’d never read it all the way through.
I remembered the We The People part. But that was only the preamble. Being an American citizen without reading a detailed publication of our fundamental rights and privileges seems quite foolish.
Similarly, investing in a private real estate deal without reading the Private Placement Memorandum – the PPM – seems quite foolish as well. After all, you’ve worked hard to earn this money. And putting it in the hands of someone who could squander it is a travesty.
How to Read and Comprehend the PPM
Most PPMs are 50-150 pages and include information necessary to make an investment decision, though reading these documents can be mind-numbing at times. I typically recommend that people read in 30-45 minute blocks until finishing. All PPMs are for private investment offerings, not public offerings. Documents that publicly traded companies publish, such as the S-1, 10-K, 10-Q and others are obviously not available for private offerings. So you must review the PPM to understand the terms and conditions of the investment.
While I say this, I want to be quite clear that reading and comprehending the PPM is only one of many steps in the due diligence process. It is critical that you go through an extensive process like this before you invest with anyone. There are dozens of other steps. These may include…
A Zoom call and perhaps a face-to-face visit with the syndicator
A thorough background and criminal check on key principals
A systematic “death-by-Google” process to unearth any hidden and past information
Calls to references (both reported and independently unearthed)
Unannounced calls and unscheduled site visits to syndicator assets
…And a few dozen other items
Many investors jump through all these hoops and more…but fail to carefully read the PPM and/or Operating Agreement.
I’m writing this today to help you understand some of the essential PPM items. I will point you to what I think are the important sections. I want to be clear that understanding these sections below is not a substitute for reading the whole document. And for asking the sponsor hard questions.
And I also want to warn you about confirmation bias. Everyone has it. This is a tendency to review logical facts (much of what’s in the PPM) to simply confirm a decision you’ve already made. Unfortunately, this is usually a decision made chiefly on emotion. Your review of a PPM or any other document is then an exercise in futility. A drill designed to tell your wife you turned over every stone. (I’ve been married for over 34 years, and I know all these tricks!)
As we know, successful investing requires that we take emotions out of the equation. As Warren Buffett said in 2015, "Investing is an easy game if you can control your emotions."
As usual, I’m using the terms “syndicator, sponsor, and operator” interchangeably here. I’m not using the term “fund manager,” but that can also be an applicable term if you’re investing in certain real estate funds.
What Are Some of the Mission-Critical PPM Sections?
Executive Summary
This is usually not the very first item in most PPMs. It’s on page 5 in our Wellings Income Fund III PPM, after the “Summary of the Offering” and “Important Notices to Investors.”
This is worth reading first for several reasons. One is that it’s one of the fastest ways to learn you don’t want to make this investment. Or that you’re not qualified.
For example, you might learn there is a minimum that is higher than you’re willing to invest. Or that the investment requires you to be “Accredited” or even a “Qualified Client”.
Or you might find out there’s a long hold time. Some will be discouraged to learn the investment (like most syndications and funds) is not suitable for a 1031 tax-deferred exchange – time to look elsewhere.
This is also where you may learn about fees, leverage, and how cash flow is distributed to members, at least at a high level.
How to Review This Offering
Our PPM includes this section early on, even before the Table of Contents. This is essentially a roadmap that explains the what and why of various sections, including The Offering Package, the Operating Agreement, the Subscription Booklet, and more.
The Table of Contents
This may seem obvious, and perhaps it is. But I’ll say most PPMs have a detailed and quite helpful TOC. At a glance, I can use this to find my voting rights, the depreciation method, risk factors, the sponsor’s track record, and much more.
Source and Use of Proceeds
After skimming the items above, I’d make a beeline to this section. This is where you’ll get a helpful summary of where all the dollars originate (from investors) and where they are utilized at the time of the investment’s initiation. This will show you how much is allocated for legal expenses. How much is stripped off the top for initial operator fees. And how much of every dollar you invest actually makes it to the investment.
Distributions to Members
This is honestly the section I reference most often, and you should become thoroughly familiar with it before making an investment decision. This is where the flow of cash from the investment is defined. Cash flow is derived from at least three sources:
The operations of the company. This is the cash flow derived from rental revenues net of expenses and debt service.
The refinance of a company asset. This is the proceeds available from the refinancing of the existing loan or the addition of a second loan.
The sale of a company asset. These are the proceeds generated from the sale of the asset that is the focus of the investment.
