Private real estate investing creates great chances for growth, but a single compliance mistake can lead to hefty fines, damage to reputation, and legal troubles. The registered investment adviser (RIA) space has seen explosive growth since the Covid pandemic started in 2020, and private equity firms have taken notice. A promising investment can quickly go wrong when compliance problems surface.
Understanding compliance’s role becomes crucial as you learn about private real estate investing. The process demands careful attention to regulatory requirements, while private loans add more complexity to real estate investing. Many advisors who believed their documentation was complete later discover their firm’s miscategorization, outdated disclosures, or missed critical updates.
This piece looks at hidden compliance traps that often derail promising RIA deals and helps you handle these challenges better. Wealth management stands out because advisor backgrounds face unusually high public scrutiny. Understanding these pitfalls isn’t just helpful—your investment success depends on it.
Understanding Private Real Estate Investing for RIAs
Registered Investment Advisors (RIAs) need a solid grasp of private real estate investment basics to manage client portfolios successfully. The asset class deserves a closer look before we tackle compliance concerns.
What is private real estate investing?
Private real estate investing lets investors own or participate in real estate properties outside public exchanges. These investments work differently from publicly traded REITs because they don’t face the same market volatility and share price swings. Investors can make money in two ways: rental income and property value increases when they sell.
Investors must commit significant capital to private real estate—usually more than $250,000 to start—and might have to wait over a decade to cash out. Notwithstanding that, this investment type ranks as America’s third-largest asset class. It offers concrete assets that have historically delivered attractive returns with few down periods.
Why RIAs are increasingly drawn to private equity real estate
Client interest in alternative investments keeps growing. A TD Ameritrade survey reveals that 62% of advisors say their clients want to explore private equity investments. Younger investors tend to favor private market options over traditional stocks and bonds.
The benefits go beyond client priorities. Private real estate has shown minimal correlation with U.S. stocks (0.06) and U.S. bonds (-0.11) in the last 30 years. This makes it great for portfolio diversification. On top of that, it helps protect against inflation in three ways: property values rise, rents increase, and debt loses value.
Looking at income, private real estate has generated better average returns (5.22%) in the last two decades compared to U.S. bonds (4.13%) or stocks (1.94%). RIAs can then help build stronger client portfolios by adding alternative investments that might magnify returns through diverse equity risk.
Key terms in private real estate investing (IRR, equity multiple, etc.)
RIAs should know several key performance metrics to assess private real estate opportunities:
Internal Rate of Return (IRR) shows the yearly percentage earned by each invested dollar during the investment period. This time-sensitive measure factors in money’s time value and helps compare real estate returns with other equity investments. A project that makes $1 million in 5 years will show a higher IRR than one making the same amount in 10 years.
Equity Multiple shows how much money comes back to investors when a deal ends. To name just one example, a $1 million investment that ended up returning $2 million has a 2x multiple. This number reveals an investment’s effect on wealth but doesn’t consider how long the money stays invested.
Cash-on-Cash Return measures average distributions during normal property operations. This metric helps understand regular income generation but might not tell the whole return story.
RIAs can use these metrics to match opportunities with their client’s goals—whether they want quick returns (IRR) or long-term wealth building (equity multiple).
Compliance Trap #1: Inadequate Due Diligence on Sponsors
The most important part of the due diligence process is due diligence on real estate sponsors. Your private real estate investment’s success depends more on its managers than the property. “A great sponsor can turn an average deal into a success, while a poor sponsor can ruin even the best opportunities,” as one experienced operator noted.
Lack of background checks on deal sponsors
Investors who skip background checks on sponsors risk investment disasters. Poor vetting can lead to several risks. These include theft by dishonest operators, losses from bad investment decisions, delayed returns, and stress from poor communication and late tax filings.
Note that the Latin phrase “caveat emptor” means let the buyer beware. Private equity real estate investors should not assume sponsors tell the whole story. You need to uncover any issues with both the property and the people managing your investment.
Background checks are the “hard work, boring side of commercial real estate investing.” Many people skip this step, yet this research often determines who succeeds and who fails.
