By Jack Jerue One of the most appealing aspects of real estate investing is the…
By Sean Sutton
Private money, a term often used for non-bank, non-agency loans, is one of the many ways for real estate investors to leverage and grow their residential investment portfolios. Investors who have never considered a loan from a private money lender usually have questions regarding the differences between conventional financing options (e.g. banks, credit unions, etc.) and private debt. One of the more frequently asked questions is about the requirement to form a Special Purpose Entity (SPE) Limited Liability Corporation (LLC).
Why the Need for an SPE LLC?
Private lenders are often capitalized differently than conventional lenders. One of the benefits of having an alternative capital source is that private lenders are not governed by the same regulations as conventional lenders. However, this likely also means that government sponsored entities (GSE) are not a source of capital accessible by the lender.
Therefore, private lenders must find liquidity for their loans using different capital sources. One source of capital for private lenders is the market for Commercial Mortgage Backed Securities (CMBS). These are a bundle of homogenous commercial mortgages sold to third party investors in the form of a bond. The sale of the bond creates liquidity for the lender as well as provides a stream of income to the bond investors from the loan payments.
The bundling of mortgages into a bond and subsequent sale to investors, called a securitization, requires partial uniformity of the mortgages inside the bond. SPE LLCs is one of the ways lenders create the uniformity needed for securitization.
LLCs offer protection to both lenders and investors as they separate the liability of the business activities inside the corporation from that of the owning parties. Should a liability against the business inside the LLC occur, that liability stops at the assets of the entity. Conversely, if a liability against the ownership occurs, the assets within the entity are protected as well. SPEs take this coverage one step further, by restricting the assets, liabilities, and activities that the LLC can take on.
The newly created entities protect the assets (properties) that are encumbered by the lender’s mortgage, from claims by outside creditors and insulate the business from outside business activities of the owning group. Thus, it offers protection and uniformity of the loans for CMBS investors.
But Why Incorporate in Delaware?
Many private lenders require that the SPE LLC be incorporated in Delaware because the state has a long judicial history – this means that the state has more predictable legal interpretations than other states. In addition to predictability, the inclusion of “Freedom of Contract” in the Delaware LLC Act boosts its preference by lenders.
It reads: “A limited liability company shall, subject to such standards and restrictions, if any, as are set forth in its limited liability company agreement, have the power and authority to make contracts of guaranty and suretyship and enter into interest rate, basis, currency, hedge or other swap agreements or cap, floor, put, call, option, exchange or collage agreements, derivative agreements or other agreements similar to any of the foregoing.” – 6 Del Code Ch 18 Sec 106
More concisely, a Delaware LLC can create and enter into the terms of a contract without the input nor restriction of government.
At the end of the day, real estate investors like the unique debt that private money lenders offer at competitive interest rates. (CMBS investors offer liquidity to private money lenders, which decreases the cost of the lender’s capital. These savings are then passed through to real estate investors as lower interest rates.)
In turn, CMBS investors want a legal structure that protects the collateral secured by the lender’s mortgage from activities against which the lender has underwritten. Delaware SPE LLCs are preferred by many private money lenders as it allows them to safely offer unique debt products at competitive prices because of the security it offers to CMBS investors, lenders and real estate investors, alike.