The Emergence of DPPs · (IPA) was an integral player in preserv-ing the nearly 100-year-old...

S E P T E M B E R 2 0 1 8

The Emergence of DPPsDirect participation programs are expanding investor choice

A Supplement to Real Assets Adviser, September 2018

Published by Institutional Real Estate, Inc. in conjunction with the Institute for Portfolio Alternatives

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Published by Institutional Real Estate, Inc. in conjunction with the Institute for Portfolio Alternatives

INSTITUTIONAL REAL ESTATE, INC./REAL ASSETS ADVISER

President & CEO Geoffrey Dohrmann

Publisher & SVP Jonathan A. Schein

Managing Director Jennifer Dohrmann-Alpert

Editorial Director Larry Gray

Special Projects Editor Denise DeChaine

Contributing Writers Joseph Dobrian, Beth Mattson-Teig

Art Director Susan Sharpe

Business Development and Ad Sales Cynthia Kudren

President & CEO Anthony Chereso

Chief Communications Officer Matt Tramel

Senior Vice President, Government Affairs and General Counsel Anya Coverman

Contributing Writers Hayley Fry, Daniel Cullen, Peter R. Matejcak, Sukbae David Gong

Copyright © 2018 by Institutional Real Estate, Inc., 2274 Camino Ramon, San Ramon, CA 94583. Material may not be reproduced in whole or in part without the express written permission of the publisher. The publisher of this special report is not engaged in rendering tax, accounting or other professional advice through this publication. No statement in this report is to be construed as a recommendation to buy or sell any security or other investment.

FEATURESContents

10 Advocating for progressive DPP legislation By Matt Tramel

4 Resilience in securitized 1031s By Haley Fry

20 QOZs: opportunity ahead By Daniel Cullen, Peter R. Matejcak and Sukbae David Gong

24 Private debt investments By Beth Mattson-Teig

26 Energy programs appear resurgent By Joseph Dobrian

14 Reg D offerings on the rise By Jennifer Dohrmann-Alpert

1EMERGENCE OF DPPs | FALL 2018

The management of Americans’ retirement dollars is undergoing a fundamental trans-formation from a world of defined benefit plans, which asked little effort of partici-pants, to a landscape dominated by defined contribution plans that require individuals

to develop their own investment strategies. This year marks the 40th anniversary of the 401k, and, today, many workers are entering retirement with only defined contribution assets. This shift pressures individual investors to secure their financial future largely without access to the institutional expertise and strategies that effectively served past generations. According to the Investment Company Institute, since 2007, defined benefit plan holdings have dropped from 39 percent to 31 percent of retirement assets, while assets in defined contribution and IRA accounts have grown substantially. There has been a 700 percent increase in defined contribution plan participants since 1975. During that same period, the number of defined benefit participants has fallen by 44 percent, according to the Department of Labor.

Fortunately, the portfolio diversifying investments (PDI) industry continues to evolve in order to provide individual investors and their financial advisers with access to institution-al-style investment strategies to better diversify their portfolios, delivering superior risk-adjusted returns and long-term outcomes. Direct participation programs (DPPs) — including 1031 exchange/DST products, Regulation D offerings, energy programs, private debt funds and qualified opportunity zones (QOZ) — offer a range of options to accredited investors.

I have found, however, that information on the latest trends and analyses of the market for DPPs and other private placement investments can be difficult to find. That is why the Institute for Portfolio Alternatives (IPA) is proud to partner with Real Assets Adviser to deliver this timely special report. Our goal is to educate registered investment advisers, broker-dealers and family offices on the distinctive features of DPPs and the role private placements can play in the management of America’s retirement assets.

You will read about the staying power of 1031 like-kind exchanges; the growing popularity of Regulation D offerings; a renewed interest in energy programs; and the unique qualities of private debt investments. We also examine qualified opportunity zones — a new investment and economic development tool established by Congress as part of tax reform. Qualified opportunity zone funds could be a significant contributor to urban renewal across the coun-try, while at the same time offering tax-advantaged investment returns. Finally, we will update readers on the latest legislative and regulatory developments affecting DPPs.

The PDI industry has a lot to be excited about. We continue to be a big — and grow-ing — tent that is evolving to offer innovative products historically beyond the reach of individual investors. DPPs play a critical capital formation role in today’s economy and can serve as the cornerstone of a well-constructed investment portfolio.

Beyond this special report, the IPA has a range of educational opportunities dedicated to DPPs in the months ahead, including: dedicated programming at the IPAVision 2018 and Due Diligence Symposium; upcoming webinars on issues unique to the DPP community; and continued public advocacy in the media, in Washington, D.C., and across the 50 states. Quite simply, we will continue to lead this important conversation.

We hope you enjoy the special report.

President & CEOInstitute for Portfolio Alternatives

Anthony CheresoPresident & CEOInstitute for Portfolio Alternatives

Portfolio diversification isn’t just for institutions anymore

EMERGENCE OF DPPs | FALL 20182

This is neither an offer to sell nor a solicitation of an offer to buy the securities described herein. Only a prospectus or private placement memorandum makes such an offer. This literature must be read in conjunction with the prospectus or private placement memorandum in order to fully understand all of the implications and risks of the offering of securities to which it relates. Please read the applicable prospectus or private placement memorandum in its entirety before investing for complete information and to learn more about the risks associated with these offerings. No offering is made to New York residents except by a prospectus or private placement memorandum filed with the Department of Law of the State of New York. The Attorney General of the State of New York has not passed on or endorsed the merits of these offerings. Shares offered through: Select Capital Corporation (Member of FINRA and SIPC).

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T he securitized 1031 exchange sector is in the midst of what could be its best year since 2007 — and industry leaders see even

more room to grow in the years to come. In the give-and-take that characterizes

the legislative process, the industry was wary that the new law would eliminate 1031 like-kind exchanges in order to raise revenue to offset other tax reductions. But industry efforts to educate lawmak-ers paid dividends, as Congress elected to

preserve 1031 real estate exchanges in the final law — a testament to the important role the sector plays in the U.S. economy.

This optimism is more meaningful because of where the industry was just a year ago: Fac-ing possible extinction as part of the hotly debated tax reform legislation. The Tax Cuts and Jobs Act was eventually passed by the U.S. Congress and signed into law by the President in December.

Previously known as Section 112(b)(1), Sec-tion 1031 of the Internal Revenue Code was

adopted in 1954 and allows investors to defer capital gains taxes by reinvesting proceeds into a similar, like-kind investment within a speci-fied 180-day time frame.

The Institute for Portfolio Alternatives (IPA) was an integral player in preserv-ing the nearly 100-year-old provision and assembling a dedicated team of tax and 1031 like-kind exchange experts that held a series of meetings with the leadership of both the House Ways and Means and Sen-ate Finance committees.

By Haley Fry

RESILIENCE INSECURITIZED1031s DRIVES REBOUND

4 EMERGENCE OF DPPs | FALL 2018

One of the key efforts: At the request of Ways and Means lead counsel, the IPA submit-ted a white paper explaining the importance of retaining Section 1031 like-kind exchanges in any comprehensive tax reform legislation.

The countless meetings that IPA members held with Congressional offices helped to effec-tively demonstrate the role of Section 1031 — and specifically the securitized 1031 exchange space — in encouraging continued invest-ments in America’s real assets, which ultimately creates jobs and grows the economy.

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RESILIENCE INSECURITIZED1031s


“The securitized 1031 market has evolved tremendously since its inception almost 20 years ago,” says Keith Lampi, president, director and chief operating officer of Inland Private Capital Corpora-tion. “Coming off tax reform, the industry continues to grow as a dynamic market-place with a bright future.”

Louis J. Rogers, founder and chief exec-utive officer of Capital Square 1031, was one of several industry leaders who worked to defend Section 1031 directly with mem-bers of Congress, alongside Dan Cullen

of Baker McKenzie, Dan Wagner of The Inland Real Estate Group, and David Fisher, co-founder and managing member of ExchangeRight.

Fisher, who oversees the acquisition of ExchangeRight’s net lease and multifamily portfolio properties, received IPA’s 2017 Outstanding Service Award for his work in representing the industry in tax lobbying efforts in Washington, D.C.

“Last year, we all worked hard to convince Congress that Section 1031 is a good provision that makes sense for our economy,” Rogers says.

“Following enactment of the tax reform bill, business has been increasing every quarter.”

