What is Real Estate Crowdfunding?
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There are many ways to raise capital for real estate deals, and, vice versa, as many ways for people to invest. The advent of real estate crowdfunding through online portals has democratized the process, but still, it’s typically been accredited investors who get first dibs on the best deals.Yet while the truly lucrative real estate deals are usually only accessible to accredited investors latest proposed SEC changes are set to change that.
Accredited investors are those who meet certain income thresholds, either individually or with their spouse. Under Title III of the 2012 JOBS Act, accredited investors were limited in how much they could invest. Many deals were only available to accredited investors. Those open to non-accredited investors had even stricter limits imposed, a regulation intended to protect people’s hard-earned dollars.
How do the SEC’s latest changes impact who can invest in real estate crowdfunding?
Earlier this year, the SEC expanded the definition of an accredited investor. Now, anyone who holds a Series 7, Series 65, or Series 82 license is considered an accredited investor. The expanded list of accredited investors also includes governmental bodies/funds, rural business development companies, family offices with at least $5 million in assets under management, and knowledgeable employees of a private fund but only with respect to investments in that fund.
In the short term, this change will not have a major impact on the number of accredited investors in the marketplace as relative to the overall population there aren’t that many people who fall into these categories – and many already met the accredited investor standard.
Longer-term, though, we expect to see the pool of accredited investors expand. This is because the SEC has explicitly included language in the new regulation that allows FINRA and other self-regulatory groups and accredited educational institutions to develop their own tests to determine who has the level of “sophistication” to be an accredited investor. In other words, just like someone must take the LSATs to get into law school, we expect to see tests emerge that will determine whether someone can be an accredited investor.
The impact of this will eventually be noteworthy. This will liberalize who can invest and under what conditions. Specifically, people will no longer need to be wealthy to invest in top-tier real estate deals.
How much money can sponsors raise under the new SEC regulations?
Under the new SEC crowdfunding regulations, sponsors can raise up to $5 million per offering. This is a staggering increase (roughly 500%!) above the previous cap of $1.07 million. This means that sponsors can bring bigger deals to the marketplace. It also creates efficiencies for the sponsor – rather than trying to fill several smaller offerings, they can approach investors with one larger offering. And under these new guidelines, accredited investors are no longer capped at how much they can invest in any one deal. This means that a single investor could, theoretically, invest a full $5 million in a single deal (more on this below).
Raising the cap on offerings also creates efficiencies for the funding portals featuring these deals. For example, a funding portal will be able to hire more staff (e.g., compliance officers), provide better marketing support, etc. as deal sizes increase.
Lastly, bigger deals will attract more investors. The deeper the pool of investors, the more likely sponsors will be to utilize online crowdfunding portals. This in turn strengthens the industry as a whole.
How much can accredited investors invest under the new SEC regulations?
The SEC has now lifted the cap on how much an accredited investor can invest in a Title III offering. This change was long overdue. In fact, some would argue that the cap included in the 2012 JOBS Act was actually a mistake. After all, accredited investors could already invest as much as they wanted through Reg A and Reg D offerings; it seemed arbitrary to cap investments made under Reg CF(crowdfunding). But at the time the JOBS Act was being written, crowdfunding was still so new and not subject to SEC review, so the intent was to limit how much people could invest and potentially lose.
The impact that this will have on the crowdfunding industry is astronomical. In fact, it will change how capital is raised. Rather than private capital placements being made solely under Reg D 506(b) or 506(c) crowdfunding, more people will begin to invest through Reg CF.
What’s the difference between a Title II and Title III Portal?
Under Title II, sponsors looking to raise capital through the sale of securities must either register the securities offering with the SEC or get an exemption from registration. Most exemptions prohibit general solicitation, and therefore, would prohibit someone from utilizing an online crowdfunding portal. There is, of course, an exemption: Rule 506 of Regulation D stipulates that companies CAN solicit online, but only to accredited investors. Realty Mogul and CrowdStreet are just two examples of Title II portals.
Title III, which was adopted in 2015 and took effect in 2016, allows a sponsor to advertise securities to non-accredited investors. Until now, though, sponsors could only raise up to $1,000,000 in a 12-month period using a Title III portal. Title III also capped how much non-accredited investors could invest in any deal (e.g., investors who earn less than $100,000 per year could only invest the greater of 5% of their annual income or $2,000).SmallChange is an example of a Title III funding portal.
Why would a company want to register as a Title III Portal?
With the proposed changes recently announced by the SEC, any company operating a Title II portal will want to quickly register as a Title III portal also. This will open the door to larger deal sizes and a broader pool of investors, both accredited and non-accredited alike. Importantly, accredited investors will now be able to invest unlimited funds in any given deal including those also available to non-accredited investors. What this also means, importantly, is that, for the first time, non-accredited investors will be able to invest in deals that were previously only available to accredited investors – i.e., the best of the best deals.
