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.

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.

Infrastructure Financing Districts Unlikely Savior for Redevelopment in California

When real estate developers and local governments consider the financial feasibility of a redevelopment project, one of the issues they must consider is how to finance the costs of supporting public improvements.

When California redevelopment agencies dissolved on Feb. 1, 2012, two key public finance tools that helped to fund public improvements in redevelopment areas were eliminated: redevelopment tax increment and redevelopment bonds.  Those tools were frequently used in public/private partnerships to replace old and deteriorating infrastructure — roads, potable water conveyances, wastewater pipelines and storm water systems, for example.  Redevelopment tax increment also paid for affordable housing, environmental clean up, parking structures and other public amenities.  Because it was recognized as a separate, stable income stream by the public finance markets, redevelopment tax increment was a reliable funding source that the bond markets were comfortable with.  

Now developers and local governments are looking for an alternative financing mechanism.  There are several options.  In this post, we will explore some of the key reasons why infrastructure financing districts are an inadequate public finance mechanism for most redevelopment projects in California under current law and in the current real estate market.

Scope and Formation

An infrastructure financing district (“IFD”) is a separate legal entity that is formed by a city  to allocate property tax revenues for public improvements of “community wide significance.” (See Government Code section 53395 et seq.)  IFDs cannot be formed by counties under current law. 

A city must make a specific finding that the public facilities will provide signficant benefits to an area larger than the area of the district.  Fortunately, the public improvements need not be physically located within boundaries of the IFD.  And an IFD may include areas that are not contiguous, which allows a local government to work selectively with cooperative landowners.  Rincon Hill in San Francisco is one example of an existing IFD that is not contiguous. 

IFDs may finance only “public capital facilities” with an estimated useful life of at least 15 years.  Permissible facilities include, but are not limited to, housing, highways, transit, water systems, sewer projects, flood control, child care facilities, libraries, parks and solid waste facilities.  IFD’s can’t pay for routine maintenance, repair work, operating costs or services. Any IFD that constructs dwelling units must set aside not less than 20 percent of those units to increase and improve the community’s supply of low- and moderate-income housing. 

Under current law, an IFD cannot be located within a redevelopment area.  An IFD may not replace facilities or services already available within the territory of the district when the IFD was created, but it may supplement those facilities and services as needed to serve new developments. 

Forming an IFD is time-consuming and difficult.  First, the city adopts a resolution of intention to form the district and notice is provided to property owners.  Then, the city or county must prepare a detailed infrastructure financing plan.  The plan must describe, among other things:

  • The proposed public and private improvements in the district, including the location, timing, and costs of the public improvements to be financed by the IFD;
  • The maximum portion of tax revenue of the city and each other affected taxing entity proposed to be committed to the district for each year;
  • The projected tax revenues expected to be received each year;
  • A plan for financing the public facilities, including a detailed description of any debt;
  • A limit on the total number of dollars of taxes that may be allocated to the district;
  • An analysis of the costs to the city of the providing facilities and services to the area, including a discussion of the tax, fee, charge or other revenue expected to be received by the city as a result of the expected development in the district; and
  • The projected fiscal impact of the district and associated development on each affected taxing entity.  

Once complete, a copy of the infrastructure financing plan must be sent to every landowner and local agencies that will be affected by the IFD. The infrastructure financing plan must be consistent with the general plan of the city within which the IFD is located. 

Every local agency that will contribute property tax revenue to the IFD must approve the plan.  School districts cannot contribute to an IFD.  Once the other local entities approve the infrastructure financing plan, the city forming the IFD must still get the voters’ approval to:

  • Form the IFD and adopt the infrastructure financing plan (requires 2/3 voter approval)
  • Issue bonds (requires 2/3 voter approval and can be sought at the time of IFD formation)
  • Set the IFD’s appropriation limit (majority voter approval).

Upon receipt of the various approvals from public entities and the electorate, the district may proceed.  There are certain exceptions to these voting and other requirements for waterfront projects in San Francisco that are beyond the scope of this post.

What Revenue Stream?

