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.

Environmental Due Diligence In Real Estate and Company Acquisition Transactions

Before a buyer purchases a company or a real estate asset, it should review and assess records and other information about the target for the purpose of providing input into potential environmental issues.  By performing environmental due diligence, a buyer can determine compliance risks, properly structure the deal, better value the target, and budget for integrating the asset into the buyer’s portfolio or operations.

Every buyer has an interest in identifying issues that will need to be resolved either prior to closing or after closing.  Up-front due diligence can quantify the costs to remedy a clean up or compliance problem or estimate a range of potential costs if further investigation is required.  If a property or product is contaminated beyond use thresholds, the presence of hazardous materials can rise to the level of preventing the business to operate.   A buyer can also be exposed to potential tort or civil liability for existing conditions at the property.  Finally, buyers are increasingly concerned about reputational risks, since many large corporations have corporate social responsibility (“CSR“) programs and reports.

Environmental due diligence can help value a target company or real estate asset.  Noncompliance with environmental regulations can be expensive to fix, as in the case of a company’s failure to install air pollution controls in its facilities.  The clean up of contaminated property can involve significant expense — in the millions of dollars — or interfere with the use or planned disposition of property.  For example, one company acquiring a target may desire to buy the target and then consolidate real estate assets and dispose of facilities that are no longer needed to efficiently operate the combined company.  If the assets of the target company that are to be disposed of are contaminated with hazardous substances, the property may have to be cleaned up prior to its sale as a separate asset, resulting in costs and delays in fully implementing a business plan.  Finally, the acquiring company may be unable to sell the target’s products legally if the target’s products do not comply with U.S. or foreign laws.

Fines and penalties imposed by the U.S. EPA can be as high as $37,500 per day per violation.  Because a myriad of federal, state and local regulatory authorities have jurisdiction over environmental compliance matters, noncompliance can trigger  conversations with regulators that impact the time, energy and financials of an acquiring company.

Early identification of environmental issues has several benefits.  First, the acquiring company can seek to avoid or resolve the issue prior to closing, through closing conditions and pre-closing covenants between the acquiring company and the target.  Second, due diligence can help business leaders appropriately value the target company or asset, if post-closing expenses will be incurred to bring the target into compliance.  Third, the parties can determine an appropriate deal structure.  For example, if a target company has numerous real estate assets and a few of them are contaminated, it may not make sense to structure a transaction as a stock purchase transaction, but rather as an asset purchase so that the contaminated assets can be excluded from the deal.  Fourth, the buyer and the seller can properly negotiate the amount of any escrow holdback from the purchase price for post-closing covenants or obligations, or determine the scope of any post-closing indemnity from the target (or a guarantor of the target).  Finally, an acquiring company can properly include post-closing environmental compliance costs into its integration planning and budgeting.  In this way, counsel and environmental health and safety professionals can engage business leaders in a conversation about the transition costs for bringing the target company or asset into compliance after closing, if necessary.

The environmental due diligence process is too complex to detail in a step-by-step way in this post, but a few essential elements should be mentioned.  It is very important to develop a due diligence strategy up front to assess compliance risks.  The more decision-makers have “buy in” on the strategy, goals and objectives of the model, the greater they will value the results of the investigations. A tiered approach to standard due diligence questions is a practical method, where general questions are followed by more specific questions once relevant issues are revealed.  This approach avoids unduly burdening the target with numerous potentially irrelevant questions.  Areas of concern can be explored either based upon publicly available information or upon the responses to due diligence questionnaires.  Representations and warranties should be included in the purchase and sale contract, customized in response to the results of due diligence.  Representations and warranties are frequently used to test assumptions and flush out accurate facts about a target.  Finally, among other things, the model should include guidance on how to deal with “red flags” and “deal breakers” that are identified during due diligence.

In today’s transactions, environmental due diligence often starts with access to a data room or electronic document depository.  As a condition to access, a buyer will likely have to sign a confidentiality agreement, which should be reviewed by counsel prior to execution.  Due diligence periods are often limited, so counsel should be consulted to determine a realistic amount of time to fairly collect, review and analyze information that will be useful for decision-makers.  To the extent that confidentiality concerns may limit the exchange of information, counsel for the buyer and the seller need to be focused  on the objective of consummating a deal that makes sense for both parties.  It may be necessary to think creatively to resolve confidentiality issues so that the deal can be properly structured and evaluated.  For example, the number of individuals with access to highly sensitive information can be strictly limited to those with a need to know.  Failing to reveal information that is material can result in future claims of fraud and concealment against a target — claims that cannot typically be avoided through the application of “as is” clauses or release provisions in a purchase and sale contract.

