New Crowdfunding Tool for Real Estate Projects Emerges – But Tread Carefully

Last week, the Securities and Exchange Commission (“SEC”) adopted final rules that will make it easier for real estate firms to pursue capital raises of up to $50 million in a 12 month period.

The rules, commonly referred to as Regulation A+, permit eligible companies to conduct securities offerings without the onerous requirements of full securities registration.  What’s more, companies can solicit funds from individuals who are not accredited investors.  In other words, companies can promote their investment opportunity to any investor with an internet connection, although unaccredited investors will be limited in the amount they can invest.  It’s no surprise why Regulation A+ has been called the private company’s mini-IPO law.

Silicon Valley’s legal community seemed to shrug and yawn when asked about the fundraising opportunities for startup tech companies, according to a recent article in The Recorder.  Time will tell if they are right.  However, in the real estate investment and development community, $50 million can help fund a very attractive real estate opportunity.

Overview of Regulation A+

Of course, the new regulation is not without its process and procedure, so real estate project sponsors need to proceed carefully.  The exemption cannot be used for a “blank check” real estate business model.   In addition, the new rules establish two tiers of offerings that can be made:

Tier 1:  Annual offerings of up to $20 million, including no more than $6 million on behalf of selling security holders that are affiliates of the issuer.  There are no minimum investor qualifications and only reviewed, but not audited, financials are required.  However, Tier 1 offerings are subject to both SEC and state review.

Tier 2:  Annual offerings of up to $50 million, including no more than $15 million on behalf of selling security holders that are affiliates of the issuer.  A company making a Tier 2 offering must provide audited financial statements, annual reports and engage in ongoing reporting.  Tier 2 offerings will be exempt from registration and full Exchange Act reporting and may list their securities on a national securities exchange by filing a short-form registration statement.  Unaccredited investors can purchase no more than (i) 10% of the greater of annual income or net worth (for natural persons) or (b) 10% of the greater of annual revenue or net assets at fiscal year end (for non-natural persons).  Tier 2 offerings are subject to SEC, but not state review.

Real estate companies can “test the waters” with, or solicit interest in a potential offering from, the general public either before or after the filing of a Regulation A+ eligible offering statement so long as certain conditions are satisfied.  This can be an important tool for real estate developers who want to gage interest in their particular project before launch.

Some Issues Unique to Real Estate Related Offerings

Unlike a typical startup company offering, structuring a real estate offering properly is crucial to take advantage of the new regulation.

For example, asset backed securities are excluded from the list of eligible securities that can use Regulation A+.  The definition of  an “asset backed security” under the Securities Exchange Act is “a fixed income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset, including (i) a collateralized mortgage obligation, (ii) a collateralized debt obligation, (iii) a collateralized bond obligation, (iv) a collateralized debt obligation of asset-based securities, (v) a collateralized debt obligation of collateralized debt obligations, and (vi) a security that the Commission, by rule, determines to be an asset backed security for purposes of this section.”   The important take away from this definition for real estate companies?  Regulation A+ cannot be used if a company’s offering is selling participation interests in real estate secured debt, in a long term ground lease, or other similar real estate secured receivables.

A more difficult question is whether Regulation A+ would allow an offering of mezzanine debt.  Most commonly, a mezzanine loan is secured by membership interests in a limited liability company or limited partnership interests in a limited partnership that holds title to a real estate asset.  Is the ability to enforce a pledge of such equity interests through a Uniform Commercial Code sale or foreclosure an example of a “self-liquidating financial asset”?  As of the date of this writing, it appears that no federal court has had an opportunity to explain the meaning of this term. In a withering critique of the lack of clarity in the defined terms in the Exchange Act amendments,  Professor Jonathan Lipson in his article Defining Securitization points out that the terms “self-liquidating” and “financial asset” could describe a wide range of things.  He points out that the term “financial asset” is not defined in the Exchange Act at all and is defined very broadly in Article 8 of the Uniform Commercial Code to include an “interest in . . . property . . . which is recognized in any area in which it is issued or dealt in as a medium for investment.”  This latter definition is obviously overbroad and ambiguous, which does not provide comfort to real estate companies.

