Real Estate As Security: What turns A simple real estate purchase into a regulated investment?
By: Collin May & Darren M. Smits
In the business of real estate development, many developers have come to expect the unexpected. However, when the unexpected comes in the form of unanticipated securities regulations, even seasoned developers can be caught off guard. As investment products become more diverse and numerous, securities regulations have expanded to turn what may appear to be a simple real estate transaction into an offering subject to securities legislation.
The question is: What turns a simple real estate purchase into a regulated investment? The answer to this question comes down to some simple principles, though they are not always easy to spot in practice. Essentially, securities regulations will apply to real estate transactions when the purchaser is not just a purchaser but also an investor with the expectation that the real estate purchased will pay returns over the long haul.
Still, not just any sort of investment will trigger securities regulations. Consider the following example: A developer offers condo units for sale to individual arms length purchasers. Along with the purchase agreement comes an additional agreement whereby the developer, often acting through an affiliated management company, will supervise and rent the condo units for set periods of time when not in use by the purchaser. The management company collects the rent and pools the funds under a rental pooling agreement, guaranteeing a minimum payment from the rental pool to each condo owner.
In this example, the condo unit owners are more than just individual purchasers. Instead, they are investors in a common enterprise, operated by a third party (in this case the management company), with the expectation of making a profit on their investment. And as a result, this apparently straightforward real estate purchase has now turned into an investment regulated by provincial securities regulations.
The key element here is the rental pooling agreement, which effectively turns each individual real estate purchase into an investment contract.
Investment contracts are the most broadly defined form of security under the Securities Act (Alberta). From the legal standpoint, various tests have been applied by the courts to determine whether or not a real estate purchase can be considered an investment contract. These tests have generally been adapted from tests that were first applied in American courts, and are often referred to as the common enterprise test or the risk capital test. In short they involve three aspects that identify investments as more than mere real estate transactions. These include:
1) an investment in a common enterprise;
2) an expectation of profit on the part of the investors; and
3) the profits will arise through the efforts of the promoter or developer.
Generally, these three elements can be found where, in addition to a simple purchase of property, collateral agreements are included that provide a benefit to investors based upon the efforts of the developer or the promoter. In these situations, a real estate transaction will now become more than just a simple real estate transaction; the purchase will become an investment subject to securities regulation.
In light of the application of securities legislation, the developer
will become a reporting issuer and will be required to comply with the continuous disclosure and reporting obligations this entails. The only means of avoiding these ongoing, and rather expensive obligations, is to sell the properties pursuant to an exemption under National Instrument 45-106. In most cases, this will mean selling pursuant to an Offering Memorandum and ensuring that each potential purchaser qualifies.
If an unwary developer thinks that failing to take note of securities regulations would have little impact on a proposed real estate transaction with collateral agreements, the developer could suddenly find itself facing purchasers refusing to close on the purchase contracts due to the failure of the developer to comply with the applicable securities regulations.
The best way to avoid confusion as to whether or not what appears on the surface to be a simple real estate transaction is actually subject to securities requirements is to consider if there is more going on than a simple sale of real estate. Where a transaction involves additional agreements with an expectation for profit on the part of purchasers through a common enterprise managed by a third party, there is a strong likelihood that the purchase is more than just a purchase. Rather, the purchase is an investment, and specifically, an investment that falls under the purview of securities legislation. Knowing the difference can save the careful developer a great deal of hassle and trouble down the road. If it is not that clear and further clarification is required, make sure to consult with a lawyer who not only specializes in real estate, but also specializes in securities