You’ve seen the news headlines about real estate crowdfunding and how it is changing the commercial real estate industry. In this article we’ll cover real estate crowdfunding in depth and give you a solid overview of what is possible with crowdfunding real estate investments and also where you need to be cautious. Note that this article has been updated as of December 2015 to reflect the latest Title III regulations, which allow non-accredited investors to fully participate in investment crowdfunding.
The JOBS Act Gives Birth to Real Estate Crowdfunding
It’s hard to be on the web without coming across an article about some new crowdfunding startup. The power of using a group of strangers to raise money for everything from funding a children’s TV program about the power of reading to finding investors for a promising new commercial real estate venture seem to be the fulfillment of all the promises of what the Internet could be. But, not all crowdfunding is the same. When the JOBS Act was signed in 2012, it was, in part, targeting a very specific type of crowdfunding.
Consumer Crowdfunding and Investor Crowdfunding
Kickstarter is the most famous crowdfunding platform in the world. But, Kickstarter is a consumer facing platform. It does not allow people to invest in companies and products in the strict legal and financial sense. Instead entities post a project on Kickstarter and ask for donations. Often, the companies promise that sponsors will be given rewards at certain levels. But, one thing they cannot promise is shares or any type of financial return on an investment. Instead sites like Kickstarter are really offering the chance for companies to get people emotionally invested and to pre-purchase products, but not to raise investment capital.
While Kickstarter has funded some impressive products, allowing a handful of entities to raise money in the seven figures, it and other consumer facing platforms pail in comparison to what investment crowdfunding can do.
Companies who are seeking infusions of capital used to be strictly limited on who they could approach because of SEC rules about solicitations and accredited investors. But, with the JOBS Act, investment crowdfunding is possible. If the proper procedures are followed, a company that needs accredited investors doesn’t have to be limited to the people in their network. Instead they can recruit investors from anywhere, so long as they meet the SEC requirements for being an accredited investor. The investors in these types of ventures get equity, subjecting them to the risks of losing their investment and giving them access to the rewards of a successful business.
Even more exciting is that investment crowdfunding is not limited to accredited investors. Under certain conditions, regular consumers can receive the benefits of investment crowdfunding. They can place their money in real estate projects all over the world, and grow their nest egg from their home computer.
Crowdfunding is Changing Real Estate Syndication
Prior to the JOBS Act, one of the major ways real estate projects pooled financial resources was through syndication. Syndication has been used for generations in real estate investments. In a real estate syndicate a sponsor would find the property and manage the transaction and put up some small percentage of the capital for the project. Investors would then fund the majority of the project and the profits from the project would be split according to the equity invested.
The problem with syndication is that under the rules that govern investments it was difficult to find investors. Rules limited who you could market to. You almost always needed some pre-existing relationship outside of the investment with a potential investor before you could solicit him or her. Sponsors sometimes would spend months or years making connections and going to networking events with the sole purpose of creating pre-existing relationships to later leverage into syndication possibilities. The investors themselves often had to meet specific requirements before you could legally allow them to invest money in your project.
Real estate crowdfunding uses the same principles of pooling capital as syndication, but leverages the changes in the rules brought by the JOBS Act to make it easier to find investors. Crowdfunding is like syndication, only with more latitude in the solicitation rules and without the need for preexisting relationships between the sponsor and the investors. In some cases you can also seek out investors who traditionally would not have been eligible to invest in a real estate syndicate because they lacked sufficient income or assets to qualify as an accredited investor.
Brief History of the JOBS Act
President Obama signed the bipartisan Jumpstart Our Business Startups Act (JOBS Act) on April 5, 2012. The bill made several sweeping changes to securities law and modernized many aspects of the way startups were treated by the law. One of the biggest changes was the legalization of investment crowdfunding.
The JOBS Act is made up of seven different titles:
Title I: Reopening American Capital Markets to Emerging Growth Companies
Title II: Access to Capital for Job Creators
Title III: Crowdfunding
Title IV: Small Company Capital Formation
Title V: Private Company Flexibility and Growth
Title VI: Capital Expansion
Title VII: Outreach on Changes to the Law
The biggest changes for real estate investing purposes are mostly in Title I through Title IV. These sections of the law also required the most action from the SEC.
Although the law was passed in 2012, various elements only took effect later. The SEC was required to implement several new rule changes before the law could fully take effect. The SEC enacted the last major piece of the legislation with the approval of a set of regulations for Title III in October of 2015.
Regulation D: What Can You Advertise?