At Capital Square, Rogers oversees the firm’s Delaware Statutory Trust — or DST — programs for investors seeking qualify-ing replacement property for Section 1031 tax-deferred exchanges, as well as other regu-lar, non-exchange investors.

Even in the face of last year’s uncertainty, the industry raised $1.9 billion in equity for the year, according to new data from Moun-tain Dell Consulting. In fact, sales growth has increased steadily since 2010.


The growth is in large part thanks to large sponsors who have helped evolve the securi-tized 1031 space based on lessons learned from the financial crisis.

“After the financial crisis, our previously growing industry took several steps back-ward,” relates Lampi. “This business is one that has long-term viability, with a very clear-cut demographic trend that will continue to pro-pel us forward.”

According to Mountain Dell Consulting’s latest quarterly market report, the industry’s total equity raise in 2018 is on track to be up to $2.4 billion. The continued growth of this market illustrates both the latent demand for these securities and the desirability of real property investment.

THE SALES ROLLER COASTERMountain Dell, an affiliate of Orchard Securi-ties, began tracking data for the industry after tenant-in-common properties became popu-lar thanks to the U.S. Treasury Department issuing Revenue Procedure 2002-22 in March of 2002.

This revenue procedure — which provided written guidance on the circumstances that the Internal Revenue Service will recognize tenant-in-common ownership as eligible for tax-free exchanges under Section 1031 — allowed investors to use the structure as qual-ifying “replacement property” to defer gains on real estate transactions involving the exchange of properties.

The number of offerings and amount of equity raised recorded by Mountain Dell nearly doubled every year from 2002 to 2006 — rocketing from 45 offerings raising $356.6 million in 2002 to 341 offerings raising $3.6 billion in 2006.

But the financial crisis brought hard times across a wide swath of commercial real estate investments. The amount of equity raised fell as low as $169.8 million from 21 offerings in 2010. At the time, there were just eight spon-sors who raised equity.

“In 2009 and 2010, which represented the trough of industry sales velocity, we stayed in the space despite low sales vol-ume,” notes Lampi, who, during his career, has been involved in more than $6.9 billion in real estate transactions across retail, office, industrial, student

housing, self-storage and multifamily property types.

“We viewed that time period as an oppor-tunity to take an introspective approach to improving the product structure. We evolved everything from how we structured trans-actions, to broadening the asset classes we offered, while also reducing the cost structure for end investors. The underlying story of today’s growth lies in the down years immedi-ately following the crisis where we made many strategic decisions to modify and improve our product structure in a way that helped catapult industry success today. From an industry per-spective, I think the marketplace has now really hit its stride,” Lampi adds.

This optimism appears to be supported by the numbers and persists even in the face of the ongoing policy risks to Section 1031. Those risks stem primarily from potential shifts of power in the House or Senate, as a result of midterm elections, that could sustain new efforts to adjust the tax law.

As of the end of June, the industry has raised $1.2 billion in 78 offerings — surpassing the total equity raised in 2015 when the industry crossed another important milestone in its

efforts to rebuild after the financial crisis: The $1 billion mark.

“At the pace we’ve seen equity raised in the first half of 2018, we’re back to just slightly under 2007 levels,” says Warren Thomas, a founder and managing direc-tor at ExchangeRight based in Pasadena, Calif., and a top retail producer in the early 2000s. “We’re not quite back to 2005 and 2006 levels when we hit more than $3 bil-lion in equity raised each year, but there is optimism we’ll get there again.”

Thomas, who has more than 30 years of experience as a CPA and has been an active commercial real estate investor for the past 20 years, has seen consistent 40 percent to 50

percent annual growth at his firm, which holds about 10 percent of the market share, accord-ing to the Mountain Dell report covering the period January through June 2018.

EVOLVING STRUCTURES SUPPORT SALES GROWTHBehind the numbers, the securitized 1031 indus-try itself has transformed drastically since 2002. Back in 2006, Mountain Dell reports there were 71 active sponsors that raised $3.65 billion in investor equity driven by the popularity of the tenant-in-common structure.

In the first half of 2018’s 78 deals, just one tenant-in-common offering was brought to market. The space now is occupied largely by DSTs.

“Essentially, the tenant-in-common struc-ture went away in the recession and is not in common use today,” says Rogers of Capital Square 1031. “At a high level, a DST operates much better for investors.”

Inland was a pioneer in the DST corner of the securitized 1031 market.

Experts believe the market is health-ier than in the early 2000s, when the tenant-in-common structure prevailed. One of the key benefits is the ability to

have more investors in a DST than in the tenant-in-common arrangement.

“For one, DSTs typically allow up to 499 investors. It may be limited by the specific arrangement a sponsor has with the bank, but the law will allow many more investors to participate in one offering than in the tenant-in-common structure,” says Thomas.

In the tenant-in-common era, each offering was limited to only 35 investors.

“Increasing the number of investors in an offer-ing also allows the industry to lower minimum investments,” adds Rogers. “The minimum investment in the tenant-in-common days could easily be $1 million. That meant, people might invest in one offering.”

The optimism appears to be supported by the numbers and persists even in the face of the ongoing policy risks to Section 1031.


That was problematic. The 35-investor limit not only led to the high minimum invest-ments, but it also didn’t allow sponsors or investors to diversify.

“The tenant-in-common was a single-asset offering as you could only raise capital from 35 investors,” comments Thomas. “The DSTs allow for the advent of multiple property port-folios — you can have multiple apartments in one offering to create balance.”

“There are diversification undertones that explain just one of the many reasons why the industry adopted DSTs over the tenant-in-common structure. The tenant-in-common structure of the past just didn’t encourage diversification,” muses Lampi. “An investor with exactly $500,000 had to choose one product with one sponsor just to meet the minimum investment threshold, which impeded a financial adviser’s ability to provide a client property diversity — say by choosing a product in the apartment sector or office sec-tor. That was a major limitation.”

“Now, regular folks can diversify and invest in multiple properties,” adds Rog-ers. “The greatest way to reduce single-as-set risk is to diversify, that is, to invest in a number of properties. The DST makes it easy for investors to diversify — the sponsor conducts all the due diligence, closes on the real estate and loan when applicable, manages the property on a turn-key basis, and sells the property at the end of the holding period. It is truly a turn-key investment, making it feasible

to diversify and reduce risk by owning a portfolio of DSTs.”

The DST not only provides diversification, but it also addresses one other major flaw in the tenant-in-common structure.

“The biggest limitation of the tenant-in-common structure didn’t rear its head until harder times,” notes Lampi. “As the recession ran its course, the fact that, under the tenant-in-common structure, a sponsor had to obtain unanimous consent for any major decision presented chal-lenges. By example, let’s say you received an attractive bid to purchase a property, the sponsor would have to get unanimous consent among all 35 investors to move forward. Time and time again, this would stymie the value proposition that sponsors aspire to deliver their investor base.”

In many respects, the DST market expanded post-recession thanks to the spotlight that exposed these flaws in the tenant-in-common structure.

“During the recession and afterward, lenders viewed financing real estate dif-ferently,” says Lampi. “It became difficult to obtain a loan if structured as tenant-in-common ownership, as lenders realized the impact the unanimous consent provi-sion had on sponsors’ ability to navigate market cycles.”

“ExchangeRight, formed in 2012 as the 1031 market was beginning to rebuild, has been intentional in offering programs that built in structural improvements compared

to the earlier tenant-in-common offer-ings,” Thomas notes. “An ExchangeRight DST portfolio typically includes up to 20 properties.”

ExchangeRight also introduced a lower dis-position fee and a model that would entirely waive the fee should a DST program fail to return all of the investors’ capital upon sale.

“Now, the DST business is very strong,” says Rogers. “The industry’s potential is firmly based on a demographic trend. Many real estate investors realize that they do not want to manage their own property, especially as they grow older. Today, many real estate investors can sell their investment property for a record price and defer all taxes by investing in one or more DSTs, where they don’t have to deal with tenants, toilets and trash.”

And opportunities still exist in the market, whether it’s the clear demographic trend in the investor marketplace or the ability to reach new accredited investors.

“This industry is now well-positioned to serve the registered investment adviser market in a significant way,” comments Thomas. “A commitment to that market-place for two to three years could help sponsor firms achieve substantial gross vol-ume in the marketplace.”

There also remains untapped potential to market to accredited investors under Rule 506(c). The rule, which came to be as part of the Jumpstart Our Business Startups Act in 2012, allows for parties to advertise their private investment opportunities to


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any interested parties, if the investor can provide proof they are accredited before they invest.