Overlooking sponsor track record and litigation history
A sponsor’s track record needs careful review beyond their success stories. Their experience through market cycles deserves special attention. The best sponsors have at least 10 years of experience and know how to handle different market conditions.
These red flags need extra caution:
- Sponsors with capital calls or big losses
- Those claiming deals they didn’t manage
- Operators who hide underperforming deals from their presentation
A sponsor claiming only successful deals might have worked in good markets or lacks experience with challenges. This scenario needs a closer look.
How to vet private real estate operators effectively
A systematic approach helps review sponsors properly. Start with a complete pre-call screening using trusted sources: peer networks, industry events, investment communities, and publications. This early research helps eliminate poor candidates quickly.
The sponsor’s digital footprint reveals much about their company history, team skills, portfolio mix, and investment style. Ask for and review these key financial documents:
- Sample quarterly investor updates
- Historical profit and loss statements
- Current rent rolls for active properties
- Bank statements (for serious investment consideration)
A sponsor’s openness to sharing information shows their transparency. Get 4-5 references from previous investors. Finding multiple good reviews proves harder than getting one or two positive testimonials.
Background checks should include litigation history and regulatory compliance verification. The Securities and Exchange Commission (SEC) requires investment advisers to meet specific due diligence standards before hiring service providers. Due diligence isn’t just a checklist but a strategic process. It helps firms understand risks in data security, regulatory compliance, business continuity, financial stability, and ethical conduct.
Compliance Trap #2: Misaligned Investment Structures
Real estate deals have hidden compliance traps that can affect investment results badly. RIAs might miss these details even with years of experience. This oversight leads to conflicts of interest and possible regulatory problems.
Improper use of private loans for real estate investing
Private lending creates major risks when not structured correctly for real estate investments. Unsecured loans put lenders at risk because they depend on borrower’s credit score instead of actual property. Lenders cannot get their money back if borrowers default without registering their security interest against the property.
Traditional loans protect lenders through legal documentation, but unsecured deals only use promissory notes which leaves lenders exposed. These private money lenders want better returns because of the extra risk. They charge higher interest rates than regular banks.
Registered mortgages against the property offer the best protection. They turn unsecured promissory notes into safer investments. Lenders need a full picture of the borrower’s finances. This includes income proof, tax returns, and details about other loans.
Unclear fund structures and waterfall terms
Distribution waterfalls control how money flows between investors and sponsors, but their complex nature can hide conflicts. These waterfalls set up tiers that determine who gets paid first. Problems often pop up from wrong incentives, incorrect IRR calculations, and waterfalls that are too complex.
Two main types of waterfalls create different incentive structures:
- Whole-fund models look at all investments together. Investors benefit because sponsors must wait until they get back their money plus preferred returns
- Deal-by-deal models treat each investment separately. Sponsors benefit because they might get paid even if other investments lose money
Smart investors should inspect preferred return rates (usually 7-9% IRR for alternatives). They also need to check catch-up provisions and clawback rules that stop sponsors from getting overpaid.
Issues with co-investment disclosures
Co-investment arrangements need careful attention to disclosure rules. The SEC found several disclosure failures about how investments get split among clients. Some clients paid higher fees for better treatment. Securities weren’t divided fairly. Clients didn’t know enough when investing at different levels in a company’s capital structure.
Co-investment vehicles must explain clearly how they divide up investments. Investment advisers must tell clients about conflicts when different clients invest in varying parts of the same company (debt versus equity). Investors can’t make good decisions without knowing about conflicts that might hurt their position.
Compliance Trap #3: Marketing and Solicitation Violations
Marketing practices in private real estate investing create serious regulatory risks. Many RIAs break Securities and Exchange Commission (SEC) rules without realizing it. They use improper solicitation methods, make misleading performance claims, or fail to verify investors properly.
SEC rules on general solicitation
The SEC maintains strict control over investment marketing methods. Most private offerings rely on Rule 506(b) of Regulation D, which prohibits general solicitation or advertising for capital raising. This ban applies to newspaper ads, public websites, TV broadcasts, and open seminars.