The big advantage to crowdfunding over traditional real estate syndication is the ease of finding investors for a given project. But, the SEC has traditionally only allowed advertising and marketing, also known as solicitation, under very narrow circumstances for investment projects. But, crowdfunding will not work without the ability to advertise offerings to investors.
The Regulation D Limits
Regulation D allows smaller companies to raise capital without going through the onerous and expensive process of registering securities with the SEC. However, the trade off for taking advantage of Regulation D has traditionally been Rule 506 of Regulation D. Rule 506 forbids “general solicitation” of investors. This means, among other things, that companies couldn’t use mass market advertising to raise attention about the offer. Under the language of Rule 506 and the narrow interpretations, it also meant that some type of pre-existing relationship be present before a project sponsor could approach an investor with an opportunity.
The trade-off for this general solicitation ban was that non-accredited investors could be approached, so long as they were sophisticated and were given the type of information that would be required in a public offering that was to be registered with the SEC.
The purpose of the ban against general solicitation in private offerings was to prevent fraud and protect investors, especially the non-accredited investors that had access to Regulation D private offerings.
When the JOBS Act was passed, Rule 506 of Regulation D meant that real estate crowdfunding companies couldn’t exist because being on the web in any way that attracted investors would be general solicitation.
2013 Changes to Regulation D
The SEC finally made significant changes to Regulation D in 2013 to begin making investment crowdfunding possible. The biggest change was the formulation of rule 506 (c), which among many other things, allowed for private offerings to begin general solicitation.
However, the SEC remained concerned about possible fraud on the parts of startups and the ability of bad actors to gain control of weak or unsuspecting companies and use them to commit fraud or other kinds of bad acts. As a result, when the SEC created an exemption from the general solicitation ban, it also increased other fraud safeguards, which make it more challenging to recruit investors to a private offering.
The Changes and the Rise of Crowdfunding Portals
While many investors were unhappy that the SEC didn’t make it even easier for private offerings to attract investors, the investment crowdfunding sector began setting up shop. Platforms, including many real estate investment crowdfunding startups, began to raise capital and plan to begin operations now that they could qualify for the exemption to the general solicitation ban.
The 2013 changes redirected the concern of investment projects from the solicitation ban, to the new strict requirements for verifying investors were accredited. The regulations for Title III of the JOBS Act opened up some opportunities for non-accredited investors. This leaves portals the choice of two different groups of investors to target. They can work under the constraints of Regulation D and Rules 506 and 506(c) and pursue accredited investors, or they can work under they even stricter constraints for Title III that allow for the targeting of non-accredited investors.
Accredited Investors and Rule 506 and 506(c)
Most real estate projects are undertaken by relatively small companies or syndicates that use the private offering provisions of Regulation D to avoid the burdensome registration requirements that they would otherwise have to fulfill. Under Rule 506 before the 2013 changes, unaccredited investors could invest in these types of projects, but the company had to obey the solicitation ban. But, as required by the JOBS Act, the SEC amended rule 506 by adding Rule 506(c).
The Burden of Certifying Investors
Rule 506(c) eliminates the general solicitation ban, but only allows accredited investors access to the project. It also requires the company to undertake the responsibility of verifying that every investor is an accredited investor. The verification process can be time and labor intensive. Most companies lack the internal resources to verify investors, and instead increasingly outsource this task to third parties. However, the company itself remains responsible for the adequacy of the verification.
The SEC defines an accredited investor as someone who meets one of two requirements. They must either have a net worth of at least $1 million, not counting their primary residence, or have an income of $200,000 for single investors and $300,000 combined for a married couple, a year, for the past two years.
Verifying that someone is an accredited investor is often more complicated than just looking at a tax return, and can be as involved as a general financial audit. While any number of firms offer to verify investors, there is some concern about firms too anxious to provide positive results for their customers and introducing fraud into the system.
Does Solicitation Increase Fraud?
The stated purpose of the general solicitation ban was to lessen instances of fraud in private offerings. Many at the SEC and in private watchdog groups worried that allowing any exemption to the ban would increase fraud. To counterbalance this new threat of corruption, additional safeguards, including the requirement to independently verify investors, were added. But, it remains unclear if there is any link between solicitation and fraud in the first place.
SEC enforcement actions since the enactment of Rule 506(c) have not shown any increase in fraud, but instead have shown the SEC’s desire to crack down on so called broker-dealers, even in cases completely absent of fraud.