“The prospective market is enormous, and we now have a way to reach a grow-ing number of investors in need of 1031 replacement property,” Rogers adds. “Rule 506(c) of Regulation D changed the world of fundraising by permitting sponsors, broker-dealers and registered reps to adver-tise and solicit for DST investments. It is now easier to educate investors on the replacement property options available in the market. The Internet is going to drive the next wave of 1031 investors; we started with TICs and now DSTs, with the abil-ity now to reach a larger audience via the Internet. That is truly amazing; I would not have believed it possible a decade ago.”

Yet with significant growth opportunity, there should come significant diligence, and that underscores the importance of the industry coming together to improve and innovate products on behalf of investors.

Thomas cautions, “The challenge with an expanding market is that increased money flow could lead sponsor firms to compro-mise their program acquisitions or mod-els and for the investment community to compromise their due diligence in an effort to expedite the placement of funds. Being uncompromising in our combined efforts is necessary for our mutual success and for these long-term real estate investments to provide value to our investors.”


Matt Tramel, the IPA’s chief communications officer, recently sat down with Greg Mesack, partner at the Eris Group, and Anya Coverman, senior vice president, government affairs and general counsel at the IPA, to discuss the latest legislative and regulatory updates surrounding direct participation programs. The discussion highlights the important role of the IPA’s policy advocacy initiatives in strengthening the capital markets for DPPs.

Let’s first talk about expanding the definition of an accredited investor, which the IPA has long supported. Could you describe the IPA’s advocacy on this important issue? What have we done up until now, and what does it look like going forward?

Greg Mesack

From a policy perspective, the IPA has been very active on the definition of “accredited investor” starting back in 2014, when the SEC, per the Dodd-Frank Act, was required to report on the definition of an accredited investor. The IPA became concerned that future SEC rules could dramatically shrink the pool of accredited investors, drying up a signifi-cant source of capital that is being used for positive economic activity — investing in commercial real estate, for example. We began actively engaging the SEC, including meeting with their staff and commissioners, to explain that we should look

Anya Coverman is senior vice president, government affairs and general counsel at the IPA.

Greg Mesack is partner at Eris Group.

A conversation with Greg Mesack and Anya Coverman

By Matt Tramel

IPA CONTINUES TO ADVOCATE FOR

PROGRESSIVE DPP LEGISLATION


for prudent, responsible ways to grow the pool of accredited investors. Even though some investors may not meet the financial-based thresholds, they could have professional experience or educational background that should be considered.

Simultaneously, we worked with Congress for the past three years on legislation — in both the House and the Senate — and, spe-cifically, we engaged the committees with jurisdiction over the bills. Now we’re seeing real progress, with bipartisan legislation hav-ing passed the House and introduced in the Senate. We’ve educated policymakers and reg-ulators, which has had a positive impact. We believe the legislation is moving in the right direction and that the SEC is also looking at the issue from a similar perspective as the IPA.

Anya Coverman

By way of background, the current definition of accredited investor was established in 1982 as part of Regulation D and provided that a person would qualify if they had an individual net worth — or joint net worth with a spouse — that exceeded $1 million at the time of purchase. Today the definition excludes the value of your primary res-idence in calculating net worth. An investor can also qualify if he or she has had income exceeding $200,000 in each of the two most recent years, or their joint income with a spouse was $300,000 for those years, with a reasonable expectation of the same income in the current year. The Dodd-Frank Act requires the SEC to review the defi-nition as it relates to natural persons every four years. While the SEC issued a staff study in late 2015 considering potential changes, the defini-tion has not been comprehensively reviewed or updated since 1982. Meanwhile, the accredited investor definition is the cornerstone of Regu-lation D, which provides the most widely used exemptions from registration for issuers of secu-rities offerings. As such, it is a vital capital rais-ing tool for many businesses in today’s market. Unfortunately, because the definition does not take into account nonfinancial thresholds, such as education, professional or investment experience, or licensing credentials, many individual investors do not qualify and are unable to participate in investment opportunities available to other high-net-worth or institutional investors. The IPA has been actively engaged in supporting the House and Senate accredited investor bills that expand

the definition in a responsible and prudent man-ner, and we continue to encourage the SEC to do the same. We are hopeful that this common sense bill, which has bipartisan support in both the House and Senate, and which passed the House with overwhelming support, will make it to the President’s desk.

As you both discussed, the IPA is supporting both the House and Senate versions of the Fair Investment Opportunities for Professional Experts Act. What would passage mean for our industry?

Greg Mesack

It does three things that are beneficial for IPA’s members. It codifies by statute the numeric thresholds for income and net worth, and adjusts for inflation only on a going-forward basis. It also allows individuals with sufficient educa-tional background or industry experience, who might not otherwise meet the financial-based thresholds, to still be defined as accredited inves-tors. These individuals should have the opportu-nity to make investments because they have the requisite financial knowledge and clearly under-stand the risks of an investment. We should be expanding investors’ opportunities to diversify their portfolios and grow their wealth outside of the traditional equities markets. And finally, for those who don’t meet either the financial thresh-olds or have the requisite professional credentials, it establishes a financial literacy test to demon-strate their investment sophistication. All three of these are common sense.

Anya Coverman

In addition to codifying the current financial thresholds into statute, the bills recognize that certain investors should qualify as accredited based on nonfinancial, or qualitative, factors. In other words, individuals can be deemed accred-ited if they have a sufficient level of financial understanding and expertise, and the ability to withstand the risk of loss. These were the core tenants of the accredited investor definition when it was originally created. The bill also includes persons that have passed examinations that test their knowledge and understanding

in the areas of securities and investing, includ-ing the Series 7 or Series 65. For our members and our industry, this means that the pool of accredited investors will be expanded, but in a responsible manner. It will also mean that the SEC will be charged, along with FINRA, with setting forth a new process — whether by test, certification or other qualification — by which these additional investors will qualify under the definition. While the IPA strongly supports this bill, we have also noted that it should include the reasonable belief standard currently found in Regulation D, and a grandfathering provision to allow existing investors to participate in future investments in the same issuer to avoid dilution of their current investments.

Regulation A+ expansion has been an advocacy priority for the IPA and was recently passed into law through the Economic Growth, Regulatory Relief and Consumer Protection Act. How did that bill achieve such wide-ranging, bipartisan support?

Anya Coverman

To be clear, there are two separate Regulation A+ bills that the IPA supports. The Regulation A+ bill that was part of the Economic Growth, Regulatory Relief and Consumer Protection Act, which passed in late May, allows SEC reporting companies — those that file annual, periodic and other reports under the Securities Exchange Act — to qualify for the Regulation A+ securities exemption. Previously, only non-reporting companies could take advantage of Regulation A+. While most IPA members are already able to raise money under Regulation A+ — or through a public nonlisted program — this was a common-sense bill that expanded the opportunities under Regulation A for reporting companies. This is significant for issuers that are subject to the Exchange Act and whose securities may trade on over-the-counter markets, as com-pared to larger exchange-traded issuers that can use the Form S-3 for quick access to capital. The other Regulation A+ bill that the IPA supports is the bipartisan Regulation A+ Improvement Act, which passed the House in March. This bill would increase the Regulation A+ Tier 2 thresh-old from $50 million to $75 million — again a

IPA CONTINUES TO ADVOCATE FOR

PROGRESSIVE DPP LEGISLATION


reasonable and common-sense measure. In fact, the IPA believes that with some additional inves-tor protections, that threshold could be further increased to $100 million or more. We hope this bill will gain traction in the Senate, and we will continue our support for it in both chambers.

Greg Mesack

The Regulation A+ bill that was part of the Eco-nomic Growth Act passed in the old-fashioned way: a lot of work and a lot of discussion! There is a desire between both parties on Capitol Hill to try to help small financial institutions and investors invest more capital into the economy. Senators on both sides of the aisle came together and asked, “What can we put together that we all agree on?” They started cobbling together the issues that are important to all of their constitu-ents and came up with a bill that was bipartisan and helps a broad array of financial institutions and investors. It took a lot of leadership from both sides of the aisle, and they got it done.

Explain why the IPA is focused on these capital market issues in terms of growth and efficiency in our own industry.

Greg Mesack

We are trying to find more ways for IPA mem-bers to offer a wider array of high-quality invest-ments to diversify people’s portfolios. When companies have more flexibility, they can pro-vide more products to their customers to help them achieve their investment goals. And when investors have more products to choose from, more capital will flow into the economy. That is the proverbial win-win.

