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.

Land Use Approvals in California Can Avoid CEQA If a City Directly Adopts a Voter Land Use Initiative

A city need not conduct an analysis of the potential environmental impacts of a proposed development if it chooses to directly adopt a voter-sponsored initiative for the project.

For developers of projects that are popular but likely to be challenged by a small minority, the California Supreme Court’s decision in Tuolumne Jobs & Small Business Alliance v. Superior Court is good news.  A popular project can skip the preparation of an Environmental Impact Report (EIR) or other environmental document pursuant to the California Environmental Quality Act (CEQA).  This strategy saves time and money in two ways.  First, developers can save months – sometimes years – waiting for a city to prepare technical studies analyzing the environmental impacts of proposed projects.  These studies are almost always prepared at the developer’s expense.  Second, if there is no CEQA document, there is no CEQA litigation.  The cost and delays that result from CEQA litigation are avoided.  As a result, project opponents have one less arrow in their quiver to try to delay or kill a project by filing a CEQA lawsuit.

The facts of the case are straightforward. Walmart Stores, Inc. (Walmart) operated a store in the City of Sonora.  Walmart sought to expand the store in order to convert it into a “Supercenter,” which would sell groceries and be open 24-hours every day.  The city circulated for public comment a draft EIR for the expansion.  After a hearing, the city’s planning commission recommended to the City Council that the EIR be certified and the project approved.

Before the matter was heard by the City Council, a citizen served the city with a notice of intent to circulate an initiative petition. The “Walmart Initiative” proposed to adopt a specific plan for the contemplated expansion. The City Council postponed its vote on the EIR and project approval while the initiative petition circulated. The petition was signed by more than 20 percent of the city’s registered voters, qualifying it for the ballot.

Under California law, when a city council receives a voter initiative petition with sufficient signatures, the city is required to do one of the following: (1) immediately adopt the initiative without change; (2) immediately submit it to a special election; or (3) order the preparation of a report within 30 days, which the city council uses to decide whether to adopt the initiative or submit it to a special election. In Tuolumne, the City Council ordered that a report be prepared to examine the initiative’s consistency with previous planning commission approvals for the Walmart expansion. At its next meeting, the City Council considered the report and adopted the proposed initiative as an ordinance without further complying with CEQA.

The Tuolumne Jobs & Small Business Alliance sought a writ of mandate, claiming, among other things, that the City Council violated CEQA by adopting the ordinance without first conducting a complete environmental review.  The trial court denied the CEQA claim.  The Court of Appeals reversed, holding that when a land use ordinance is proposed in a voter initiative petition, full CEQA review is required if the city council adopts the ordinance rather than submitting it to an election.

The California Supreme Court disagreed. CEQA does not apply to a city council’s action to adopt a voter-sponsored land use initiative. The language and legislative history behind the Elections Code statutes did not support the proposition that the city was required to comply with CEQA before adopting the voter-sponsored measure.

The project opponents argued that “developers could potentially use the initiative process to evade CEQA review, and that direct adoption by a friendly city council could be pursued as a way to avoid even the need for an election.” While that may be true, the Supreme Court was not convinced: “The initiative power may be used to thwart development [too]. . . . The process itself is neutral. The possibility that interested parties may attempt to use initiatives to advance their own aims is part of the democratic process.” What’s more, California’s election laws offer another protection from overreaching by the city: the referendum power. If voters disagree with a city council’s adoption of a voter-sponsored initiative, they can file a referendum petition and a vote to block the enactment of a land use measure.

The Tuolumne case can be an effective tool when both a city council and the public support a popular development project. However, a well-thought-out legal and political strategy is crucial for success. For example, a city must still hold a public hearing before adopting the voter measure, affording the public an opportunity to be heard. How city council and the developer prepare for this hearing is important. Wise city council members will order a report to help develop a record in support of their decision and to show that they have considered countervailing arguments. In addition, environmental protections are still afforded by California’s other environmental laws and regulations. It is crucial to develop a plan for project approvals that must be obtained from other regulatory agencies that may have permitting authority over the proposed project. Indeed, CEQA compliance may still be required in order to obtain permits or approvals from state agencies or other governmental authorities. Developers do not get a “free pass.” Before using the Tuloumne strategy, developers should consult counsel to understand the legal and political risks.