Real estate has long served as an attractive investment opportunity for those with some extra cash to spend. Whether as rental property generating monthly income or as a long-term investment offering the potential for significant appreciation in value, real estate can provide the investor with a relatively stable place to park his or her money. Add to this stability the fact that most people can understand a real estate transaction as compared to more complex investment structures, and real estate comes off as an excellent investment strategy for most investors.
However, what seems so straightforward at first can quickly become complex, especially when that simple real estate transaction turns into an offering subject to securities regulation. The question then becomes, how does a real estate purchase morph into an investment regulated by the often confusing intricacies of securities law?
The first thing an investor, not to mention a developer or legal advisor, has to watch for is whether or not the real estate purchase is designed to pay returns over the longer period. Not every investment delivering long-term dividends will trigger securities provisions. Certain conditions must be met that can best be described by an example.
A condo developer offers units to individual purchasers via arms-length transactions. In addition to the typical sale and purchase contract, the buyer enters into an agreement with the developer whereby the developer will manage the condo complex as well as advertise and rent the condos for set periods during the year when the units are not being used by the owners. The developer, often acting through a management company, collects the rent, pays expenses and then pools the remaining funds in a rental pool. Each owner then is paid a minimum payment from the rental pool.
In this example, the owners are not simply owners of individual units, but are involved in the common enterprise of renting out their units under the supervision and management of a third party. And, as with all investments, the goal at the end is to make a profit. It is these elements – common enterprise, third party control and the anticipation of profit – that turn these individual condo purchases from straightforward real estate transactions into investment contracts regulated by securities legislation.
Investment Contracts are the catch-all of securities legislation and are the most broadly-construed type of security. The legal tests that determine whether or not an investment falls under the category of Investment Contract derive from the tests first applied in courts in the United States. Broadly speaking these tests identify three factors that constitute an Investment Contract:
- The investors are involved in a common enterprise;
- Investors have an expectation that profit will be earned; and
- The investors are not themselves controlling the investment.
Generally, where a collateral agreement exists, such as the pooling agreement in the above example, an Investment Contract will arise triggering securities regulations. As a result, a developer offering such investments will be required to comply with prospectus requirements under provincial securities regulation, unless the properties, along with the pooling agreement, can be offered to investors pursuant to an exemption under National Instrument 45-106.
Failure to take account of securities regulations in these circumstances can have substantial consequences for developers. Where an issuer of securities has failed to comply with applicable regulations, the real estate investor would have the right to refuse to close on the purchase contract.
An unwary legal counsel can run into problems here as well. In order to properly advise clients in these matters, a lawyer needs to know if a client is dealing with a simple real estate investment, or whether the investment is an Investment Contract. Failing to spot the difference can result in a client who is unaware of his or her options, making for a disgruntled client down the road.
In the real estate context, what is at first glance a simple purchase, has the potential to be much more. As a rule of thumb, where there are collateral agreements involving the management of property for the benefit of a pool of owners, there is a good chance that the investment falls under securities legislation. Catching the difference can save developers, investors and their legal counsel a great deal of hassle.