Anya Coverman

The IPA will continue to support and push for capital formation measures that give investors more opportunities and options, stimulate the economy and support job creation. We also believe in high-quality, transparent products. Our members are uniquely positioned to sup-port these initiatives because they provide these

types of long-term investment products, many of which are state- and SEC-registered, thus provid-ing a great deal of disclosure and transparency. This aligns with Congress’ goals — to create fair and efficient markets and investment opportuni-ties not only for institutional investors, but also for the average mom-and-pop investor.

Moving on to the Small Business Audit Correction Act of 2018, why did the IPA support the bill, and what effect would it have on raising capital in our industry?

Greg Mesack

This bill is a perfect example of common-sense legislation that removes unnecessary burdens. The Public Company Accounting Over-sight Board (PCAOB) was created out of the Sarbanes-Oxley Act in 2002 to provide over-sight of public company auditors. Eventually all brokers-dealers would be required to have their audits completed by a PCAOB-registered auditor. But what they didn’t realize is that, for a small broker-dealer with only a few reps, or that doesn’t have custody of the actual assets, that is overly burdensome from a time and financial resources perspective. This bill says that if you are noncustodial or you have 150 reps or less, and you are not public, you can go to any auditor that works best for your business. So while this law isn’t targeted to capital formation, it will remove unnecessary regulatory burdens. The IPA is trying to make their members’ lives a little bit smoother and easier.

Anya Coverman

The IPA conducted a survey of its members and found that it is very difficult for small broker-dealer firms to find a PCAOB-registered auditor to conduct small firm audits. Few con-duct these audits and increasingly charge high fees, as it is not cost effective for them from a profit standpoint. Moreover, the paperwork required is tailored not to small firms but to large public companies or brokers that carry customer funds or securities. There is a lot of support for the bill, including from industry coalitions. In

fact, the FINRA Small Firm Advisory Commit-tee and its three small firm representatives on the FINRA Board of Governors are also working separately with members of Congress, the SEC and the PCAOB to gain this small firm exclusion from the requirements. This is another bipartisan effort supported by many different participants.

The growth in Direct Participation Programs continues, given how popular they are with advisers and the important investment solutions they offer. What does the future regulatory environment look like from the state securities perspective, and is there anything on the front burner in relation to DPPs?

Anya Coverman

The states continue to review nontraded, registered investment products, including nontraded REITs and business development companies. From a private placement perspective, states do not review or regulate federally covered securities offerings such as Regulation D (i.e., Rule 506) private placements. States continue to have an important role in policing markets for fraud and bad actors, which is work that the IPA fully supports. The IPA believes that protecting investors and giving them confidence to invest in the market and diversify their portfolio is the best way to increase access to capital. Working alongside federal and state regula-tors supports the growth of our industry, and so we view the role of the states as going hand-in-hand with the mission of the IPA..

Greg Mesack

The states are trying to protect the investors in their states from fraud. What the IPA has also been doing for years is continuing to educate state regulators about our products and about the value they provide, given that some of them are not as well known. Some state regulators may have preconceived notions about some DPP products, and it is our job to continue to explain their value in the market. We want to make sure that everyone can benefit from the important products that IPA’s members provide.


Martel Day Founder and Principal

Drew Dornbusch Managing Director

Vickie Stone Director of Client Services

404.963.8138 | www.nlradvisoryservices.com

Private Placements NAV REITs

Interval Funds 1031 Exchanges

Preferred Stock

Helping Alternative Asset Managers Access Retail Capital

Cameron Hellewell, General Counsel, Orchard Securities

Louis Rogers, Founder and CEO, Capital Square 1031

Michael Schwartz, Chief Executive Officer, SmartStop Asset Management

Scott Lawlor, Founder and CEO, Waypoint Residential

A conversation with Cameron Helewell, Michael Schwartz, Scott Lawlor, Louis Rogers, Cory Johnson, Edwin Stanton and Kirk Montgomery. Introduction by Jennifer Dohrmann-Alpert.


Capital formation through private placements, particularly in Regulation D’s, has increased substantially since the onset of the financial crisis. Amounts raised through unregistered securities offerings have outpaced the level of capital formation through registered securities offerings during recent years. Revolutionary changes in the private placements market have given businesses the unprecedented opportunity to begin or expand operations by reaching new markets for their securities to quickly and inexpensively raise capital. The same kind of change that swept through the mutual fund industry, making investing in a fund a quick and easy process and bringing billions of dollars into the industry, is now impacting the world of private placements.

The following contributions from lead-ing industry executives in the private placement space serve to explain the vari-ous definitions and applications of private placement Reg D vehicles.

Orchard Securities: In an effort to clarify terminology, please describe the difference between 506(c) and 506(b) offerings, as well as define a Reg A+ offering. Are there more suitable distribution channels for each?

Cameron Hellewell

Although both Rule 506(b) and Rule 506(c) of Regulation D provide exemp-tions from registration when selling to accredited investors, there are significant differences between them. The primary difference is that Rule 506(b) prohibits any general solicitation or general advertising to market the securities, whereas such mar-keting is not prohibited under Rule 506(c), provided that all investors are accredited and the issuer takes reasonable steps to ver-ify that the investors are accredited. There are no limitations on how much equity can be raised through Rule 506 offerings.

Regulation A+ became effective in June of 2015 and also provides an exemption from registration. Unlike Rule 506 offer-ings, however, subject to certain limita-tions, nonaccredited investors may be admitted into a fund offered through Reg-ulation A+, though there are limitations on what can be raised through Regulation A+ offerings — $20 million in a 12-month period on Tier 1 offerings, and $50 million in a 12-month period on Tier 2 offerings. Regulation A+ offerings are qualified by the SEC.

Bad actor disqualification provisions apply to both Rule 506 offerings and those made through Regulation A+.

Depending on the investors that an issuer wants to attract and the manner they want to solicit them, offerings conducted through any of these exemptions can be a suitable means to do so.

The adoption of nontraded investment vehicles like Reg D offerings by financial intermediaries has been increasing over recent years. What broad trends do you see with respect to the utilization of Reg D offerings? Do you see these trends as long lasting or temporary?

Michael Schwartz

Wealth advisers are increasingly exploring opportunities to incorporate alternative invest-ments into their clients’ portfolios, just as insti-tutions have done for decades. Alternatives can provide greater yields than traditional invest-ments like stocks and bonds, and they often offer attractive cash distributions that many investors seek to supplement their incomes. Alternatives also offer investment options that are not correlated to the stock market and can provide valuable diversification advantages that well-balanced portfolios rely upon.

Private placements are growing in popular-ity among high-net-worth investors for these

Kirk Montgomery, Partner, Kirk Montgomery Law

Louis Rogers, Founder and CEO, Capital Square 1031

Cory Johnson, Co-Founder & Managing Director, Pender Capital

Edwin M. Stanton, Chief Executive Officer & Director, HC Government Realty Trust


very reasons. Individual investors and their advisers are growing more sophisticated every day and their comfort level with alternative investments continues to increase. More and more, individual investors are walking the path that large institutional investors have followed for many decades.

Among Reg D alternative investments, 1031 exchange private placements are grow-ing rapidly — they may raise upwards of $3 billion this year. They are growing not only for the reasons previously stated, but also because IRC Section 1031 is a powerful tool to protect and create wealth via reinvestment of capital that would otherwise be consumed by state and federal taxes. The Baby Boom-ers have trillions of dollars in direct real estate investments, much of which will flow into Section 1031 exchanges over the com-ing years and decades, as they seek to divest from actively managed real estate into passive investments that continue to provide income and the potential for further appreciation.

How are Reg D private place-ment offerings being regulated? What are the risks and rewards for investors?

Scott Lawlor

Recent regulatory changes have spawned a significant increase in the number of asset managers accessing retail capital through Reg D private placement offerings. Less informed industry constituents frequently cite freedom from the regulatory restrictions imposed on corresponding public offerings as the reason for the uptick. A closer look confirms that the independent due diligence is no less stringent than the due diligence

on the public programs. Due diligence at the broker-dealer level is many times more stringent because of concerns over height-ened regulatory scrutiny of private place-ment transactions. And while statement pricing, disclosures concerning distribution sources, the need for audited financials and periodic valuations are not dictated for pri-vate placements by the regulators, a mean-ingful and growing number of independent broker-dealers and RIAs require that those best practices be in place before they con-sider participating in a Reg D private place-ment offering.

