The real estate development market continues to open up to crowdfunding, and the changes to capital raising for real estate projects could be significant if only a small portion of the potential of these new methods take hold. It appears that the changes are well underway.
In previous blogs, our Business Transactions Team has described the types of capital raising that are commonly called “crowdfunding.” The real estate crowdfunding referred to in this article involves raising debt or equity capital under the terms of Regulation D, 506 (c) by way of general solicitation, more specifically, internet augmented solicitation and sales, offered only to “Accredited Investors.”
There are other crowdfunding regulations that are in the review process at the Securities and Exchange Commission (“SEC“) under Title III of the Jumpstart Our Business Startups Act (“JOBS“) that involve smaller investment amounts; however, the SEC has yet to publish its final regulations for these Title III offerings. These crowdfunding rules, which are labeled as “Crowdfunding” by the SEC, may have some potential for broadening the reach of crowdfunding by permitting non-accredited investors to participate in offerings, within certain limits. However, the SEC has not yet finalized the rules for these Title III “Crowdfunding” offerings. Under the proposed regulations for the Title III rules, the maximum amount of capital that a sponsor or developer could raise in a 12-month period would be $1 million. If there are no changes to the proposed rules for these offerings, when they become effective, their usefulness may be very limited. Therefore, for now, most real estate projects that go under the name crowdfunding are using general solicitation to Accredited Investors under Regulation D Rule 506 (c).
How Does it Work?
Most real estate developers, project sponsors, and operators are well-acquainted with deal syndication – the process of pooling investments from a group of investors to finance a portion of the equity for a real estate project. Most traditional equity capital raising in the private real estate markets has been through private equity real estate funds, real estate investment trusts (“REITS“), or other pooled investment funds, for larger projects. For small to mid-sized capital raising projects, Regulation 506 (b), the traditional private placement mechanism, has been the preferred method for bringing in outside investors. The new Regulation D 506 (c) has not altered or done away with the private placements under 506 (b), which are still available for use.
Rule 506 (b), permits sales to an unlimited number of Accredited Investors and up to 35 non-accredited investors, provided that there is no “general solicitation,” and there are appropriate resale limitations imposed, applicable information requirements satisfied and other conditions met. The presence or absence of a preexisting, substantive relationship between the issuer or its agents and the offerees is a key indicator for deciding whether a communication constitutes general solicitation. In addition, there needs to be sufficient time to elapse between the offeree’s initial contact and collection of information from the issuer and the inception of any particular offering, so that the contact and exchange of information is not deemed to be a solicitation with regard to a particular offering.
For these reasons, Regulation 506 (b) offerings are usually available only to a close circle of pre-existing, high-net worth individuals who were sophisticated and who had preexisting relationships with the issuer or were insiders such as officers or directors of the issuer. This bore a kind of air of the country club investing style. If other investors outside of this circle wanted to invest, it would take a considerable period of time to establish the preexisting substantive relationships, assess financial suitability for an investment, and also would cause delays for the issuers who needed to raise capital on short time schedules. Moreover, the overall universe of possible investors using this traditional process was limited.
Now with the new Reg. D Section 506 (c), the issuer or its registered broker-dealer can raise funds from a number of Accredited Investors quickly through the use of “general solicitation.” Most importantly, this means the process is streamlined via the internet and reaches a larger number of available capital sources quickly and efficiently.
There are numerous real estate crowdfunding platforms in the market and the numbers are growing fast. They constitute a form of modern online real estate marketplaces. Some examples of real estate crowdfunding platforms (without making any recommendations) are: EarlyShares, RealCrowd, Fundrise, and Realty Mogul, among many others. These platforms can provide various services to both issuers and investors. On the issuer side, the crowdfunding platform can be a curator of the deal. It can perform background checks, criminal and credit checks, and other due diligence on the developers and real estate investment companies and their management teams, thus providing some quality assessment and a level of confidence for investors. On the investor side, the platforms can provide the service of verification of the Accredited Investor status. Under the provisions of rule 506 (c), the issuer is required to take “reasonable steps” to verify that each investor is an Accredited Investor. The platform can collect evidentiary documentation such as tax returns, financial statements, IRS Form W-2s and Form 1099s, bank account information, accounting records and other documents, which can assist in verifying Accredited Investor status.
There are different types of funding mechanisms in use by the crowdfunding platforms. Direct crowdfunding accepts individual investments from the investors directly into the entity that will own the real estate. The projects are often set up as single purpose entities, which are frequently limited liability companies (LLCs) and have favorable flow-through tax treatment. A separate LLC can be used for each individual property or project thus allowing projects to stand on their own without having an impact on other portfolio properties. The issuer can accept investments for each particular property’s entity from members of the platform’s network of new Accredited Investors who contact the issuer through the internet platform site. The real estate sponsor or developer syndicates a portion of the debt or equity and accepts the new investors into the transactions. Another model for crowdfunding is for the platform to pool all investor commitments together and then use the pooled fund to invest directly into the issuer’s deal. Using this model, the deal sponsor only has one new investor in the offering: the fund.
One variation of this process is used by Fundrise. Fundrise reviews the due diligence materials and underwrites the investment. Once the project is approved, Fundrise funds the investment up-front. Then they collect investments from the Accredited Investors, manage the investors and automate the payment process. Other funds open the fund directly to investors and close the offering once the target goal is reached. The platform typically acts as the fund manager and shares a percentage of the profits after investors receive their share.
The Accredited Investors can invest in most projects with either debt or equity investments. Investors who qualify can go online and browse pre-approved real estate investments that have been vetted by the platform provider, conduct due diligence, make a full investment online, and follow the investment by using an online dashboard. Some internet sites have minimum investment amounts such as $5,000 to $10,000 per investor but some platforms have even smaller minimums. The investment properties should have their own property management service firms to handle the day-to-day management of the properties. The returns for the investors include a share of the rental income once the property starts to produce income and then a share of the proceeds and capital appreciation when the property is sold.
Crowdfunding has already served to help fund some notable deals. Fundrise raised $5 million for Three World Trade Center, the 80 story office building near ground zero in New York City. Fundrise bought a $5 million share of the $1 billion in tax-exempt liberty bonds sold by the developer and resold them to small investors by way of crowdfunding.
Private Equity capital raising for real estate investments still remains a proposition fraught with risk. Both developers and investors must be diligent, especially with a broad and anonymous investor base that could result through general solicitation. The usual investment warnings still apply and there is no substitute for fundamental due diligence investigation of each investment. Nevertheless, all involved in real estate investing should understand that this could be a tectonic shift in how capital is raised for real estate projects.
Contact our Business Transactions Team if you would like to discuss this new way of raising capital for commercial real estate.