When raising money for a commercial real estate investment, the transaction sponsor is required to provide a number of legal documents to prospective investors.  These documents include marketing materials, a subscription agreement, operating agreement, legal disclaimers, and the Private Placement Memorandum (PPM).  

Of these documents, the PPM is one of the most important because it describes key information about the investment, its risks, and the underwriting assumptions used to calculate returns. The specific contents of the document can vary widely from one transaction to another, but they typically contain the same general sections, which are described in this article.  

In order to understand why the PPM is important, it is first necessary to understand how a typical commercial real estate transaction is structured.

Typical Transaction Structure

One common misconception about commercial real estate investing is that individuals are purchasing a fractional share of a real estate asset.  This is incorrect.  In most cases, investors are purchasing shares in the Limited Liability Company that owns the asset.  As shareholders in the company, investors are entitled to a portion of the income and profits generated by the underlying real estate asset.

In a private offering of real estate, shares in the company are sold under an exemption to Securities and Exchange Commission (regulatory authority) requirements.  To qualify for the exemption under Regulation D, the company is only allowed to sell shares in the LLC to “Accredited Investors” who meet certain income and/or net worth requirements.  In these types of transactions, the PPM is provided to investors to outline the terms and conditions under which shares in the LLC are offered.

Most PPMs contain the following major sections.

Legal Disclaimers  

Nearly all PPMs start with legal disclaimers designed to protect the company offering the securities.  The disclaimers can cover several pages, but typically contain the following key points:

• Potential risk factors for the investment 
• Suitability statement which says something like “this investment is only suitable for investors with the appropriate risk tolerance and time horizon.”
• A discussion of the fact that the document contains forward looking statements, but they should not be relied upon as an indicator of investment performance.  Actual performance can vary from the initial proforma.

The important point is that legal disclaimers are the fine print in the transaction and they should be read carefully.  Although they can be lengthy and presented in legalese, they present a very clear warning to investors that the investment involves a high degree of risk and that they could lose all or some of their investment capital.

Executive Summary

The executive summary section provides an overview of the investment opportunity, including the following key points:

• The Manager:  This section describes who is “running” the investment.  Often, the section names several entities, but a close inspection will reveal that the manager typically boils down to a handful of individuals identified as the “principals” of the company.
• Market Opportunity:  The market opportunity describes current market conditions and why the manager believes that they are conducive for a profitable investment.
• Investment Strategy:  This section provides an overview of the investment strategy / business plan that will be used to deploy investor capital.  In an investment fund, the statement could be more broad like “the manager will use capital to pursue value-add investment opportunities in the southeastern United States.”  Or, if the PPM is for a specific deal, the strategy could be something like “investor capital will be used to purchase a retail shopping center located in New York, NY.”
• Track Record & Investment Highlights:  If the manager has an established track record of success, they may prefer to highlight it as a way to reassure investors that they are experienced investors.
• Key Terms:  This is a critical section that highlights the most important aspects of the investment opportunity.  It typically includes things like:  target fund raise, minimum investment, investment holding period, preferred return, and cash distribution/cash flow split structure, additional capital contributions, and fees.
• Management of the Company:  Finally, this section describes how the company will be managed.  Typically it includes biographies of the investment principals and an overview of how major investment decisions will be made, what the investment objectives are, and how conflicts of interest will be managed.

If an investor is only going to read one section, they would be well served to read the executive summary.  The remainder of the document provides supporting detail.

Investment Approach and Investment Experience

This section focuses on the investment manager’s experience and approach and it is written to allow potential investors to determine if it is a firm they are comfortable investing with.  But, they should also remember that it is also written to portray the manager in the best possible light.  Usually it includes additional information like:

• Past profitability:  It may highlight past investments and their total returns 
• Current holdings:  To prove their experience, they may outline their other investments.
• Approach:  An overview of how the firm will deploy capital, what sort of pre-purchase due diligence they perform, and a summary of their risk management practices. 

Individuals should only invest with sponsors whose approach, objectives, and experience are consistent with their own beliefs.  This section will allow them to determine that.