There is a common belief that private placements represent more risk to investors than public offerings. My contention is that the integrity and expertise of the sponsor, the validity of the value proposition and the transparency around the risk disclosures are critical to any evaluation of risks and rewards and are independent of whether a private or public offering is being evaluated. The qual-ity of new sponsors bringing Reg D private placement offerings to market, the expanded access to institutional-quality investment pro-grams for retail investors and the enhanced transparency around the risks associated with these programs all bode well for investors in Reg D private placement offerings.

Crowdfunding programs have feverishly adopted the 506(c) offering structure. Will 506(c) structures become more widely accepted by financial intermediaries going forward? Where is the widest adoption anticipated to come from? Which asset classes are best suited for these offerings?

Louis Rogers

The exemption under SEC Regulation D, Rule 506(c), is the future, and we should embrace it.If, 10 years ago, you told me that an issuer could solicit and advertise to raise capital in a private placement, I would have suggested you have your head examined. However, the Jobs Act removed the handcuffs and permits solic-itation and advertising, provided a number of strict conditions are satisfied.

To date, 506(c) has not been widely used outside of a relatively small group of crowd-funders in Internet-based offerings. How-ever, subsection (c) has universal application for private placements, including real estate offerings. For example, Capital Square 1031 made the conscious decision to rely on the (c) exemption for its future Delaware Statutory Trust offerings for real estate investments. This permits advertising by the issuer and the salesforce of broker-dealers, registered repre-sentatives and investment advisers. The ability to advertise is a great benefit to the issuer and salesforce by exposing offerings to a very large pool of potential investors.

Some traditional broker-dealers have been reluctant to approve (c) offerings. They are concerned about satisfying the conditions to qualify for the exemption; other broker-dealers seem to fear losing investors to Internet sales.

Investors are increasingly using the Internet to locate investment opportunities. I believe it will be clear over time that broker-dealers and their representatives will benefit from use of the (c) exemption through access to a massive pool of new investors. By using the exemp-tion, BDs and reps can grow their books of business, and issuers can gain access to large sums of new capital seeking a home. This is


a win-win for all the parties, and supports the goals of the Jobs Act by removing major road blocks to raising new capital.

What are the general attributes of 506(b) products that financial intermediaries are seeking today? What is required to stay competitive in the 506(b)?

Cory Johnson

There is an unlimited range of offerings avail-able through Rule 506(b) of Regulation D pri-vate securities. The sale of these sophisticated alternative investments comes with extensive and complicated regulatory requirements, so work with a sponsor of these products you have strong confidence in.

To stay competitive in the 506(b) space a sponsor’s transparency is crucial. You need to ensure investors understand the fees, terms and redemptions involved for each product and how these are in line with the underlying investments. The spon-sor should have a sound, investor-centric, long-term investment strategy that you fully understand and can communicate to investors. Sponsors of these products should provide audited financials, profes-sional fund administration and managerial oversight. Additionally, sponsors should communicate in a timely fashion and set appropriate expectations.

506(b) products are best suited for sophis-ticated investors who are willing to commit to a sustainable long-term investment that does not need to be monitored daily. These offer-ings are generally uncorrelated to the public markets and offer valuable diversification ben-efits and potentially higher yields.

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With a $50 million cap on Reg A+ offerings, is that enough deal size to make an impact in the industry? Which players stand to gain the most from these offerings and which investors are best suited for this type of an allocation? Will we see a continued rise in Reg A+ offerings and an uptick in sales in the next 12 months to 18 months?

Edward Stanton

For some companies, $50 million will provide adequate equity to capitalize their business model, particularly given their total levered capital structure. Others may choose to use the offering as one of several managed vehicles. The limitation in offer-ing size and the increased start-up, oper-ating and reporting costs will ultimately restrict the number of companies that jump into the space, limiting the impact on the total capital that is raised in alternative real estate investments.

Smaller real estate companies interested in accessing retail capital will stand the most to gain, particularly if their long-term growth plan contemplates a major exchange IPO or listing event. Furthermore, there may be certain lower-risk property types that are better suited to Reg. A+ invest-ments over private placements.

Reg. A+ opens up investment opportu-nities to nonaccredited investors that were historically prohibited from accessing alter-natives. Individual suitability will depend on offering specifics. Such components as

the underlying tenant credit and renewal risk and an individual’s liquidity needs will play an important role in their ultimate investment decision.

With access to nonaccredited retail inves-tors, it seems logical to expect an increase in offerings, especially as various marketplace and distribution channels become better educated on Reg A+. Education will cer-tainly improve offering specific sales. How-ever, interest from potential offerors may be limited by the increased formation and operating costs over Reg D. We do believe the increased transparency provides signif-icant value to the investor, and we expect to see other sponsors with well-established distribution platforms adding Reg A+ to their “suite” of products.

The Securities and Exchange Commission adopted final rules increasing the threshold for offerings made under Rule 504 of Regulation D and broadening the intrastate offering exemption afforded by Rule 147. These finalized rules facilitate crowdfunding efforts for smaller companies. Despite the unique features of intrastate offerings, both sponsors and investors alike have been slow to accept. What hurdles do intrastate offerings continue to face?

Kirk Montgomery

SEC Rules 147 and Regulation D 504 were adopted to provide more flexibility and cost efficiency for smaller private offerings.

Rule 147 is an SEC “safe harbor” for intra-state offerings, unlimited in size and with the ability for Internet solicitation. Intra-state means that the investors must reside in the same state as the issuers “principal place of business.”

Rule 504 is an exemption for offerings up to $5 million during a 12-month period (with some restrictions on types of issuers). While limited in offering size, there is no restriction on the number of investors, no specially required disclosures, and, unlike Rule 506(c), in most states nonaccredited investors are allowed.

But despite being faster, less expensive and generally more marketing-friendly, why have Rule 504 and 147 offerings been so rarely utilized? The answers are that both are still subject to state “blue sky” regulations, which vary widely and in some cases may limit their appeal, and thus they are simply not very well known by issuers or investors.

Just keep in mind that for a smaller offering with accredited investors also looking to include some combination of nonaccredited friends, family, employees or others, Rule 504 should be considered.

Further, in the limited situations where you expect to raise all your capital within the specific state where you conduct your primary business, at least take a look at “intrastate offering” Rule 147 as an option for your fundraising strategy.

The overall popularity of both of these rules could certainly change when the defi-nition of “accredited investor” is adjusted, as expected.


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Mandell Crawley, head of private wealth management at Morgan Stanley, had a different career in mind; then he landed an internship on the trading desk at the firm

Diversification strategies for private wealth advisers

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Jennifer Dohrmann-AlpertManaging Director, Real Assets Adviser

[email protected]+1 925 244-0500, ext. 134

2274 Camino Ramon, San Ramon, CA 94583 USAwww.irei.com • Ph: +1 925-244-0500

REALASSETSADVISER

Late last year, Congress passed sweep-ing tax reform legislation, com-monly known as the Tax Cuts and Jobs Act. Of the numerous changes

that were made to the tax laws, many are now realizing the potential of investing in a “quali-fied opportunity zone” (QOZ), a sleeper pro-vision that could provide tremendous oppor-tunities for communities in need, real estate developers, sponsors and investors. Specifi-cally, Sections 1400Z-1 and 1400Z-2 created a QOZ, which offers tax incentives to inves-tors who are willing to invest in low-income neighborhoods or other economically dis-tressed areas for the long term.

To take advantage of the tax benefits associ-ated with a QOZ, an investor needs to invest the gain amount it realized from any sale or exchange of property (to or with an unrelated party) in an equity interest of a “qualified opportunity fund” (QOF) within 180 days. If structured and executed properly, investing in a QOZ (through a QOF) could provide three major tax benefits: (1) temporary deferral

of capital gains reinvested, (2) a reduction of a portion of such reinvested capital gains through limited periodic basis bumps, and (3) elimination of tax on the appreciation (and depreciation recapture) arising after investing in the QOF, if held more than 10 years.

WHAT IS A QOF? — THE BASICS AND LINGOA QOF is an investment vehicle organized as a corporation or a partnership for the purpose of investing in “qualified opportunity zone property” and that holds at least 90 percent of its assets in qualified opportunity zone property (the “90% Test”). The “90% Test” is applied by taking the average of the percent-age of qualified opportunity zone property held by the QOF: (1) on the last day of the first six-month period of the taxable year of the QOF and (2) on the last day of the taxable year of the QOF. Penalties apply if a QOF fails to meet this test.

