SPVs have legitimate uses in real estate investments | Whitman Legal Solutions, LLC
William, Charles and Alfred Voller were expert luthiers and forgers of the early 20th century. They made near-perfect “copies” of several early Italian violins – which they sold at high prices. Their Balfour Stradivarius fake was so good that it was certified as a genuine Stradivarius by a famous London violin dealer.
Another famous violin scam occurred in the early 21st century when New Jersey millionaire Herbert Axelrod sold thirty counterfeit stringed instruments, reportedly worth $49 million, to the New Jersey Symphony Orchestra for $17 million. In reality, the instruments were worth about $17 million at most. Axelrod may have added value in hopes of getting a tax benefit for a below-market sale. The symphony, mired in debt from the purchase of the instruments, avoided bankruptcy by later selling the instruments for $20 million.
Fraudulent violin sales make headlines because they are unusual. And while we read about Special Purpose Entities (SPEs) – also known as SPEs – used to commit fraud, most SPEs serve legitimate business purposes. This article discusses legitimate business reasons people use SPEs in real estate transactions.
Enron – poster child for special forces abuse
Enron Corp. was an energy industry darling during the bull market of the 1990s. Enron was formed after deregulation and became an energy trading company. In July 2020, Enron contracted with Blockbuster (the video rental company) to develop a high-speed Internet network to deliver video-on-demand to consumers. Enron’s stock soared and the company was touted as one of the most innovative companies in the world.
The bursting of the tech bubble in 2001 would reveal the weak points in Enron’s armor. By 2002, Enron’s stock became unmarketable. A closer look revealed a number of related party transactions in which Enron used special purpose vehicles to hide losses. Enron executives were jailed for fraud and insider trading. And Arthur Anderson, the Big Five’s accounting firm that served as Enron’s bookkeeper, would soon disband.
SPVs in the news
Even though accounting rules have been tightened to make another Enron unlikely, SPEs still sometimes get negative press. SPEs made headlines again when then-President Trump gave his financial details, including information about some 500 limited liability companies (LLCs) he owned. No details were given as to how the SPEs were used, but chances are most of these LLCs were associated with specific real estate investments.
News articles also expressed surprise that Jared Kushner resigned from positions at 266 companies when he took up a position with the US government. Two hundred and twenty (220) of these companies were LLCs formed for individual real estate projects. Ivanka Trump had resigned from even more positions—292 in total. As with her father and husband, most of these companies were LLCs, and most were associated with real estate investments.
Special Purpose Acquisition Vehicles (SPACs) have also been in the news lately. Also known as “blank check companies,” SPACs are a type of SPE used to raise capital for a merger or acquisition with an existing company. Pending a merger or acquisition, SPACs will only be funded by cash raised in the offering. SPACs (and sometimes SPEs in general) have received negative press when SPAC mergers have been cancelled. How SPACs work is beyond the scope of this article.
In December 2020, Congress passed the Corporate Transparency Act (CTA), which applies to companies that are considered “letterbox companies” with no significant operations. The implication is that these “letterbox companies” are at high risk of fraud. However, the CTA applies to both legitimate real estate investments and small businesses that are not involved in illegal activities simply because they have fewer than 20 full-time employees or less than $5 million in gross revenue or sales in the United States.
Why Mortgage Lenders Need Special Purpose Vehicles
Although the number of SPEs in the Trump family may sound shocking and the CTA may imply nefarious intentions, it is common to use SPEs in real estate. Given the family’s vast holdings, it’s no surprise that the family owns hundreds of SPEs. The use of SPEs in real estate does not in and of itself indicate illegal or unethical conduct. And unlike SPACs, real estate SPEs are backed by an asset (the property) and not just investor money. SPEs are the norm in commercial real estate transactions for legitimate business reasons.
Almost all real estate investments are financed with mortgage loans. And mortgage lenders generally require that the properties backing the loan be owned by a special purpose vehicle that is “bankruptcy-agnostic.”
Lenders underwrite mortgage loans based on the property and its risk and reward profile. By requiring the property to be held in an SPE, the lender can isolate its exposure to the property and other business ventures will not interfere with the borrower’s ability to pay the mortgage loan.
Joint venture and private equity investors in real estate transactions also typically require their investments to be made through an SPE. Like mortgage lenders, they only underwrite their risk based on property and want their investment returns to be tied solely to property.
Property owners may also want to insulate the risk of their real estate investment. Homeowners often seek non-recourse mortgage loans, which means that the mortgage lender agrees to rely on the income and value of the property to pay off the mortgage loan. Real estate is a risky investment – sometimes real estate’s financial performance doesn’t live up to forecasts and earnings don’t cover mortgage payments. In a non-recourse loan, the lender can foreclose on the property, but cannot claim default from the SPV owners.
Businesses use special purpose entities to isolate different types of assets and business activities
SPEs can also help protect real estate from business risks. For example, investing in senior housing includes both a leased property and a business that provides meals, health care, and other services to seniors. A retirement home has a risk profile similar to that of any home. However, providing meals, health care and personal services to seniors carries significant additional risk.
The owner of the senior living community will purchase property, casualty and liability insurance for the property and fault and omission insurance for the senior services business. But no matter how careful you are and no matter how much insurance you buy, the risk of catastrophic loss (eg, multiple fatalities) in the senior service business is greater than renting an apartment.
The senior housing owner can form two SPEs – one to own the property and a second to operate the senior housing business. Typically, the real estate SPE leases the property to the senior housing SPE. Done right, this isolates risk into two ‘silos’.
Tax considerations can also drive the use of SPE. An investor can use a Section 1031 exchange to buy real estate in the example of senior housing. But tax laws don’t allow an investor to use Section 1031 funds to purchase a senior housing company. So the investor could use an SPE to buy the property and lease the property to a senior housing company, which would use its own SPE to operate the senior housing business. In this scenario, the same investor cannot own both the real estate SPE and the retirement housing SPE when a Section 1031 exchange is involved. If that were the case, the IRS would likely disregard the lease to the SPE for senior housing and prohibit the section 1031 exchange
Other types of companies may also use SPEs to isolate or isolate risk by business unit or to facilitate financing. Also, isolating individual business units into their own SPEs can facilitate a spin-off or sale of individual business units. For example, a company that owns two brands of restaurants (e.g., formal seating and fast-casual) might use separate SPEs for each brand. By keeping each brand’s revenue, expenses, and assets separate, the company could more easily conduct an IPO for the fast-casual brand or sell the formal restaurant brand.
Because of Enron, SPEs have an undeserved negative image. As with fraudulent violin sales, the percentage of SPEs created for fraudulent purposes is likely small compared to the number of SPEs used.
The reality is that SPEs have many legitimate business purposes. Rather than assuming that an SPE conceals illegal activities, each SPE should be assessed individually to determine whether the SPE was formed at the behest of a lender or key investor, what the SPE’s business objectives are and what they are
This series draws on Elizabeth Whitman’s background and passion for classical music to illustrate creative solutions to legal challenges faced by corporations and real estate investors.