Nevertheless, the definition of an “asset backed security” in the Securities Exchange Act does have an exception that may be helpful to real estate project sponsors.  An “asset backed security” does not include “a security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.”  What this language suggests is that structuring a real estate investment transaction so that a finance subsidiary is the party involved in the capital raise may provide a path forward that has the comfort of being an exception that appears in the Securities Exchange Act itself rather than in the SEC’s rules.  But again, one should proceed with caution in structuring the opportunity.

Finally, another alternative that should be considered is structuring a Regulation A+ offering with preferred equity in a limited liability company.  This mechanism is likely outside the definition of a “self-liquidating financial asset” because its features are similar to a typical equity investment in a startup company, which was the focus of the SEC’s action and the federal JOBS Act.  That being said, it is important think through the structure from a legal and economic perspective before moving forward.  One important consideration would be review of SEC rules at the time of the offering, because the SEC has the flexibility to adopt new rules as to whether a particular offering strategy involves an “asset backed security.”

Other structuring options may be available.  The good news is that one more tool will soon be available to help real estate project sponsors raise funds in the capital stack. Regulation A+ will take effect 60 days after its posting. We will see how the real estate community reacts to this new financing tool.

Los Angeles County Moves Toward New “General Plan” Governing Development for Next 20 Years

The Los Angeles County Board of Supervisors yesterday took the first important step toward adopting a new General Plan, the constitution for land use policy and development for the unincorporated areas of the county.  The County’s current general plan was adopted in 1980.  This update is intended to apply to all the County’s unincorporated areas through 2035.

With little fanfare, the Board took action on the Final Environmental Impact Report for the General Plan update.  The Board also indicated its intent to approve the general plan, related zoning changes, a climate action plan, and a new Hillside Management Ordinance.  County Counsel will now prepare the necessary final documents for the General Plan update and related approvals and bring them back to the Board for final consideration.  Once finally approved, all future development in the unincorporated areas of the County must be consistent with the new General Plan.

The General Plan divides the county into 11 planning areas to accommodate a more refined level of planning.  Those areas are:

  • Antelope Valley Planning Area
  • Coastal Islands Planning Area
  • East San Gabriel Valley Planning Area
  • Gateway Planning Area
  • Metro Planning Area
  • San Fernando Planning Area
  • Santa Clarita Valley Planning Area
  • Santa Monica Mountains Planning Area
  • South Bay Planning Area
  • West San Gabriel Valley Planning Area
  • Westside Planning Area

The General Plan also establishes mechanisms to implement capital improvement plans for each of these 11 planning areas.  Once funding has been secured and priorities have been set, each capital improvement plan will include studies of necessary infrastructure improvements.

The General Plan also establishes Transit Oriented Districts within one-half mile of a transit station to promote transit-oriented development, or pedestrian-friendly and community-serving uses that encourage walking, bicycling, and transit use.

A sub-element of the plan — the Community Climate Action Plan — includes a greenhouse gas emissions inventory and specific measures to reach the County’s greenhouse gas emission reduction goals in the unincorporated areas. The plan includes a 2020 GHG emissions target for the unincorporated areas — a reduction of 11% below 2010 levels to achieve consistency with the State’s AB 32 goals and the California Air Resource’s Board’s Scoping Plan.  This reduction is the equivalent to removing 506,000 passenger vehicles from the road each year, reducing gasoline consumption by more than 272 million gallons, and providing renewable energy to power over 121,000 homes.  The majority of emissions reductions will come from state-level mandates, and the balance will come from new County policies in five areas:  green building and energy; land use and transportation; water conservation and wastewater; waste reduction, reuse and recycling; and land conservation and tree planting.

The plan sets aside additional land in the County with a “Significant Ecological Area” designation.  The designation is given to land that contains significant biological resources.  Some SEAs include undisturbed or lightly disturbed habitats that support valuable or threatened species, linkages and corridors to promote species movement, and are sized to support sustainable populations of species.  Hillside Management Areas, or lands with a natural slope of 25% or greater, are also governed by new policies to incorporate sensitive hillside design measures to preserve the physical integrity and scenic value of the hillsides.

