Change is afoot in the business of how to issue securities for the purpose of funding a small commercial real estate project. It is already possible, though burdensome, to do so. The Jumpstart Our Business Startups Act, enacted in 2012, promises to make it easier through a new crowd-funding exemption under the Securities Act.
When real estate operators seek advice on how to structure a real estate project, they want to be able to raise the most money in the most cost-effective way. Assuming the mortgage and mezzanine pieces, if any, are taken care of, the question is how to raise the remaining debt and equity. For a massive undertaking, such as the recapitalization of the Empire State Building that occurred in 2013, a public offering may be the best way. For other projects, a traditional private placement may be optimal. Where the law has truly fallen short is in how to issue securities to fund a small real estate project, which for these purposes means a project where a sub-$1 million piece of the capital stack is meaningful.
When a security is offered for sale, the transaction must be registered with the SEC unless an exemption from the registration requirement is available. The existing exemptions do not address crowd-funding.
Regulation D either prohibits general solicitation and advertising or permits it, provided that all purchasers are “accredited” (i.e., affluent) investors and the issuer takes reasonable steps to verify their status as such. Regulation D is the domain of the private equity real estate space, and sponsors typically find that a fund-raising needs to exceed the low millions of dollars in order to justify the cost of compliance. Among other burdens, having to choose between forgoing general solicitation and advertising or limiting the offering to accredited investors limits the use of Regulation D for sponsors of small real estate projects.
Regulation A, the “mini public offering” exemption, has been relied upon by more than one sponsor of Web-based real estate investments and enables issuers to register up to $5 million in securities over a 12-month period. However, the deal must be filed under the “blue sky” laws of relevant states, a requirement that turns away most sponsors of small real estate projects.
Under the rarely used intrastate offering exemption, an offering may only be made to the residents of a single state and is subject to “blue sky” review, two restrictions that limit the utility of the exemption.
Crowd-funding is a capital-raising technique that involves issuing very small denominations of securities to relatively large numbers of investors. Crowd-funding initially was a nonsecurities-related concept. When entrepreneurs in recent years sought to “crowd-fund” online donations for developing prototypes of products, the technique’s potential application to real estate development was obvious. Surely, the reasoning went, there was a desire by small investors to fund small projects without having to concentrate all of their funds in a single asset. Moreover, developers and other sponsors wanted access to this capital. The only problem was how to make it legal.
In 2012, Congress passed the Jobs Act, arguably the most significant rollback of the federal securities laws since their enactment in 1933. Title III of the Jobs Act, which creates an exemption under the securities laws to enable the crowd-funding of securities, has the potential to open the door for small investors to invest in small real estate projects, much as the REIT Act of 1960 provided tax incentives that encouraged ordinary investors to invest in large real estate projects.
Late last year, the SEC proposed rules that would implement the legislation. Under the new regime, a company would be allowed to crowd-fund up to $1 million in a 12-month period. Over that period, investors would be allowed to invest up to A) the greater of $2,000 or 5 percent of their annual income or net worth, if both their annual income and net worth are less than $100,000, or B) 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000, up to $100,000 per investor.
The new regulatory system will require a company engaged in crowd-funding to provide to the SEC and to investors information about the company, including its insiders and capital structure, the terms of the offering and the use of proceeds. The company also would need to provide financial statements and prepare an annual report. Notably, the crowd-funding exemption preempts registration with state “blue sky” regulators.
Crowd-funded offerings would need to be conducted online, either by a registered broker-dealer or by a “funding portal,” an online intermediary exempt from registering with the SEC as a broker-dealer. Funding portals would be prohibited from soliciting the purchase or sale of securities displayed on their websites or taking custody of investor funds or securities.
Until final rules are adopted, crowd-funding of securities does not exist—at least not legally. This is a point of confusion in the media, which frequently refers to Regulation D or Regulation A offerings as “crowd-funding.”
Real estate sponsors should take care not to offer or sell securities without having registered them or fit within an exemption. The devil is in the details, and sponsors always should consult with counsel about what may constitute an offer. Gun-jumping concerns are real, and even appearing in the media can adversely impact the legal status of an offering.
Sponsors of small projects may be better served by waiting for final crowd-funding rules than attempting to navigate the existing regulatory structure. Potentially more damaging is attempting to structure a deal without appropriate legal and accounting advice, which cost-conscious sponsors frequently attempt.
Crowd-funding may prove to be as transformative to the financing of small real estate projects as the Securities Act and the REIT Act were to the financing of larger ones. Until then, and also before, real estate sponsors should exercise great care in designing the capital structures of their projects.
Evan Hudson is a New York-based associate at the global law firm Proskauer’s Real Estate Capital Markets Group.