In addition to documents provided in an electronic data room, environmental due diligence may need to include a review of filings made with regulatory authorities.  Occasionally, the target company will have to consent to the release of this information, particularly regulations recognize that such filings may include trade secrets or other proprietary information, such as the chemicals used in a particular process.  The buyer’s coordination with the target company is crucial in order to maintain good relations with both the target and the regulator.

Finally, environmental due diligence typically involves the hiring of a third party consultant to enter and inspect the property.  Prior to the entry, a target will typically require an access agreement and proof of insurance.  It is important that counsel review the scope and limitations in the access agreement, so that the buyer and the seller understand the types of inspections that are permitted and a process is established for more extensive inspections should problems be revealed.  An inspection of the property can be merely visual or invasive.  A Phase I Environmental Site Assessment is an investigation designed to determine whether hazardous materials have been released on property and the potential for hidden liabilities for purchasers, owners, operators, insurance and financial institutions.  Proper compliance with the laws and regulations applicable to a Phase I Environmental Site Assessment is crucial to shielding the buyer from future liability under the federal Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).  If the Phase I Environmental Site Assessment discloses matters of concern, a Phase II Environmental Site Assessment may be necessary which requires more invasive testing of the property. If the property is contaminated, consultants can characterize the extent of the release of hazardous materials and the potential remedial actions that may be required. Of course, any final corrective action would need to be approved by the applicable authorities who are becoming increasingly likely to impose “green and sustainable” remediation of sites. Hiring a consultant or counsel that has experience negotiating clean up solutions with regulators can help clients assess whether “green and sustainable” remediation will be required, which may be more costly than more traditional restoration methods.

Environmental due diligence is a complex process that requires coordination among buyer, seller, counsel and their consultants. Successful efforts rely on thoughtful preparation, open communication and strategic decision-making.

Option to Buy Real Estate Does Not Confer “Interest” in Real Property

A California appeals court has held that an option to purchase real property is only a contract right and is not an interest in real estate.  The decision has ramifications for real estate developers that seek to use option agreements to create a “legal or equitable interest in real property” for purposes of California’s development agreement statute. 

An “option to purchase” is a contract in which the owner of land agrees not to revoke an offer to sell real property for a defined period of time.  The option is granted to a potential buyer, called an optionee, who pays a fixed amount for the option.  While option agreement terms vary, an option agreement must describe the subject property and the purchase price, among other things.

An option can be beneficial to both the potential buyer and the landowner.  For example, an option is used to give a potential buyer time to secure development approvals for the land.  If the development approvals cannot be obtained, the potential buyer lets the option lapse, because he is not bound to purchase the property.  Real estate investors also sometimes use an option to tie up property before equity and debt financing is secured.  

Usually, a memorandum of option is recorded in the real estate records of the county where the property is located.  By recording the memorandum of option, anyone searching the real estate records has notice of the potential buyer’s right to purchase the property under the option.  However, sometimes a memorandum of option is not recorded against title to the property, occasionally because the seller will not allow it, or other times because the parties simply elect not to do so for another reason.

People who record a memorandum of option sometimes mistakenly believe they have real property “interest” upon recordation of the memorandum.  It’s easy to make that assumption.  A recorded memorandum of option is a cloud on title even if it is not exercised.  Once recorded, all subsequent purchasers or encumbrancers are on notice of the optionee’s rights to buy the property.  Upon the completion of a sale pursuant to a recorded option, the title received by the purchaser “relates back” to the date the option was given and extinguishes the interests of the intervening party — including intervening easements, leases, deeds of trust, and other transfers.  

Cyr v. McGovran is one of a growing number of cases that find that an option does not vest or grant an “interest” or “estate” in real property.  Dwayne and April McGovran owned a ranch consisting of eight parcels of land in San Luis Obispo County.  The McGovrans listed the property for sale.  The McGovrans and Cyr agreed that Cyr would buy two parcels outright from the McGovrans and, apparently for tax reasons, could have options to buy the remaining six parcels over a period of two years.  If Cyr timely exercised his option to purchase the lots in an agreed-upon sequence, he would then have an option to purchase the next lot in sequence.

