Crowdfunding is the practice of soliciting financial contributions from a large number of people. Recently, this has been accomplished in the online community and in the last few years it has expanded into the real estate industry.
What are the regulations?
The use of crowdfunding to raise capital has been around for a long time but its widespread use, particularly through websites, is a new concept. In 2012, President Obama signed the Jumpstart Our Business Startups Act (“JOBS Act”) into law and the opportunity for real estate crowdfunding began to take hold in the United States.
Title II of the JOBS Act, “Access to Capital for Job Creators,” allows for crowdfunding by accredited investors with fewer regulations. In 2013, prompted by the JOBS Act, the SEC loosened the general solicitation rules and advertising in offerings for private companies seeking to raise capital where the purchasers are all accredited investors. Real estate crowdfunding websites multiplied with this rule, referred to as Rule 506(c) of Regulation D.
Many companies are hesitant to use crowdfunding because of the extra due diligence required to verify the accredited status of investors. Instead, many companies follow Rule 506(b) of Regulation D. Under Rule 506(b) of Regulation D, a company may sell an unlimited amount of securities, raising an unlimited amount of money from an unlimited number of accredited investors or 35 unaccredited investors as long as the company does not generally solicit investors.
Under Rule 506(c) of Regulation D, a company may generally solicit and advertise its securities but only to accredited investors. Also, it must take heightened steps to assure that investors are accredited (not a “check the box” approach). Think of this option as crowdfunding but only to select members of the crowd.
Title III of the JOBS Act, “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012,” is intended to allow for crowdfunding through regulatory requirements beyond those found in existing exemptions available under US securities laws (i.e. private offerings to accredited investors).
Provisions of Title III of the JOBS Act:
- Provides equity investments in aggregate up to $1,000,000.
- The aggregate amount invested per investor:
- If the annual income or net worth of the investor is less than $100,000 the investment cannot exceed the greater of $2,000 or five percent of the annual income or net worth, as applicable.
- If the annual income or net worth of the investor is $100,000 or more the investment cannot exceed 10 percent of the annual income or net worth of an investor, as applicable, and not to exceed an aggregate investment of $100,000.
- The transaction is conducted through a regulated crowdfunding intermediary (broker or funding portal)
- The company complies with certain information delivery requirements.
- Nonaccredited investors will need to meet certain investor-education requirements.
Significant growth in crowdfunding could occur under Title III of the JOBS Act; however, the industry is still awaiting SEC rules. For the time being, companies must consider the federal and state rules and regulations before getting involved.
Also, those looking to raise capital should be aware of recent changes to Regulation A of the Securities Act of 1933. Effective June 19, 2015, the SEC adopted amendments to Regulation A which have been dubbed Regulation A+. These rules, which came about through Title IV of the JOBS Act, allow companies to sell shares to the public through unregistered offerings without being subject to the reporting requirements for Initial Public Offerings (IPOs). The rule was approved for “Tier 1” offerings of up to $20 million and “Tier 2” offerings of up to $50 million.
Why are more real estate deals incorporating crowdfunding?
Real estate companies want to move quickly on a project and traditional forms of financing and capital raising can be time consuming and relatively expensive. Crowdfunding allows real estate operators to easily obtain access to millions of potential investors through the power of the internet.
Individual real estate investors like crowdfunding because they can gain access to deal flow without the time, energy and resources required to manage the properties. It is a new distribution platform that is increasing access to real estate deals by allowing hundreds of investors to participate in each deal. In addition, instead of spending hours performing their own due diligence on each real estate investment opportunity, the crowdfunding websites provide pre-screened lists of investment opportunities.
How does it work?
Crowdfunding platforms or portals allow people to ask for or donate money. A project creator asks for funds to support his or her goal and individuals have a chance to invest in the project. Real estate crowdfunding is a means for a sponsor of a real estate project to fully or partially fund their project by offering equity or debt investment opportunities to individual investors. The sponsor typically forms an LLC and either creates a crowdfunding site or uses a white label website to seek investments in the LLC’s real estate project. A crowdfunding project could ask for as little as $5,000 to participate and dozens, if not hundreds, of investors will invest various amounts toward a project.
Projects range in size but typically they seek a crowdfunded capital raise of $1-3 million. A sponsor may use crowdfunding to secure funds for a substantial portion of a real estate deal or simply to provide a few million dollars toward a $100 million plus project.
What are the benefits?
A real estate company looking to obtain capital through crowdfunding can promote the fact that investors have the opportunity to invest in a specific property they may be familiar with and may already have detailed information about such property. A crowdfunding project could allow investors to receive distributions within a few months of closing on the capital raise; however, distributions could take much longer, especially for ground up development projects. Crowdfunding provides the ability to participate in real estate deals that traditionally were only available to insiders or those deals within one’s own network.
Crowdfunding projects are typically housed within LLCs or other pass-through entities, whereby gains and losses are not taxed at the entity level. Pass-through entities thereby avoid double taxation. The entities’ tax losses flow through to the partners or members while also allowing them to receive distributions without an impact to their current tax liability. Investors can also offset their passive income generated by the investment in a pass-through entity against any passive losses from other real estate investments.
Who is currently participating?
Parties involved in crowdfunding include sponsors or syndicators who may be real estate developers, or holding companies acting as co-investors in their offered projects, listing services, accredited investors, investment advisors, broker-dealers, and major crowdfunding companies running the websites.
An accredited investor is one who has annual income of at least $200,000 for the prior two years ($300,000 for a couple) or a net worth, excluding primary residence, above $1,000,000. Sponsors must verify that investors are accredited.
Though real estate crowdfunding has focused on low-profile, relatively small projects, some notable real estate projects that are using crowdfunding include the redevelopment of Detroit Tiger Stadium and the development of 3 World Trade Center.
What are the risks?
There are several potential hidden costs for a project so there should be significant due diligence performed before getting involved. Some sponsors may charge fees for funds raised (three percent or more of the capital raise), fees for funds not raised, and credit card fees. Sponsors should align themselves with experienced crowdfunding companies—those that have a successful track record supporting real estate crowdfunding projects. Companies need to reach investors using the right advisors, be they sponsors, accountants, attorneys or investment bankers.
The regulations for Title III of the JOBS Act have yet to be written but are expected to impact the entire industry in the near future. With few regulations, there is concern that no one is policing the industry; however, the SEC is closely monitoring activity. Real estate entities getting involved in projects funded this way must be ready to deal with hundreds or thousands of shareholders and a high volume of recordkeeping and communications.
What is the potential size of real estate crowdfunding?
In 2014, more than $175 million was raised on real estate crowdfunding platforms. Meanwhile, Regulation D filings generate hundreds of billions in new capital. In 2014, Forbes magazine estimated the US commercial real estate market was estimated to be $15 trillion. How soon will it be before the average investor obtains access to such a large market?
At a recent industry event, crowdfunding was compared to the transition the travel industry has made from agents to web-based portals. The risks are certainly not the same; however, many people in the industry believe crowdfunding is how real estate capital will predominantly be obtained in the future. Online access to capital will be fast and efficient as opposed to slow and expensive with the current brick and mortar banker. Additionally, individual investors, family offices, and small endowments may soon get involved.
Ultimately, the use of crowdfunding in real estate may fizzle out without the SEC taking steps to write final rules in the next few years. Should the SEC provide the necessary guidance, crowdfunding has the potentially to grow exponentially.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.