You must limit communications to investors with whom you have a “pre-existing, substantive relationship” before the offering starts. A valid relationship gives you enough information to assess a potential investor’s accredited status.
Rule 506(c) allows general solicitation if all investors are accredited and you take “reasonable steps” to prove their status. Despite this marketing freedom, many firms stick with Rule 506(b) because 506(c) has tougher verification rules.
Misuse of performance data in marketing
Performance data requires careful handling. The SEC’s marketing rule only allows performance results that meet specific criteria. Advisers must show both gross and net performance using similar methods over matching time periods.
A serious violation happens when advisers highlight one investment’s performance from a portfolio without proper context. The SEC might take action against those who display gross performance figures without net results. Any performance claims must be proven if the SEC asks.
Failing to document accredited investor status
Verification problems top the list of compliance issues. Rule 506(b) offerings need more than just self-certification. Simply checking a box without knowing an investor’s financial situation isn’t enough.
Rule 506(c) sets even higher standards and requires “reasonable steps” to verify accredited status. This process looks at:
- The investor’s claimed accreditation type
- Available information about the investor
- How the investor was solicited
- Minimum investment amounts
The biggest risk comes from poor documentation of this verification process. The issuer bears full responsibility to prove compliance.
These violations can cost up to $73,000 for each case, and might lead to investment cancelations or years-long fundraising bans. penalties for these violations
Compliance Trap #4: Incomplete or Inaccurate Disclosures
Transparent practices are the foundations of compliant private real estate offerings. The most promising investment opportunities can fail when advisers don’t provide complete and accurate disclosures to investors and regulators.
Missing risk disclosures in offering documents
Risk disclosure failures are a fundamental compliance violation in private real estate investing. Offering documents that omit material facts about property value or desirability leave investors without critical information they need to make informed decisions. In fact, a material fact is any information that would have a “significant and measurable effect on market value”.
Failing to disclose known property defects can lead to serious consequences:
- Lawsuits for misrepresentation or fraud
- Contract rescission where buyers withdraw entirely
- Substantial financial penalties
- Permanent reputation damage in the real estate market
Note that disclosure requirements cannot be waived through “as-is” provisions in sales contracts. This makes thorough documentation crucial.
Failure to update Form ADV with private fund info
RIAs must amend their Form ADV quickly when information becomes materially inaccurate. They need to update private fund information—a requirement many overlook until regulatory examination. The SEC requires annual updating amendments within 90 days after fiscal year-end, along with additional amendments for specific information changes.
Overlooking Form ADV updates can result in registration revocation. The SEC reported nearly $5 billion in monetary recoveries in 2023, with much related to disclosure failures.
How disclosure gaps can trigger enforcement
Enforcement actions often start from minor disclosure oversights. The SEC actively pursues RIAs for:
- Inconsistencies between Form ADV Parts 1 and 2
- Incomplete conflict of interest disclosures
- Inaccurate reporting of assets under management
These disclosure violations ended up triggering severe consequences, including rescission orders that require returning invested capital. Complete, accurate, and current disclosures protect you from regulatory action and build client trust through transparency.
Conclusion
Private real estate investments need constant alertness to avoid the compliance traps we looked at. These investments can give you great diversification benefits and higher returns. But regulatory mistakes can turn promising chances into pricey problems.
You need to watch out for four major compliance pitfalls. A full picture of sponsors serves as your main defense against investment disasters. Their track record through market cycles tells you nowhere near as much as marketing materials. Your interests stay protected when investments are well-laid-out with clear waterfall terms and proper security measures for private loans. Marketing violations lead to harsh penalties, so you must follow SEC solicitation rules and represent performance accurately. Trust builds on complete and accurate disclosures that also protect you from regulatory enforcement.
The private real estate market keeps changing, and compliance requirements will without doubt get more complex. Working with seasoned professionals who know these nuances can reduce your risk by a lot while making the most of your investment potential.
Note that successful private real estate investing needs both opportunity and caution. Smart investors know that compliance isn’t just about dodging penalties—it gives you a strategic edge that protects capital and improves long-term performance. This knowledge helps you pursue private real estate opportunities with confidence while staying clear of hidden traps that catch unprepared investors.