The action taken by the Board included an amendment offered by Supervisor Hilda Solis, requesting that the Regional Planning Commission report back to the Board in 90 days on the viability of including “value capture” policies in future land use planning.  Value capture mechanisms, as commonly understood, allow local governments to require land owners to “share” the economic value created by “upzoning” changes to land use entitlements, over and above revenue that may be generated by simple increases property taxes when a new structure is finished.  It will be interesting to see how the staff reports back on this issue.

Crowdfunding Your Real Estate Project — Current Opportunities and Future Prospects

Real estate investors and developers are increasingly looking to raise money for their projects through “crowdfunding,” as legal and regulatory issues become better understood.

In the real estate context, “crowdfunding” is the raising of funds for a project through the use of social media to obtain contributions from many individuals.  Technically, each one of these investments in a real estate project by individuals is considered the purchase of a “security” from the project sponsor under federal law and regulations.  In the U.S., a project sponsor cannot offer to sell a “security” to the public without either registering the security with the U.S. Securities and Exchange Commission (a time-consuming and expensive process) or qualifying for an exemption from registration.  Therefore, the goal of any project sponsor is to structure the investment opportunity so that it qualifies for an exemption.

In the real estate context, there are several different ways of implementing a “crowdfunding” strategy.  This article will briefly address one of the most popular crowdfunding structures being used today in commercial real estate to reach high income investors and the current status of “true” crowdfunding rules.

Regulation D/Rule 506(c) “Crowdfunding” Offerings  

Most “crowdfunding” real estate investments are structured using a modified form of fund-raising that has been around for a long time. Crowdfunding offerings structured with Regulation D/Rule 506(c) allow unlimited capital to be raised from an unlimited number of “accredited investors.”   So-called “accredited investors” are those who have a net worth of more than $1 million or whose annual income exceeds $200,000 individually or $300,000 for a married couple.

Under prior law, Regulation D/Rule 506 private placements had a clear prohibition on any sort of marketing effort beyond family and friends to whom there was a prior relationship.   New rules issued in September 2013 pursuant to the JOBS Act now make it possible to market directly to investors through a number of mediums, including the internet.

With the new freedom to market comes a new responsibility for the project sponsor, who must now use validation mechanisms to confirm that accredited investors actually meet the financial requirements in order to participate in the offering. While some may shy away from this latter validation exercise, those with greater courage will see that this financing method opens up huge possibilities for financing real estate projects that have a compelling business plan.

True “Crowdfunding” — Not Here Yet!

True “crowdfunding” over the internet from small individual investors who are not so-called “accredited investors” is not here yet, as regulations have been proposed, but not yet finalized by the SEC.  Those regulations are tied to a provision of the federal JOBS Act that exempts issuers from registration requirements when an issuer offers a maximum of $1 million in a 12 month period in crowdfunding securities and other conditions are satisfied.  All of the conditions can’t be listed in this short article, but some of the key issues are:

  • Issuers of the crowdfunding securities must use the services of an intermediary that is either a broker registered with the SEC or a “funding portal” registered with the SEC.  A funding portal cannot (i) offer investment advice, (ii) solicit purchases, sales or offers to buy securities offered or displayed on its website portal, (iii) compensate employees for solicitation or sale of securities displayed on its website, (iv) hold investor funds or securities or (v) engage in other SEC banned activities established by rule.
  • Dollar limits are placed on the aggregate amount that can be sold to any one investor, generally $2,000 or less depending on income.
  • A targeted offering amount is disclosed.
  • The intermediary must ensure that each investor reviews investor-education information.
  • The intermediary must conduct background checks on the project sponsor.
  • Funds raised may only be provided to the project sponsor when the target offering amount is reached, although there is some ambiguity.
  • Purchased securities cannot be transferred during the one year period after the date of purchase, unless transferred to the issuer, to an accredited investor, as part of a registered offering, or to a family member.

