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” used by Regulation A+ is the definition found in Regulation AB, which reads in part:  “a security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite term period, plus any rights or other assets designed to assure the servicing or timely distributions of proceeds to the security holders[.]” 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 a pool of real estate secured debt, in pools of long term ground leases, or other similar pooled real estate secured receivables.

Nevertheless, the definition of an “asset backed security” in the Securities Exchange Act does not prohibit single “asset-backed” transactions.  It would be possible to structure a real estate investment transaction so that investors can participate in a single loan or single lease (in the latter case, one for a significant rental value for a long term).  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.  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.

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.

There Goes Our Redevelopment Bond Rating . . .

If you are a holder of California redevelopment bonds, you received some unwelcome news from the bond rating agency Moody’s this week.  Moody’s downgraded by one notch all California tax allocation bonds (also known as redevelopment bonds) rated Baa2 and better.  The rating agency also said that all redevelopment bonds could be subject to further downgrades because they will remain under review by Moody’s.

The main reasons given by Moody’s for the downgrade:  “Compliance with the requirements of the new legislative framework may prove challenging, particularly in the near term as affected agencies attempt to interpret the law and comply with its specified timelines. Most significantly, in the new law County Auditor-Controllers are given new auditing requirements to be met by July 1, 2012, and on-going administrative responsibilities that may initially conflict with existing bond indentures. The resolution of any such conflicts according to the new law’s property tax reallocation process could take a substantial amount of time, and it is entirely untested. The limited, one-notch downgrade across the Baa2-and-above rating spectrum reflects the broad-based but modest nature of this new risk. While Baa3-and-lower rated tax allocation bonds also face this new risk, their overall risk profile remains consistent with their current ratings.”

Moody’s action is not a surprise.  Under the redevelopment law, County Auditor-Controllers will be the ones establishing each redevelopment agency’s assets and liabilities, documenting each redevelopment agency’s passthrough payment obligations, and the amount and terms of any indebtedness incurred by the redevelopment agency.  Not only that, but the County Auditor-Controllers determine the amount of property taxes that would have been allocated to each redevelopment agency had the agency not been dissolved.  Thus, the County Auditor-Controllers will have broad authority to establish the initial books and future cash flow for each successor entity.  Therefore, in going through this exercise, the County Auditor-Controller will be deciding not only what debts get paid, but what revenue stream is available for repayment of those debts.  The decisions by the County Auditor-Controllers are, of course, subject to review, by the oversight boards, State Controller, and the Governor’s Director of Finance.

While we are on the subject of oversight, we should quickly mention that while Moody’s release expresses some concern with the powers of County Auditor-Controllers, it is the oversight boards created by the law that dissolved redevelopment agencies, AB 1x 26, that raises further political and legal uncertainty that would be of interest to the rating agencies.  The oversight boards are given broad discretion to approve the actions of the successor entities, including, among other things, “refunding of outstanding bonds . . . in order to provide for savings or to finance debt service spikes,” and “setting aside of amounts in reserves as required by indentures.”   What’s more, each oversight board also has the power to direct each successor entity to “[c]ease performance in connection with and terminate all existing agreements that do not qualify as enforceable obligations [as defined by the law]” and “terminate any agreement, between the dissolved redevelopment agency and any public agency located in the same county, obligating the redevelopment agency to provide funding for any debt service obligations of the public entity for the construction, or operation of facilities owned or operated by such public entity[.]”  The availability of these broad powers further underscore the concern that implementation of the new law could raise “issues” with respect to the interests of bondholders.

If you have an interest in bonds from a California redevelopment agency, whether as the registered owner of the bonds, as the trustee, redevelopment agency or perhaps even a developer in a redevelopment area, now is the time to pull out those bond documents and read them again.  Does a downgrade trigger default?  Does a downgrade trigger the trustee’s recourse to a credit enhancement, such as a letter of credit or other security, if only to hold it? Does the credit downgrade affect the interest rate in any way?  Who will pay for the difference in the interest rate spread, if any?  Those are just some of the questions that should be considered.

Moody’s also gave some guidance as to how future actions by stakeholders in the redevelopment agency transition could further affect bond ratings.  What could make the bond ratings go down further? Moody’s says:

• Implementation of the legislation in a way that does not preserve timely debt service payment

• Continued legal uncertainty and conflict between the law’s requirements and compliance with existing bond documents

• Judicial clarification that compliance with bond documents is subordinate or to be balanced against other objectives of the legislation

What could make the bond rating go up according to Moody’s:

• Implementation of the legislation in a manner that clearly preserves timely debt service payment and enables compliance with bond documents

• Legislative or judicial clarification that compliance with bond documents takes precedence over other, apparently conflicting aspects of the legislation

• In the long-run, assuming resolution of the legal and practical cash flow uncertainties, a sustained resumption of property tax growth

The demise of redevelopment agencies is having ripple effects on the bond markets.  This credit downgrade should be taken as a warning by all stakeholders that the markets are watching.  This is the time to act with deliberate care and prudence to avoid further action by Wall Street and its advisors.