IFDs do not levy a separate tax or increase the rate of tax within the district.  Instead, IFDs passively receive revenues from taxes levied by other agencies.  Specifically, IFDs divert a share of property taxes paid by every landowner within the boundaries of the district.  The county collects ordinary property taxes based upon the then-current assessed value.  From those receipts, all of the affected taxing entities other than the IFD are paid first (e.g., state, county, city, and other entities that existed before the IFD was formed).  Then, the IFD is allocated its portion in accordance with the infrastructure financing plan. This is important: an IFD is only entitled to receive the increase in property taxes that occurs after the IFD is formed.  If the total assessed valuation of taxable property within the district at the time the IFD was formed does not exceed the total assessed value of taxable property within the district at the time property taxes are assessed in future years, the IFD does not receive anything.    

Some have questioned whether the IFD’s share of increased property taxes is enough to justify the effort of creating an IFD.  Today, approximately 65 cents of every ad valorem tax dollar goes back to the counties for distribution, the rest is kept by the state.  As a result, the share of available funds is already less than what redevelopment agencies were able to collect. What’s more, the 65 cents is divided up among the county, the cities in that county, and any other taxing entities that exist within the county that are entitled to a share of the revenue. As a result, the share of available tax revenue is substantially less than would could have been derived from redevelopment tax increment. 

Of course, San Francisco is uniquely structured to take advantage of the IFD law.  Unlike the rest of California, San Francisco is both a city and a county, so property tax revenue does not need to be split between a county government and individual city governments within the county.  However, cities and counties in the rest of the state are not so lucky.  

One other issue is the limited life of IFDs under current law.  IFDs may only exist for 30 years.  As a result, an IFD’s bonding capacity is limited, especially when the improvements that will generate additional tax revenues will not likely be completed until years after the IFD is formed.  The effective IFD tax income stream as a practical matter is more like 25 to 28 years (or even less), limiting the fundraising and bonding capacity of IFDs. 

Public Finance and Market Reality

Recently, at a panel discussion on redevelopment tools hosted by the San Francisco district council of the Urban Land Institute, the public finance professionals on the panel acknowledged that there is no current market for IFD bonds.  And the main reason wasn’t that there are no IFD bonds out there to sell.  The main problem is investor risk.  The income stream supporting IFD bonds is more susceptible to real estate market volatility.  An economic downturn can affect the amount of ad valorem property taxes that are collected.  In addition, in California, every property owner has the right to seek reassessment of property if the assessed value exceeds the current market value.  Therefore, the income stream of overall ad valorem tax payments can be diminished in response to the market.  As described above, an IFD is only entitled to funding to the extent that the future value of the property exceeds the value of the property when the IFD is formed.

Another concern from the point of view of the public finance markets is that there is no independent real property lien on land within the district to secure the IFD’s obligations.   Under the IFD law, the bonds and other obligations of an IFD are not the debt of any city, county or other political subdivision other than the IFD itself.  Only an IFD’s funds or property is liable for the debts of the IFD. As a result, the income stream of future tax payments to the IFD will likely be the only security, unless some sort of credit enhancement is provided.  These risks, unless properly managed, will affect the interest rate and bond rating of any IFD bonds.     

Amending the IFD Law

There have been several efforts by the California legislature to reform the IFD law.  Four bills were introduced last year to expand the authority of infrastructure financing districts.  Most of those efforts have stalled, as some legislators have viewed those bills as a replacement for redevelopment agencies.  Bills were introduced to eliminate the voter approval requirements, extend bond terms from 30 to 40 years, allow IFD territory to overlap with redevelopment areas, and permit financing of transit projects and brownfield clean up.  We will see whether these bills gain any traction in 2012. 

Conclusion

IFDs are an inadequate tool for replacing redevelopment tax increment.  IFDs may make sense in San Francisco because of its unique governmental structure as a combined city and county.  Political considerations as to whether a particular project is of communitywide significance can be better managed and one single governmental entity is making decisions about how to best spend revenues derived from property taxes.  However, even in San Francisco, market confidence in the proposed project will need to be high.  The income stream devoted to the IFD will need to be able to survive an economic downturn.  Investors in the public finance markets will have to get comfortable with the lack of real estate security and assumptions made about future land values.  Until adjustments are made to the IFD law, these risks may be too great in the current economic environment to support a public market for IFD bonds.