Crowdfunding is here for real estate project sponsors seeking investments from accredited investors.  However, true democratization of real estate investing through crowdfunding is still awaiting final SEC approval.  In some states today, other than California, other crowdfunding mechanisms may be available, such as Regulation D/Rule 504 or Regulation A structures in conjunction with applicable state laws.  However, legislation in California that would allow full use of these structures is still working its way slowly through the California Legislature.

Real estate project sponsors have a means of eliminating financing intermediaries — traditional private equity and banking sources — if they can well articulate the risks and benefits of their opportunity in a compelling private placement.  With access to an open field of potential investors over the internet, ambitious real estate investors and developers could use this tool to their advantage to find financing at attractive pricing.  At what price should project sponsors go to market with these new creative strategies?  As the market further develops for crowdfunded real estate opportunities, only time will tell.

California Supreme Court Will Hear Suit On SANDAG’s Transportation Plan

The California Supreme Court will decide whether the environmental impact report for SANDAG’s regional transportation plan must include an analysis of the plan’s consistency with statewide greenhouse gas emission reduction goals established by executive order. The San Diego Association of Governments (“SANDAG”) brought the appeal in Cleveland National Forest Foundation v. San Diego Association of Governments.

This is an important case to watch.  Greenhouse gas emissions analysis will become more complicated and expensive for local government agencies and project applicants if consistency with the executive order is required.

In 2005, Governor Arnold Schwarzenegger issued Executive Order S-3-05, establishing greenhouse gas emissions reduction targets for California.  The executive order required reduction of greenhouse gas emissions to 2000 levels by 2010, to 1990 levels by 2020, and to 80 percent below 1990 levels by 2050.  This executive order, still effective today, was at issue in the case.

SANDAG is the public body charged with preparing a regional transportation plan and sustainable communities strategy for the San Diego region. The proposed plan is the guidance document for transportation investment of approximately $214 billion over the next several decades.

SANDAG prepared an EIR to analyze the environmental impacts of the proposed transportation plan.  The EIR was held defective by the lower court for several reasons, but the most controversial reason related to the EIR’s discussion of the plan’s greenhouse gas emissions.  While the EIR did include a lengthy discussion of the plan’s greenhouse gas emissions impacts, the EIR did not specifically analyze whether the overall increase in greenhouse gas emissions levels disclosed by the plan conflicted with the executive order or would impair or impede the achievement of the executive order’s goals.  The court held that SANDAG’s decision to omit an analysis of the plan’s consistency with the executive order “did not reflect a reasonable, good faith effort at full disclosure and is not supported by substantial evidence because SANDAG’s decision ignored the Executive Order’s role in shaping state climate policy.”

SANDAG argued that the court was asking it to do something that CEQA did not require.  There is no statute or regulation translating the executive order’s goals into scientifically based emissions reductions targets.  The EIR’s analysis of the transportation plan’s greenhouse gas emissions impacts complied with CEQA because it used significance thresholds specified in CEQA Guidelines section 15064.4.  Moreover, SANDAG argued that, as the public agency with applicable authority, it had the discretion to select the criteria to determine the significance of the plan’s greenhouse gas impacts.  We will see if SANDAG takes up these arguments again with the high court.

The California Supreme Court may also answer an important question raised by the dissent in the lower court case:  whether Executive Order S-3-05 is a threshold of significance, as understood by CEQA.  A “threshold of significance” is an objective, criteria or procedure used to measure or determine the significance of the environmental effects of a project.  Thresholds of significance must be adopted through a public review process.

The dissent argued that there is no authority for the proposition that the Governor has the power to establish thresholds of significance, qualitative or quantitative.  Rather, the Legislature has retained control over the regulation of environmental planning, vesting responsibility in the California Air Resources Board in particular to help implement greenhouse gas emissions policy.

This latter, exciting “separation of powers” issue is more apparent than real.  The executive order established greenhouse gas emissions targets, certainly.  But was the governor’s executive order intended to have a CEQA purpose? More specifically, was it intended to establish a threshold of significance?  Since all seven members of the Supreme Court voted in favor of taking this case, could this suggest that they are willing to take on this tough issue raised by the dissent?