Real estate crowdfunding has been quietly evolving on the sidelines during the latest commercial real estate bull market. Critics dismissed this new form of capital raising as just another fad or buzzword du jour. However, crowdfunding platform founders claim that it is destined to overtake traditional capitalization methods in the not too distant future. Regardless, the major objections to crowdfunding are dissipating rapidly as advancements in supporting technology trends (to be discussed in a subsequent post) allow for greater investment transparency and growing user-adoption. As this industry matures, real estate investors and sponsors will be able to connect more efficiently, creating greater competition for capital and deals. This increased efficiency and competition will result in a broader demand for quality deals and cheap equity. However, before market participants may hope to reap these benefits, they should first be aware of the basics of crowdfunding.
Over the course of a series of posts, I intend to cover some of the key differentiators of crowdfunding platforms that affect investors and sponsors. These consist of two major areas: differentiation of platforms and differentiation of offerings. While both platforms and offerings have significant effects on both investors and sponsors, investors should be more concerned with understanding the platform, and sponsors with understanding the offering.
Accredited Investor Offerings vs Non-Accredited Investor Offerings
There are two major types of real estate crowdfunding offerings: accredited investor offerings and non-accredited investor offerings. Both fundraising mechanisms allow for real estate sponsors to solicit capital online without being a registered investment advisor and filing with the SEC. This is exceptionally important to the real estate capital markets because it reduces the time, cost, and legal barriers for both real estate sponsors and investors desiring to invest directly in a commercial real estate transaction. The hallmark regulatory reforms were created in 2012 by President Obama with the creation of the Jumpstart Our Business Startups (“JOBS”) Act in an effort to stimulate small businesses and startups during the Great Financial Crisis. The JOBS Act contained three important investment reforms known as Title II, Title III, and Title IV. These affect the crowdfunding industry and are still evolving. Title II addresses accredited investor offerings and Titles III and IV address non-accredited investor offerings.
Accredited Investor Offerings
Accredited investor offerings, also known as “online syndication,” refer to capital that is raised in accordance with the commonly used private placement memorandums (“PPMs”). These rely on the SEC offering exemption known as Regulation D (“Reg D”). This exemption has been around since the Securities Act of 1933. However, the use of broad marketing and the internet was not permitted until the creation of Title II of the JOBS Act, which permitted general solicitation in rule 506(c). This deregulation gave legal credibility to the nascent online syndication industry and fostered the creation of real estate crowdfunding. Aside from this seemingly small change, this type of syndication is no different from traditional “Reg D” real estate syndications, which must adhere to many federal and state requirements. As a result, sponsors raising capital through online syndication should be aware of the following:
- The investment should have less than 2,000 investors. Reg D states that you can have an unlimited number of accredited investors; however, the SEC requires additional files and registration for more than 2,000 investors. This results in increased regulatory scrutiny and costly reporting requirements. However, if the entity raising capital is considered an investment entity, such as a fund, it will trigger the Securities Act of 1940, which restricts the number of investors to less than 100. There are many different laws to take into account, so be sure to seek counsel from an experienced securities attorney if you have any confusion
- All investors must meet the minimum requirements of an SEC qualified “accredited investor.” Under the SEC definition, each investor must demonstrate that they have a minimum net worth of $1 million, excluding their primary residence (using FMV), or make at least $200,000 per year for the last two years ($300,000, if combined with a spouse). However, the $1 million requirement increases to $2.5 million for investments in an investment company or fund, and $5 million if the investor’s assets are owned by a trust. The burden of proving accreditation lies with the sponsor, who must take reasonable steps to verify that their investors meet these requirements. Technically, there can be 35 non-accredited investors in a Reg D 506(c) offering; however, you will have the burden of proving that they are “sophisticated,” and such investors can ultimately create more liability for the sponsor.
- The total investment raised must be less than $100 million. While this is not defined in the SEC Reg D Offering, it is defined in other SEC requirements concerning investment companies and the need to be Registered Investment Advisors. Raising over $100 million tends to attract a lot of state and federal attention, which will likely result in increased regulation. Therefore, it is best to stay below this number when trying to minimize regulatory requirements.
- There are many different SEC regulations that overlap with crowdfunding and can get very complicated very quickly. In addition, there are other regulatory bodies such as FINRA and state regulators that impose other requirements beyond the scope of this article. These regulators will likely increase the above requirements. So, be sure to play it safe by staying inside of conservative interpretations of the law, and always consult with an experienced securities attorney before engaging in any form of online syndication.
Non-Accredited Investor Offerings
Non-accredited investor offerings are considered authentic “crowdfunding” because they target online investment from the general public, aka the “crowd.” For this reason, Titles III and IV of the JOBS Act (general public investment) comprised the most publicized reforms. Title III, known as Regulation CF (“Reg CF”), allows for minimal federal oversight and can be attractive for raising a small amount of capital for local real estate projects. Title IV, known as Regulation A+ (“Reg A Plus”), refers collectively to Regulation A Tier I and Regulation A Tier II. Reg A+ is a derivative of an IPO. It is often described as “IPO-lite” or a “micro public REIT” when referring specifically to real estate investments, because of its smaller size and reduced regulatory burdens. A sponsor can raise significantly more capital in a Reg A+ offering than in a Reg CF; however, Reg A+ is more costly than Reg CF and comes with additional regulatory hurdles. Below are some major hurdles a sponsor should be aware of when attempting to crowdfund from the general public using either regulatory exemption.
Important factors to consider when contemplating Regulation CF:
- The max offering size is $1,070,000 in a 12-month period for their first round.
- Non-accredited investors can invest, however they are limited to the following:
- Investors with an annual income or net worth under $107,000 can only invest the lesser of $2,200 or 5% of their annual income or net worth.
- Investors with an annual income or net worth over $107,000 can only invest the lesser of $100,000 or 10% of their annual income or net worth.
- Investors self-attest to meeting the above requirements. Sponsors are not responsible for investor verification of the income and net worth requirements.
- Solicitation is limited only to the internet.
- Sponsors must file certain disclosures with the SEC (Form C, Form 1A, etc.).
- Regulation CF is largely regulated by states. Thus, sponsors must file with the state regulatory agency in which the investment resides and abide by state limitations, which may restrict out-of-state investment and cap investment limits. If the sponsor is permitted by the state to raise capital out-of-state, the sponsor must also file with the state regulatory agencies in which 50% of its investors reside. This brings additional restrictions and costs.
Important factors to consider when contemplating Regulation A+:
- Maximum offering of $20 million for Reg A Tier I and $50 million for Reg A Tier II.
- Non-accredited investors can invest; however, they are limited to the same restrictions in Regulation CF.
- Subject to SEC and State qualification and approval. Tier I does not require annual and semi-annual reporting and audit financials, however, Tier II does.
- No limits to number of investors other than state restrictions.
- Can be a costly and time-intensive process.
Below is a comparison of Titles II, III, and IV.
Besides meeting the investor suitability requirements of an accredited vs. non-accredited investor, the differentiation of offering is typically of larger concern to the sponsor. The sponsor must create and manage the legal and regulatory structure, whereas the investor does not control this process. However, understanding the platform differences can be far more valuable for an investor attempting to find the highest quality deals. Investors: stay tuned for Part 2 of this series, which explores what you need to know before using real estate crowdfunding.
For more information on real estate crowdfunding, obtaining a commercial real estate bridge loan, or investments in commercial real estate bridge loans, please feel free to reach out to firstname.lastname@example.org.
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