Moreover, under a proposal floated (but not yet approved) by the SEC, portals will soon be able to act as a “finder” and collect commissions on the deals they help bring to fruition (more on this below).
Can I start my own Title III portal to raise capital?
This is a common question but unfortunately, the answer is no. A sponsor cannot create their own Title III portal to raise capital for their real estate deals from non-accredited investors.
At first glance, it is tempting for a sponsor to consider creating their own portal to raise up to $5 million from accredited and non-accredited investors under these new regulations. However, the SEC requires regulation crowdfunding to be done through a funding portal that the sponsor does not own. The owner of the portal and the sponsor must be two completely different entities. Therefore, to raise money via Title III regulation crowdfunding, a sponsor MUST utilize someone else’s platform.
What are real estate “finders”?
As noted above, the SEC is contemplating changes to how “finders” earn their compensation. Historically, finders have been anyone operating in a third-party capacity to connect sponsors and investors. Finders were typically people who had a big rolodex full of wealthy individuals who they could call upon to pitch investment opportunities to. Most finders were not registered as “broker-dealers,” and therefore, were not technically allowed to earn a commission on the deals they helped to arrange (though in practice, many did and continue to do so to this day).
Although earning a commission was illegal, it’s a key component of how the private equity markets have operated for decades. The SEC has always just turned a blind eye, if you will, only bringing enforcement actions for non-compliance on an occasional basis.
How do the proposed changes to SEC regulations impact finders?
For some time now, the SEC has been under pressure to legalize what finders do. While the SEC hasn’t enacted any new legislation to date, there are proposals being floated that would legitimize finders and allow them to earn a commission on the deals they facilitate.
The SEC has proposed two tiers of finders:
- Tier I Finders would be limited to providing issuers with the contact information of potential investors once every 12 months. A Tier I Finder would be prohibited from speaking with potential investors about the issuer or terms of the offering.
- Tier II Finders would be able to participate in as many offerings as they so choose, soliciting direct investment on behalf of the issuer. They’d be able to help identify, contact and screen potential investors, arrange and participate in meetings between the sponsor and potential investors, distribute offering materials, and discuss the details of the offering as long as they are not providing actual investment advice.
It is still unclear what the final legislation would look like, but under the current proposal, there will be no license requirements to be a finder. Instead, finders would be required to have two contracts: one with the issuer (sponsor) that outlines what he’s being hired to do and how he’ll be compensated; and one with investors that discloses the finder’s role in arranging the deal including compensation. If a deal goes sideways, a finder would be no more liable than he is today (assuming he has not lied about any aspect of the deal). In fact, one might argue that a finder is more liable today, under the existing regulations, given that he is operating illegally as a broker-dealer.
When will the changes to how finders are regulated take effect?
The flurry of SEC activity, as it pertains to crowdfunding regulations, has taken many investors by surprise. Some speculate that these changes are being made ahead of the November election as a way of bolstering the economy and building support for one party vs. another. While some changes have already been adopted, we suspect that it will still take several months before changes to how finders are regulated will take effect. The SEC will likely need to work through some anticipated pushback from Wall Street’s existing broker-dealer community, which has long carved out this niche for themselves and will protest anyone perceived to be invading their turf.
How will these changes benefit real estate sponsors, investors, and portals alike?
These changes will have a seismic impact on real estate crowdfunding. Fortunately, this is a win-win-win situation for all parties involved.
- ISSUERS: Issuers (sponsors) will have broader reach. The pool of capital will be much deeper. Title II portals now appeal to some 11 million American people (accredited investors). By utilizing a Title III portal, they will be able to solicit capital from 150 million Americans (non-accredited investors). Issuers will also be able to raise more capital from these investors (up to $5 million per deal), which will increase the scale of deals, in turn attracting even more wealthy investors to these deals.
- INVESTORS: Crowdfunding is a way to provide access to really good deals—deals that have historically only been available to accredited investors. These changes will open the doors to terrific investment opportunities that can help everyday individuals build equity.
- PORTALS: Lastly, portals will benefit from their ability to attract accredited and non-accredited investors alike. Of course, the biggest benefit for portals will be if they can legally accept commissions, which will be a windfall for these portal operators.
CONCLUSION- Is this a dawn of a new era with the SEC?
The SEC has been hesitant to overly regulate online crowdfunding to date. The regulations that were enacted were really just to hedge against potential fraud, particularly given the newness of online crowdfunding and the uncertainty around how portals would operate. Now that the fraud that people had anticipated never came to be, the SEC is making welcome changes that will open the floodgates for even more investment via crowdfunding portals. Real estate crowdfunding is already a multi-billion dollar industry, but we’re just standing on the precipice of what’s yet to come.
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