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.