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.