This section deals with the order of payments to investors and the syndicator. It deals with concepts like preferred return, return of capital, profit splits, and waterfalls. This section can get complicated quickly.
Manager’s Fees or Other Compensation
This section may be structured like the Source and Use of Proceeds section of the PPM. This is a detailed breakdown of all the fees charged by the syndicator. These may include acquisition fees, capital placement fees, asset management fees, property management fees, and more. This section may even define expense reimbursements and interest on fees that were not taken by the syndicator they were due.
Risk Factors
Every investment has risk. This section provides a detailed overview of every risk the attorneys and operator could come up with to warn you about.
Some operators complain that this section will scare any investor out of investing. Some cynics say this section is just a way for the operator to cover their butt if anything goes wrong. But I would point out that this is an important section to review to really determine whether this is an investment that is right for you.
Some of the issues outlined include risks derived from the sponsor, investors’ voting rights, economic conditions, the asset type, the location, regulatory changes, conflicts of interest, taxes, and more.
While most investors understand that an economic crash, pandemic, or war could impact their returns, they might not have thought of specific risks related to an asset class that is new to them.
Prior Performance of the Company, the Manager, and Affiliates
This is a section outlining the track record of the operator, its managers, and key employees. It may refer the reader to exhibits with more detailed explanations of the other projects and investments managed by the sponsor. Statistics, sometimes in table form, outline the size and timing of previous and current investments as well as unrealized and realized returns.
Investment Objectives and Policies
This section provides the operator’s detailed plans to acquire, upgrade, operate, refinance, and sell assets. It may include the operator’s criteria to source the asset, the team’s competitive advantages, and how it plans to exit. This section also contains objectives like “providing members with limited liability” and “providing cash distributions to members.”
Taxes
Private Placement Memorandums typically have a section on tax treatments. Many investors skip over this. You may not enjoy or understand this section, but I recommend doing your best to understand (with your CPA or tax strategist) how you will be taxed or not taxed.
The majority of the tax language is actually in the Operating Agreement. This section deals with federal tax treatment for cash flow derived from operations, refinance, and the sale of assets. It anticipates taxes paid on depreciation recapture, phantom income, and Unrelated Business Income Tax (UBIT).
Definitions
Most PPMs include a section with the most important terms of the document all defined in one place. Capitalized terms throughout the document are often explained here. I recommend that readers skim this section to ensure they understand the basic terminology used throughout the PPM.
Concluding Thoughts
We’ve briefly reviewed some of the most critical sections of the PPM. The article is far from complete since there are so many variables concerning asset class, sponsors, deals, geography, and more. I hope this draws your attention to these items in particular. But I also hope this serves as a reminder for you to read every section of the PPM. And the Operating Agreement, aka the LLC Agreement, and the Subscription Agreement.
One quick tip for finding terms and sections in PPMs and OAs: Use Command-F on Mac or Ctrl-F on Windows when the PDF is opened. For example, if I wanted to quickly find out all details on the preferred return throughout the legal document, I would use Command-F and search “preferred return”. Then I would scroll through the search results to get my answers in short order.
I recommend you review these documents, make a list of questions, then see what you can answer on your own, from the web and other research. Then I would schedule a call with the sponsor’s investment representative (often a principal) to review open items. This provides you with a chance to test their comprehension of their offering and to see if they get back to you in a timely way on items they are unable to address on the call. This could give you a hint about their integrity, which is more important than any document.
Then before investing, I recommend you seek counsel from your spouse or significant advisors, as well as your attorney or CPA, to assure you get your questions answered and to confirm this investment matches your goals and objectives.
After making any investment, I recommend you occasionally refer back to the PPM to ensure the offering is operating as stated. And if you have doubts about inconsistencies in distributions or reporting, this document will serve as your constitution and bill of rights. Don’t hesitate to hold your operator accountable to it.
Please reach out to us if you’d like to discuss this article or learn more about passively investing in commercial real estate. Our team will be glad to assist you with any questions you have about any deals you’re considering or one of our offerings in particular.
If you have further questions, please email us at invest@wellingscapital.com or use this scheduling link to set up a call to see if Wellings Capital’s investments are a fit for you.
As with all financial matters, please do your own research, draw your own conclusions, and seek professional advice. The information contained in this article is for informational purposes only and is not intended to provide investment advice. Investors should consult their own tax, legal and accounting advisors before engaging in any transaction.