The SEC requires brokers register with the SEC, but the agency seems to be widening whom it considers to be a broker. Anyone who receives compensation, even a company employee, for helping to find investors might need to register as a broker to avoid negative SEC consequences. The SEC seems to be sending the message there is not any exemption to this registration requirement.
Does Rule 506(c) Apply to Crowdfunding?
When the SEC made the changes to Rule 506 it was enacting Title II of the JOBS Act, which does not specifically cover crowdfunding. Instead, Title III of the JOBS Act is the investment crowdfunding part of the legislation. Because the SEC took so long to enact Title III, many crowdfunding portals initially focused only on accredited investors.
506(c) is intended to only cover private offerings to accredited investors. However, many real estate crowdfunding and investment crowdfunding platforms made their offerings fit not under the actual crowdfunding part of the Jobs Act, but instead under the Title II rules.
The official position is that Rule 506(c) does not apply to crowdfunding, as that will require further rulemaking at the SEC. But, so long as companies follow all of the rules and regulations, including those that require investor verification, they may be able to create an offering that looks like investment crowdfunding, but is legally just a private offering.
Regulation A+: What Needs to be Registered?
The SEC issued changes to Regulation A+ as part of its duties under Title IV of the JOBS Act in March of 2015. Like the earlier Rule 506 and 506(c) changes, these regulations do not deal directly with the investment crowdfunding portions of the JOBS Act. Many of the provisions of Regulation A+ opened up real estate investment opportunities to non-accredited investors.
The New Regulation A+ Changes
Regulation A lays out the requirements for registering securities with the SEC. The problem with the original Regulation A is that in addition to the federal registration rules, companies have to also comply with different state registration rules in every single state where the securities are sold.
Regulation A+ has two different tiers. Tier I offerings are any offering under the regulation where $20 million or less in capital is raised within twelve months. These offerings will still require companies to register securities with both the SEC and state regulators. Tier II offerings are those there the company raises more than $20 million and less than $50 million within twelve months. Companies raising more than $50 million are not eligible for Regulation A+ treatment.
Under the March 2015 changes SEC rules will preempt state registration rules for any Tier II offerings. Additionally, anyone can invest in Regulation A+ offerings, no matter what tier. Even non-accredited investors can participate in Regulation A+ offerings.
There is a catch with the new regulations. There are strict limits to the amounts non-accredited investors can invest in these offerings. The amounts vary depending on net worth. However, unlike the burdensome requirements under Regulation D Rule 506(c), investors under Regulation A+ can self certify. This saves companies from what could have been a verification process even more cumbersome than the Rule 506(c) one.
Other changes include the requiring audited financial statements for companies seeking Tier II offerings and requiring investor circulars be pre-approved by the SEC.
How Does Regulation A+ Impact Crowdfunding?
Because Regulation A+ does not have a general solicitation ban and non-accredited investors can participate in these offerings, it seems possible for a real estate project to get capital from a large dispersed group of people in a similar way to crowdfunding.
Any real estate crowdfunding targeted at non-accredited investors will have to meet the requirements the SEC announced in October 2015 as part of its regulations for Title III investment crowdfunding.
What is legal under Regulation A+ is “accredited crowdfunding”. Offers that conform to the rules of Regulation D Rule 506 (c), where only verified accredited investors participate is the type of “accredited crowdfunding” that is legal. But, likely few real estate crowdfunding projects will be pursued on this basis now that the SEC has finally opened the way for investment crowdfunding as long anticipated when the JOBS Act was passed in 2012.
Some platforms were already working on helping to attract non-accredited investor money to real estate projects in compliance with Regulation A+ prior to the most recent regulations. This included providing detailed disclosures and having a system for investors to self-certify. However, the SEC will likely not allow this type of runaround of its crowdfunding regulations now that they have been approved.
What Are the Advantages and Disadvantages of a Regulation A+ Offering?
The biggest advantages of a Regulation A+ offering include being able to use advertising to access more capital from a bigger pool of investors and, in many cases streamlined registration requirements. However, there are several significant downsides to one of these offerings as well.
Regulation A+ only allows for streamlined registration in projects between $20 million and $50 million. If a project is smaller, it will still have to abide by both state and federal registration requirements. If the project is smaller than $5 million, it’s not clear that a Regulation A+ offering can even be made.
The new changes also require a lot of expensive audited reports and regulatory paperwork. Regulation A+ may be a great vehicle for fast growth companies and real estate projects that are large in scope, but the reporting requirements will most likely be too expensive for smaller operations.