The McGovrans’ lender filed a notice of default as to some of the parcels subject to Cyr’s options.  As a condition to obtaining a new loan, the McGovrans gave the new lender an option to purchase the same six parcels that Cyr had options to purchase.  The lender’s option was exerciseable only if Cyr failed to timely close escrow on two of the lots.  The lender’s option conflicted with Cyr’s options in that the escrow closing dates shown in Cyr’s options were later than those shown in the lender’s option.  Pursuant to Cyr’s options, he had until December 30, 2003 to close escrow on two of the lots.  Pursuant to the lender’s option, Cyr had until September 15, 2003 to close escrow.

In August 2003, Cyr became aware of the potential problem with the lender’s option which could cloud title to the properties.  Cyr did not close escrow on the two lots by the September 15th date shown on the lender’s option.  On September 16, the lender recorded a Memorandum of Option Agreement clouding title to the two lots.  On November 4, 2003, Cyr’s attorney took issue with and denied the claim by the lender that it had some right in the properties which was superior to Cyr’s rights.

Cyr assigned his option rights on one of the lots to Mesa Vista, Ltd.  He assigned his option rights on the other lot to Mid-Coast Capital.  Both companies timely closed escrow pursuant to their options.  On November 26, the lender filed a complaint for specific performance of its option.  On the same date, the lender recorded a lis pendens.  The lawsuit was eventually dismissed and the lis pendens was expunged.

On December 23, 2005, Cyr filed an action against the McGovrans and their real estate agents.  One of the causes of action was for negligence, alleging that the McGovrans negligently failed to assure that the McGovrans did not grant to their lender an option inconsistent with Cyr’s options.  The McGovrans filed a motion for summary judgment.  The trial court agreed with the McGovrans on the basis that the complaint was not filed within the two year statute of limitations for an action based upon professional negligence.

On appeal, Cyr argued that the three-year statute of limitations for an injury to real property applied, not the two-year statute of limitations for a professional negligence action.  The court rejected Cyr’s argument.  The court reasoned that Cyr did not have title to the real property and it was the lender, not Cyr, who recorded the Memorandum of Option Agreement and the lis pendens that clouded title to the properties.  The basis of the negligence action was not injury to the real property, but injury to the option rights to purchase the properties.  The latter injury was allegedly caused by respondents’ negligent performance of professional services.  Quoting Wachovia Bank v. Lifetime Industries, (2006) 145 Cal.App.4th 1039, 1050, the court reasoned:  “Although an option gives the optionee contractual rights to purchase the property, it is ‘merely an offer to sell and vests no estate in the property to be sold.'” The option holder does not have an “interest” in the land, the court found.

The court went on to say:  “An option is transformed into a contract of purchase and sale when there is an unconditional, unqualified acceptance by the optionee of the offer in harmony with the terms of the option and within the time span of the option contract,” quoting Steiner v. Thexton (2010) 48 Cal.4th 411, 420.

Real estate developers and investors that purchase option rights should pursue recordation of a memorandum of option when feasible.  A recorded option offers more protection to a potential buyer because it offers constructive notice of the option and  “relation back” benefits. On the other hand, some sellers of real estate may prefer that the option not be recorded, because it acts as a cloud on title.  This is a matter of negotiation between the parties.

The Cyr case also calls into question a strategy used by cities, counties and developers in redevelopment transactions where the city or county owns the land.  When this strategy is followed, a city or county grants an option to a prospective developer/purchaser to create an interest in the property.  A “legal” or “equitable” interest is necessary to support the vested rights secured by a development agreement.  The Cyr case stands for the proposition that an “interest” in real property is not created by an option agreement, but the court’s decision does not expressly distinguish between “legal” and “equitable” interests.  There may be an argument that an “equitable” interest is created upon the signing of the option, but that argument looks less compelling in light of the Cyr court’s holding.  Depending on the facts, it may be more prudent for a city and developer to enter into a real estate purchase agreement, instead of an option, at the time the development agreement is entered.  The purchase agreement could be structured with pre-closing conditions that relieve the developer from the obligation to purchase the property in the event entitlements are not secured.  Legal counsel should be consulted to negotiate and draft such an agreement.