Qualified opportunity zone property means any of the following: (1) qualified

opportunity zone stock, (2) qualified oppor-tunity zone partnership interests, and (3) qualified opportunity zone business property. Broadly speaking, qualified opportunity zone stock and qualified opportunity zone partner-ship interests are equity interest in a corpo-ration or a partnership whose only trade or business is a qualified opportunity zone busi-ness (discussed below) for substantially all of the QOF’s holding period for such interest.

“Qualified opportunity zone business property” is tangible property used in a trade or business of a QOF if (1) such property was acquired by the QOF by purchase from an unrelated party after December 31, 2017, (2) either the original use of such property in the QOZ commences with the QOF or the QOF “substantially improves” the property, and (3) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ. For this purpose, the “substantial improvement” test will be met if, during any 30-month period after the QOF acquires such property,

OPPORTUNITY AHEADNewly created qualified opportunity zones could provide substantial tax benefits to investors

Daniel F. Cullen Partner Baker & McKenzie

Peter R. Matejcak Associate Baker & McKenzie

Sukbae David Gong Associate Baker & McKenzie


additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period. This rule essentially requires that improvement costs equal, or exceed, the QOF’s original acquisition cost.

An entity is a “qualified opportunity zone business” if (1) substantially all of the tangible property owned or leased by such entity is qualified opportunity zone business property (determined as if such owner were a QOF), (2) at least 50 percent of the total gross income of such entity is derived from the active conduct of such trade or business, (3) a substantial portion of the intangible property of such entity is used in the active conduct of such trade or business, (4) less than 5 percent of the average of the aggre-gate unadjusted bases of the property of such entity is attributable to nonqualified finan-cial property (as defined in Section 1397C(e) such as stock, options, or partnership inter-ests), and (5) such entity does not operate,

or lease land to, certain businesses, such as a golf course, country club, massage parlor, or any store whose principal business is the sale of alcoholic beverages for consumption off premises.

THE TAX BENEFITS When an investor sells any appreciated asset (e.g., stocks, bonds or real estate), unless certain statutory exceptions apply, the sale is generally a taxable event and the investor will owe taxes on the capital gain realized. How-ever, assuming that the investor reinvested its capital gain into a QOF that is and will be in compliance with the rules discussed above, the investor may be able to receive the follow-ing tax benefits:

First, in exchange for reinvesting capital gains in a QOF, the investor receives a temporary deferral of inclusion in taxable income of such capital gain amount. This deferred capital gain must be recognized on the earlier to occur of (1) the date on which the QOF investment is sold or exchanged, or (2) December 31, 2026.

Second, the investor in a QOF will receive a step-up in basis attributable to the capital gains reinvested in a QOF. Increased basis means that these amounts will be excluded from future taxation. The applicable basis in the deferred capital gain is increased: (1) by 10 percent if the investment in the QOF is held for at least five years, and (2) by an addi-tional 5 percent (for a total of 15 percent) if the investment in the QOF is held for at least seven years.

Third, if the investor in a QOF holds such investment for at least 10 years, the capital gains associated with the sale or exchange of the investment in such QOF will be perma-nently excluded from taxable income. From a tax perspective, this is achieved through a step-up in basis: at the time of sale or exchange, the investor’s basis shall be equal to the fair market value of such investment on the date the investment is sold. This per-manent exclusion only applies to apprecia-tion (and depreciation recapture) subsequent to investment in the QOF and does not

OPPORTUNITY AHEADNewly created qualified opportunity zones could provide substantial tax benefits to investors


apply to the capital gains achieved prior to the investment in the QOF.

There are some noteworthy distinctions between tax deferral achieved via a Section 1031 like-kind exchange — another popu-lar tax deferral tool — and reinvesting in a QOF. Most notably, only real estate quali-fies for a Section 1031 like-kind exchange. On the other hand, gain from the sale of any property can qualify for reinvestment into a QOF. Additionally, in a Section 1031 like-kind exchange, a taxpayer must reinvest its original investment amount (i.e., principal) and capital gains within 180 days of the sale. In contrast, only the capital gains amount needs to be reinvested in a QOF, which could potentially provide a QOF investor with more liquidity upfront. Finally, unlike a Section 1031 like-kind exchange, which most often requires a qualified intermedi-ary, a taxpayer may invest in a QOF directly without involving an intermediary.

QOF INVESTOR’S TAX BENEFITS: AN EXAMPLESuppose Anna, an early investor in the “hot-test tech-stock” (“HTS”), hit the jackpot with a very successful initial public offering: she sells her HTS portfolio with a basis of $50,000 to an unrelated party for $500,000. This leaves her with a $450,000 gain and potential tax liability of $90,000 (assum-ing a 20 percent long-term capital gains rate). After being inspired by the Real Assets Adviser, she decides to redirect her invest-ments into real estate. Instead of paying tax on her gain, Anna invests the $450,000 into a QOF and holds her investment in the QOF for 10 years (until 2028). For the purpose of this example, we will assume that the QOF met all the requirements discussed above and remained in compliance through-out its holding period. Assuming she has

not sold her investment in the QOF, Anna will recognize gain of $382,500 ($450,000 less 15 percent of $450,000 from basis step-up (i.e., $67,500)), leaving her with tax liability of $76,500 for the 2026 taxable year. Note, this is less than the $90,000 of tax she would have owed in 2018 (and the benefit is even greater when considering the time value of money as this lesser amount is paid eight years later). If the QOF sells its investment after 2028 for $700,000, Anna pays no tax on the $250,000 gain ($700,000 less $450,000 original investment) realized on the QOF investment. For the purpose of this example, we will assume that there is no depreciation recapture.

As Anna’s example illustrates, the tax bene-fits of investing in a QOF can be substantial. Without investing in a QOF, Anna would have owed $90,000 of taxes as of 2018. If invested in a QOF, and even if the QOF made no gains for eight years, Anna would owe $76,600 of taxes in 2026. If invested in a QOF and the QOF made roughly a 5.7 percent annual return, Anna would owe $76,600 of taxes in 2026 and no taxes on her $250,000 gain. By contrast, if Anna invested in stock that provided the same returns, she would have owed $90,000 of taxes in 2018, invested $360,000 of after-tax proceeds into the stock, would have had $200,000 of gain ($360,000 x 56 percent) in 2028, resulting in an additional tax of $40,000 (20 percent x $200,000) — a total of $130,000 in taxes. The table below summarizes the alternative scenarios; note the significant difference in total taxes paid and after-tax proceeds at the end of the investment period.

DESIGNATION OF OPPORTUNITY ZONESThe chief executive officer of each state has been tasked with nominating the census

tracts to be designated as Opportunity Zones. Each state nominated accordingly, and as of July 9, 2018, the IRS issued Notice 2018-48, 2018–28 I.R.B. 9, which lists all population census tracts designated as QOZs for purposes of Sections 1400Z-1 and 1400Z-2.

OPPORTUNITIES AHEADMany sponsors, developers and investors are still digesting the new law on QOFs and QOZs. As Sections 1400Z-1 and 1400Z-2 were drafted over a relatively short time period, many unforeseen practical issues are being highlighted by commentators. For example, the testing period for the “90% Test” implies that a QOF must deploy its capital within six months. This is a relatively short and unrealistic runway for a real estate construction or rehabilitation project. Further, the law is silent on how to measure the 90 percent — by fair mar-ket value, tax basis, or original cost basis? Fortunately, the Treasury and IRS have broad authority to proscribe necessary reg-ulations to advance Congressional intent under these rules — offering tax incen-tives to taxpayers with appreciated assets who are willing to harvest their gains and invest proceeds in economically depressed areas for the long term — so many of these issues are expected to be addressed in the near future.

QOFs represent significant opportuni-ties for communities in need, developers and investors. Given the bullish run of the market and a U.S. economy in recent years that has created tremendous unrealized capital gain, QOFs should be able to attract much-needed capital for community devel-opment, while at the same time providing significant tax benefits to investors, if they are structured and executed properly.