Summary of Key Terms

This section highlights the key terms of the investment solicitation.  Often, they are provided at a summary level, with more detailed terms in the LLC Operating Agreement or other supplemental materials.  The Key Terms section includes information about:

• The Offering:  The units or number of shares being offered and the price for each.
• Principal Involvement:  Often the company offering the securities invests their own capital alongside investors.  This section describes how much, usually as a percentage of the total equity raise.
• Additional Closings:  Describes whether or not the manager, in their sole discretion, can conduct additional closings (capital raises) to allow additional membership interests to be acquired.
• Defaults:  What happens if any member defaults on their capital commitment.
• Capital Calls & Operating Expenses:  If the company requires additional capital, this section outlines how the “calls” are made and what the obligations of each member when they get one.
• Fees:  Describes what fees are charged by the manager and how much they are.  Fees typically include: management fees, debt placement fees, and sale fees.
• Liquidation of Assets:  How and when the property will be sold.
• Removal of Manager:  If the investors are unhappy with the manager, this section describes the procedure for removing them.
• Valuation:  Describes how and when the real property is valued.  Typically, this means hiring a qualified appraiser to conduct an appraisal on a regular basis.
• Financial Statements:  Describes who is responsible for preparing the company’s financial statements and whether they will be audited by an outside firm.
• Securities Laws:  Describes the specifics of the securities laws that make the offering possible.  Usually, it is under the Securities Act of 1933 and subsequent amendments.  There may also be citations for applicable state securities laws.

Clearly, this is a critically important section that outlines the key terms and conditions for the investment.  Individuals are well served to pay close attention to understand the risk profile of the opportunity.

Conflicts of Interest

Professional real estate investment firms invest in a lot of different deals with many different clients.  As such, there is always the potential for conflicts of interest.  If they exist, they are described in this section.  For example, potential conflicts of interest could include things like:

• The manager may form other investment entities in the future with similar objectives to the offering.
• Principles of the manager may have a time allocation that is split between the investment being offered and other projects.  This has the potential to have an adverse effect.
• All or some portion of the LLC has the potential to be acquired by the manager. 
• The compensation paid by the LLC to the manager may not be “arms length” meaning that the manager has a vested interest in the LLC and the ability to determine their own compensation.

Like the Terms section, it is important that investors read the conflicts of interest section carefully to ensure they are comfortable with the risk profile of the deal and the current or potential conflicts of interest for the manager.

Risk Factors

This may be the most important section in the document.  In it, the manager outlines the risks in the transaction as they see them.  Each deal is unique, but the risk factors tend to fall into the same categories:

• Market Risk:  The value of the investment could be impacted by certain factors out of the manager’s control.  They include things like:  adverse economic conditions, changes in the federal income tax rate, changes in interest rates, changes in internal revenue service (IRS) rules, changes in tax laws (and their associated tax consequences), and changes in federal securities laws.
• Liquidity:  Traditionally, commercial real estate investments are somewhat illiquid, which can pose a risk to individual investors.  In addition, the transferability of the investment may be somewhat limited.
• Default Risk:  There is always a risk that the tenant can default on their lease payments, which could impact the investment’s return of capital.
• Financing Risk:  The property’s indebtedness may raise the risk profile of the deal either through variable rates or an inability to refinance the loans.

Typically, the risks section is quite lengthy as the manager is obligated to identify all possible risks so potential investors are fully informed.

Securities, Anti-Money Laundering, and ERISA Considerations

Because money is changing hands, the manager is required to cite their compliance with a series of important laws that govern the transaction.  They typically include the:

• Securities Act 
• Investment Company Act
• Investment Advisers Act 
• Anti-Money Laundering Laws like the Patriot Act and other OFAC rules.
• ERISA 

It is important for investors to understand what laws are applicable to the transaction and what steps the manager is taking to demonstrate compliance with them.

Tax Considerations

Finally, The PPM will outline the major tax considerations in the investment.  Usually, this section includes an overview of the company’s organizational structure and how it is taxed.  It may also discuss how individual investor tax liability / taxable income is calculated.  Such information should always be provided to tax advisors and CPAs if there is any doubt about how it works.

Summary and Conclusions

Any time a real estate firm is looking to raise money from individual investors, one of the documents that they will issue is called a Private Placement Memorandum (PPM).  This document details all of the terms and conditions of the issuance and all of the risks associated with participating in it.

Although they can be lengthy, they should always be read in detail by prospective investors before committing capital.  If there is any uncertainty, individuals should ask questions of the company offering the securities or consult with their own tax advisors and attorneys.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. We leverage our decades of expertise and our available liquidity to find world-class, multi-tenanted assets below intrinsic value. In doing so, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

If you are an Accredited Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.