Title III Crowdfunding Regulations
After more than three years of waiting, the SEC finally released the proposed regulations for Title III of the JOBS Act. This step will finally allow non-accredited investors to fully participate in investment crowdfunding. The rules will not be in full effect until June 2016, but the process for online crowdfunding portals to register with the SEC will begin the end of January 2016.
The Rules for Investors
While non-accredited investors will be able to participate in crowdfunding, individuals will be limited in the amounts they are able to invest. Investors with a net worth of less than $100,000 can only invest either $2,000 or 5% of their annual income or net worth, whichever is greater, a year. This means that most investors in this category are limited to investing less in equity crowdfunding than they can put into an IRA each year.
Investors with a net worth of $100,000 or more can only invest up to 10% of the lesser of their net worth or annual income a year in equity crowdfunding securities. No investor is allowed to purchase more than $100,000 in crowdfunding securities in any 12-month period.
Investors will not be allowed to sell their crowdfunding securities for at least one year in most circumstances. Investors will not be required to register their crowdfunding securities so long as the issuer is in full compliance with SEC reporting obligations is has less than $25 million in assets.
The Rules for Companies and Sponsors of Crowdfunding Projects
Companies that wish to raise money through equity crowdfunding, whether for real estate investment or any other reason, can only raise $1 million in a 12-month period. Companies will also be required to use a portal or broker-dealer that has already registered with the SEC to handle the offerings.
Companies will also face extensive reporting and disclosure requirements under the new regulations. Companies will need to disclose information about the officers, directors, and owners of more than 20% of the company. The company must describe its core business and how the money raised through crowdfunding will be used. Pricing information such as the method for determining price of the securities, the fundraising goal, and the deadline for the fundraising must also be disclosed to investors.
The SEC also requires companies seeking to make a Title III equity crowdfunding offer to disclose details about the ownership and capital structure. Any select-party transactions must also be disclosed. Companies will need to describe all of the material terms of any indebtedness along with a statement about the company’s financial condition.
In most cases, first time crowdfunding efforts will not require an audited financial statement. However, a reviewed financial statement, at a minimum, will always be required. Under certain conditions after the first round of crowdfunding, an audited financial statement will be required.
The Rules for Crowdfunding Platforms
The proposed SEC regulations require that all equity crowdfunding take place through a SEC registered broker dealer or portal and that the funding takes place exclusively online.
The funding portal is a new type of SEC registered entity. Registration for funding portals will open the end of January 2016. The platforms that will manage the equity crowdfunding process for companies will be required to provide investors with the mandatory educational materials, act to reduce the risk of fraud in the system, disseminate or make available all the information about the offering and the issuer, and provide communications channels to allow for discussions about the offering on the platform. These requirements are on top of the main job of the portal to actually facilitate the offering and sale of crowdfunding securities.
The portals are prohibited from making any investment advice or recommendations. The portals are also banned from soliciting the offers to buy securities offered on the portal website. This includes a prohibition on soliciting purchases or sales of the securities available on the portal website.
Portals are also not allowed to hold, possess, or handle investor funds or securities. Many restrictions also limit the ability of a funding portal to compensate people for solicitations.
Possible Drawbacks to the New Regulations
While no one is accusing the SEC of acting rashly with its latest regulations on investment crowdfunding, many have expressed concerns about the regulations being too limiting.
The two biggest concerns are the $1 million annual limit and the exhaustive reporting and disclosure requirements. For real estate investors the $1 million annual limit immediately takes many types of lucrative commercial and residential real estate projects off of the table. Non-accredited investors may be left with only investing in smaller projects that often have lower rates of return.
The reporting and disclosure requirements will be expensive to implement, monitor, and maintain. There is some concern that when combined with the $1 million annual limit on securities sold through crowdfunding, the cost of the disclosure requirements will be too onerous for most real estate projects.
What Can Legally be Done Now?
The SEC has created two different investment crowdfunding tracts. Non-accredited investors will be limited to opportunities governed by the new Title III regulations. Accredited investors will be able to invest in the kinds of crowdfunding deals governed under the revised Regulation D and Regulation A+.
The Title III regulations will not be in full effect until the middle of 2016. Non-accredited investors will have to wait until then to take advantage of investment crowdfunding.
Even though a full-fledged real estate crowdfunding platform is not yet legal, accredited investors can continue to take advantage of investment opportunities under Regulation D Rule 506 and 506(c) and Regulation A+. Many of these opportunities provide many, if not all, of the advantages of investment crowdfunding to both the investor and the company issuing the securities.