$450,000 of Capital Gain Realized

Tax in 2018

Reinvestment Amount Tax in 2026

Investment Balance in 2028 (assuming an approximately 5.7%

annual return)

Gain Realized in

2028Tax in 2028

After-Tax Proceeds in

2028Total Taxes

Paid

Invested in QOF Deferred $450,000 $76,600 $700,000 $250,000 $0 $623,400 $76,600

Invested in stock $90,000 $360,000 $0 $560,000 $200,000 $40,000 $520,000 $130,000


TIMELINE ILLUSTRATION

WHAT IS AN OPPORTUNITY ZONE?

Created as part of the Tax Cuts and Jobs Act of 2017, the Opportunity Zone Program is designed to incentivize investment capital into designated census tracts nationwide and may be eligible for significant preferred tax treatment.

WHAT IS AN OPPORTUNITY ZONE FUND?

Opportunity Zone Funds (OZ Funds), are investment vehicles where capital gains from prior investments can be invested into designated state opportunity zones. These funds may provide significant tax benefits to investors and stimulate economic development and job creation.

HOW DOES OPPORTUNITY ZONE FUND INVESTING WORK?

An investor who has triggered a capital gain by selling an asset can receive temporary deferral, then a significant reduction in their capital gains tax, as well as permanent exclusion from capital gains tax on their Opportunity Zone Fund investment, if the investment is held for mandated time periods of 5, 7, and 10 years.

Sound West Realty Capital

423 Pacific Ave | Suite 402 | Bremerton, WA 98337 | 877-277-7886 | soundwestrc.com | soundwestozfunds.com

DISCOVER OPPORTUNITY ZONES AMERICA’S NEWEST TAX-INCENTIVIZED INVESTMENT PROGRAM

ONE STEP, THREE BENEFITS

By rolling over capital gains into an Opportunity Zone Fund...

DEFER the payment of your capital gains tax.

REDUCE the tax you owe by up to 15% after 7 years.

ELIMINATE tax on gains earned from the Opportunity Zone Fund after 10 years.

D ebt appears to be the new flavor of the month for both institutional and retail investors, and they are find-

ing plenty of options to place capital in both corporate and commercial real estate debt.

Demand for debt is being fueled by a variety of factors, chief among them being the long stock market bull run. “That, com-bined with the volatility in the stock market in 2018, has led a good portion of investors to take some of the equity gains off the table and invest in debt,” says Don MacKinnon, portfolio manager – real estate, at Sound

Point Capital Management. Many investors consider debt to be a more protected part of the capital structure, and it also provides the ability for investors to collect income with it, he adds.

The robust economy has produced strong performance across several asset classes, including real estate. “We see real estate prices, in many cases as being fully priced. And while there are still opportunities in real estate equity, you need to have great exper-tise to find those opportunities as compared to half a dozen years ago,” adds Mitchell Sabshon, CEO and president of Inland Real Estate Investment Corp. Investors also like

the risk-adjusted returns, considering that debt is higher in the capital stack compared with equity. “Mortgage debt is particularly attractive on a relative basis given where we are in the cycle,” he says.

The Federal Reserve’s policy over the last decade that has kept interest rates near zero has led to extremely low rates across the entire fixed-income spectrum, both in credit risk and maturities, says Chirag Bhavsar, co-CEO of CNL Financial Group. “That has led to signif-icant demand for yield from both institutional and retail investors. One obvious solution to that has been corporate credit funds in their various forms,” he says.

Private Debt

Investments

By Beth Mattson-Teig

Rising rates pique appetites

for floating-rate debt.


In particular, there has been growth in pri-vate bank loans and collateralized loan obli-gations, as investors shift away from straight bonds and search for more floating-rate secu-rities that offer protection in a rising interest rate environment, adds Bhavsar.

INVESTORS SEEK OUT HIGHER YIELDSInvestors are seeking risk-adjusted returns in a market where rising interest rates — both on short- and long-term rates — are chang-ing the playing field. The Fed has raised the federal funds rate multiple times over the past year, and the expectation is that the Fed will raise rates further in the second half of 2018. “Investors are not sure where rates are going, but they know they can benefit by being in floating-rate funds,” says MacKinnon.

For example, three-year floating-rate first-mort-gage loans are generating unlevered returns of 5 percent to 7 percent and levered returns of 10 percent to 12 percent. Typically, a lender gets 1 percentage point as an origination fee and then a rate on that loan that will range between Libor+ 300 basis points to 500 basis points.

Atlanta-based Peachtree Hotel Group provides debt financing to hotel owners and investors through its private equity real estate funds. One way the firm navigates the ris-ing interest rate environment is by playing a “spread game,” says Rob Woomer, president of capital markets at Peachtree. “We tie our loans to some type of Libor or Treasuries or Prime. So, when we make loans, we lend on a fixed basis and a floating basis, but at the end of the day, we are looking for that spread between what we can negotiate,” he says.

Another key piece of the strategy for Peachtree is to hold a B piece of the loan. For example, if one of its funds does a fixed-rate loan at 7.5 percent and interest rates rise 3 percent, that could theoretically erode returns. However, the company brings in a fixed-rate partner to fund the A note, keeps the B note, and then takes the spread between the two. The same strategy applies to floating-rate loans. The firm brings in a floating-rate part-ner or line of credit that floats up and down together, but they still maintain the spread.

On the corporate debt side, credit funds have had a rough time so far in 2018, mostly because of the deteriorating credit

prices and higher rates, adds Bhavsar. “For investment-grade funds, we are typically seeing a dividend of 3 percent to 4 percent. Speculative-grade credit funds usually have a higher dividend, anything from 6 percent to

10 percent annually, depending on the type of fund,” he says. Mezzanine debt, which is one of the riskiest sectors, typically delivers returns between 10 percent and 14 percent.

One of the biggest tailwinds for debt funds continues to be the robust U.S. economy, which helps reduce the credit risk in a port-folio. “That is why you have not seen credit spreads widen meaningfully, even though many people expected them to,” says Bhavsar. So far, none of the major indicators, including the Leading Economic Indicators, Purchasing Managers Index or business and consumer confidence, points to an imminent recession. “Furthermore, the U.S. government has pro-vided a strong fiscal impulse through its tax reform and overall increased spending that is likely to support the economy over the next 18 to 24 months,” he says.

OPPORTUNITIES SURFACE POST- RECESSIONThe private debt market has exploded in the post-recession era where a more conservative regulatory environment and new rules from Dodd-Frank and Basel III resulted in tighter lending. Banks are feeling more pressure from a risk-based capital perspective to focus on “middle of the fairway” first-mortgage lending, notes Sabshon. Specific to commer-cial real estate, it is tougher for banks to do credit-type financing that requires a little bit more expertise to understand the strategy of a property owner; property-level dynamics; and the ability of the owner/borrower to be able to execute on that strategy.

Peachtree is a hotel owner/operator that rec-ognized the opportunity to provide short-term loans for groups that were buying and renovating

hotels post-recession and were hungry for capi-tal. The company started out making a few direct loans in 2012 and then launched its first $50 million fund in 2013. Its second $180 million fund is almost fully deployed. “The opportu-

nity doesn’t look like it’s going to go away, in the hospitality sector, and more broadly across real estate,” says Woomer.

The Dodd-Frank rollback did ease some lending restrictions, but the focus is more on banks that have less than $100 billion in assets, and it was less impactful on commer-cial real estate lending. So, it is not likely that those regulatory changes will shift the current landscape in terms of shrinking the pie for non-bank commercial mortgage lenders. “It’s hard to tell at this point in time what some of the rollback on the smaller institutions is, but that will be something to monitor over the coming months and years to see how hard some of those players will come into the mar-ket,” says MacKinnon.

One of the challenges for debt investment products is that it has become a very compet-itive niche with dozens of different private debt investment vehicles in the market. On the real estate side, many players see plenty of business to go around in a commercial real estate debt market valued at nearly $3 trillion. In addition, there is less competition on loans today as compared to pre–financial crisis. These days, it is typical to be competing with two to three other lenders as compared to 12 to 15 lenders pre-crisis, notes MacKinnon.

Yet competition is something that the industry will have to watch going forward. “Even though competition in some respects may be less than it was several years ago, spread tightening is something that we have to be mindful of,” says Sabshon. “If there is a headwind, so to speak, it is making sure that lenders can continue to get, on a relative basis, attractive spreads on the loans that they have been taking on.”

One of the biggest tailwinds for debt funds continues to be the robust U.S. economy, which helps reduce the credit risk in a portfolio.


By Joseph Dobrian

Energy programs appear

E nergy programs, as investment vehicles, continue to attract investors. While the profitabil-ity of drilling projects might wax

and wane depending on commodity prices, investors are finding many other ways to get into the game. Securitized ownership of infrastructure — pipelines, fracturing devices, etc. — is appealing to some inves-tors. Energy programs sometimes help inves-tors to lower their taxes, and experienced players are finding ways to reduce the finan-cial risk of drilling.

Shale oil extraction has become safer and easier. Liquid natural gas offers various invest-ment opportunities. Sustainable energy, and programs that might reduce carbon footprints, have their adherents among investors. In all, an investor determined to allocate funds to energy programs will find plenty of alternatives.

Shale oil extraction has become safer and easier. Liquid natural gas offers various invest-ment opportunities. Sustainable energy, and programs that might reduce carbon footprints, have their adherents among investors. In all, an investor determined to allocate funds to energy programs will find plenty of alternatives.

According to Matthew Iak, executive vice president and director of U.S. Energy Development Corp. (Arlington, Texas), cap-ital raised for drilling programs is usually a

function of the overall perception of pricing of the commodity. Investors get most inter-ested in investing after the price of oil rises, typically above $80 per barrel (bbl), and the news media start focusing on that rise. In time, prices rise too high too fast; then the bubble bursts. Oil and gas drilling funds have historically been designed to make allowance for the nature of drilling, in which the big expense comes in the first year of a project. The economics work so long as prices stay within a reasonable margin or standard devi-ation from the price when drilling occurred — but if they drop below the drilling cost, the investment suffers permanent damage.

“Investing in direct drilling at the nadir of the market is also risky,” Iak says. “You will end up spending all that money drilling wells that are marginal, at low pricing, hoping for a quick recovery in price. If you are trying to time the market in a drilling program, you should look for pricing off the bottom, yet before markets are peaking again.” That is likely to be somewhere between $50/bbl to $85/bbl in today’s market.

Also, investors are looking at other ways to invest in energy besides drilling. In all, the number of ways to invest in energy programs, directly or indirectly, continues to grow.

Wallace Kunzman, an attorney with the firm of Kunzman & Bollinger (Oklahoma City),

notes that drilling programs have gained pop-ularity due to the elimination of some state and property taxes as federal deductions. In addition to intangible drilling cost deductions, drilling equipment can be depreciated in the first year of a drilling program, enhancing tax benefits.

“Drilling programs tend to be tax-driven,” Kunzman says. “But there are lots of ways to make money in oil and gas, creating value and selling at the right time. Upfront fees for IPOs are coming down; front-end costs are com-ing down; payouts to the investors, before the sponsor gets paid, are more appealing. Bottom lines have improved overall.” While traditional drilling funds will probably see continued pop-ularity over the next few years because of good market conditions, energy funds with struc-tures different from that of a traditional drilling fund will emerge.

Kunzman notes a tendency for investors to treat energy deals like real estate deals, but he is skeptical of that attitude. In energy, the asset is underground; exploiting it depends on scien-tific processes; its price can change fast due to various geopolitical factors. A sharp uptick in price can be good news, but a rise in costs will follow quickly, whereas if prices drop, it will take time for costs to readjust.

Bradford Updike, an attorney with Oma-ha-based Mick Law, notes that growth in the

RESURGENT


Energy programs appear

energy sector has been slow over the past two years. In 2016, the retail broker-dealer channel hit a low point, where only about $250 million was raised in syndicated programs. Last year, fundraising increased to about $330 million. By contrast, that channel was raising $700 million to $800 million annually, from 2012 to 2014. So, the sector is recovering — slowly.

“We see fewer opportunities today than five or six years ago,” Updike explains. “Back in 2012, we had 20 to 25 companies raising cap-ital in the retail broker-dealer channel. Today, we have perhaps 10, due to companies going out of business when oil prices dropped to $30/bbl. The widespread use of leverage killed off many companies.”

Most of the retail energy capital, Updike says, is raised by drilling partnerships for tax planning purposes. These programs pass through intangible drilling cost deductions, which can amount to 75 to 85 percent of the investment. The depletion allowance shelters about 15 percent of an investor’s gross oil/gas revenue from federal taxation.

Also, mineral acquisition programs that utilize a direct title structure are seeing a decent level of interest from retail broker-dealers. Investors can go into these programs on a 1031 basis and use deferred asset gains from real estate to acquire interests in oil and gas minerals and roy-alties. Additionally, investors get to use depletion

This is not an offer to sell or a solicitation of any offer to buy securities. Offers are made by private placement memorandum only. All investments have risk. To obtain further information, you must meet the suitability standards required by law. Contact U.S. Energy for additional information.

Sponsored Content

Michael HavenVP of Broker Dealer Relations

t: 800-636-7606 ext. 278e: [email protected]

www.usedc.com | 800.636.7606

U.S. ENERGY Development Corporation®

Looking For New Tax Planning Strategies?Changes to the US tax code for 2018 are the most comprehensive in over 30 years and while many high-net-worth individuals may be surprised to learn that the tax deductions they’ve relied on for years have been reduced and/or eliminated, new tax planning strategies have also emerged.

Direct Investments In Oil & Natural Gas May Be Able To Replace Lost Tax Deductions From...• State and Local Taxes (SALT Tax)• Qualified Business Income (QBI) Deduction for incomes above $315,000 (married filing joint)• Charitable Donations (Itemized Deductions)• Mortgage Interest Deduction (New mortgages above $750,000)• Moving Expenses, Tax Preparation, Alimony, and more!

To Learn More About U.S. Energy... one of the largest sponsors of direct energy investments, and our multiple tax planning solutions which include: • Ordinary Income Tax Write-Off potential in Drilling Funds • Passive Income Generation potential in Acquisition Funds • Like-kind exchange potential in 1031 Exchange Funds

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www.cartermultifamily.comdeductions, which again shelters 15 percent of royalty gross income from federal income taxes. Throw in the 199-A deduction, which allows a deduction for up to 20 percent of qualified busi-ness income from partnerships, limited liability companies, S corporations, trusts, estates, and sole proprietorships, and the picture looks favor-able indeed for investment in energy.

However, aside from the competitive income tax benefits, drilling programs have been chal-lenged from a performance perspective. This, Updike notes, is due to the difficulty in hav-ing to commence drilling within the first 90 days of the year following the investment, to accelerate the large intangible drilling cost deductions. On a positive note, the programs that spread out the drilling dollars over multi-ple years almost always outperform those that

are chasing accelerated intangible drilling cost deductions. Updike urges investors to not let the tax tail wag the dog when considering the merits of a drilling program.

Many observers agree that traditional drill-ing deals have many weaknesses, and limited upside. Safer, more lucrative plays might lie in securities based on infrastructure: pipelines and fracturing devices. Long-term, investment funds may become more agnostic about the sectors in which they invest, and may look to snap up the operating companies that one expert describes as “walking dead,” waiting to be acquired or looking to get rid of noncore assets so they can operate within their cash flow. Such opportunities will remain if oil prices stay in the $50/bbl to $80/bbl range. If prices rise too fast, “stupid money” will enter

the market, driving prices and risks higher still.As for future opportunities, fossil fuel fun-

damentals will continue to drive demand for retail energy programs in the next few years. Renewable energy programs are best suited to investors in the very highest federal tax brack-ets, that can use tax credits immediately. The price of shale as a commodity is a concern, but shale drilling has become more of a manufac-turing process than a drilling process, now that fracking techniques have become more sophis-ticated and safer. Liquefied natural gas appears to be a growing industry, with more countries signing on as importers of American LNG. In all, investment opportunities abound in the energy industry overall. Success is a matter of watching the market and choosing (or creat-ing) the smartest vehicle.


WHO WE ARE

•B/C CLASS VALUE-ADD APARTMENT STRATEGY

•TARGETING A FAST-GROWING DEMOGRAPHIC OF RENTERS

•SPECIALIZED & EXPERIENCED LEADERSHIP TEAM

•ESTABLISHED RELATIONSHIPS = OFF-MARKET OPPORTUNITIES

A SPECIALIZED MULTIFAMILY ACQUISITION STRATEGY

Carter Multifamily Fund Management Company’s asset focus targets value-add multifamily communities favored by middle market Americans who have been priced out of Class A luxury apartments. Our executive team is comprised of experts in this field, with an average of 31 years of experience in acquisitions, development and management.

CARTER MULTIFAMILY4890 W. Kennedy Boulevard, Suite 825 | Tampa, FL 33609

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