Here are some tips on what’s legal and what isn’t about real estate crowdfunding from A Real Estate Crowdfunding Lawyer.
A Real Estate Crowdfunding Lawyer’s Wise Advice
The number of real estate developers who used crowdfunding to source debt and equity for their projects has recently increased. The timing is no coincidence: significant changes to federal regulations began in 2012, allowing for general solicitation of investment in real estate deals.
Most of the nuances in the new real estate crowdfunding regulations are not understood by the typical real estate sponsor or potential real estate investor.
Jillian Sidoti is an attorney specializing in real estate crowdfunding that will explain what’s legal and what isn’t. She concludes the interview by offering sound advice to those considering raising capital in this manner.
Crowdfunding for real estate: what is it?
Before we begin, let’s go over the fundamentals. Real estate crowdfunding is a “new” term for a practice that uses to build railroads after the American Civil War in the late nineteenth century. It occurs when a real estate sponsor brings capital from various sources to help fund a commercial real estate project depending on the size of their investment. The investors receive a pro-rata share of the profits or interest payments.
Until recently, federal regulations demanded that the sponsor have a personal, prior relationship with the investors. The federal JOBS Act of 2012 began to change this in 2012, allowing sponsors to engage in “general solicitation” under certain conditions.
There are dozens of media available today. Some allow people to invest as little as $100. In contrast, others require more significant investments and are only available to accredited investors.
However, real estate crowdfunding is not limited to these platforms. Real estate sponsors can crowdfund capital using various tools and strategies, online or off. Sponsors will increasingly develop their portals for raising debt and equity. They will market directly to prospective investors in conjunction with or independently of these marketplace platforms.
Who can benefit from real estate crowdfunding?
One of the reasons crowdfunding is so appealing is that virtually any sponsor or real estate developer can use it to raise capital. There are limitations to how they raise capital, which we will discuss in greater detail below. However, any real estate sponsor is eligible to raise capital through crowdfunding. It allows sponsors to get their projects in front of a larger, more diverse pool of potential investors. They would if they raised capital solely through personal networks and in-person meetings.
It is one of the reasons investors must conduct thorough research before investing. Not every sponsor is an expert in real estate. Investors should always research sponsors before making any commitment, no matter how big or small, and consult with qualified accountants, attorneys, and financial advisors.
What rules apply to real estate crowdfunding?
A sponsor will want to evaluate their options before beginning a real estate crowdfunding campaign. There are several options available, and each has its own rules and regulations regarding who can invest and under what conditions.
Here’s a very simplified version of some otherwise complex laws:
- The Securities Act Regulation D: The federal Securities Act governs the entire sale of securities. Historically, anyone wishing to publicize their securities had to hold an official IPO. As a result, it was difficult for real estate developers to raise capital; most deals take time to go through the IPO process. Rule 506 of Regulation D provides a pathway for sponsors to crowdfund capital for real estate projects and is comprised of two major components:
- Rule 506(b): As long as the sponsor has a pre-existing relationship with the investor, this allows them to raise unlimited money for their real estate deals (s). The sponsor is not permitted to market their real estate securities through general solicitation or advertising. On the other hand, sponsors can raise capital from accredited (unlimited) and non-accredited (up to 35) investors. A simple questionnaire allows investors to self-certify as accredited investors. Nothing in 506(b) prevents a sponsor from making educational materials available to anyone through their website or social media.
- Rule 506(c): The rule allows anyone issuing securities to market their offerings to investors through general solicitation or advertising. Unlike Rule 506(b), these offerings are only available to accredited investors. To ensure that all buyers are accredited investors, the sponsor must take “reasonable steps” (vs. the self-certification method described above). Accredited investors must earn at least $200,000 per year (or $300,000 if married) or a net worth larger than $1 million, excluding the value of their primary residence.
- The Securities Act of Regulation A: Real estate developers can raise capital for their projects through Regulation A. Any company selling securities under Regulation A must file their offering with the SEC for review. Before any capital campaign, the SEC must determine whether the offering is eligible under Regulation A.
- Regulation A+: This regulation, which went into effect in 2015, provides certain exemptions from state and SEC registration. Companies can raise $20 million in Reg A+ “Tier I” offerings and up to $50 million in Reg A+ “Tier II” offerings, each with its own set of requirements, including the level of SEC review required before opening the offering.
Which type of crowdfunding offering is best for you?
The amount of capital needed to raise, the timeline, and the robustness of your existing digital marketing systems. It will determine whether you raise capital under Rule 506(b), Rule 506(c), or Regulation A+. As previously stated, each regulation has its own set of constraints. Sometimes, you must have a prior relationship with investors, which can take time to develop. However, you can certainly start that process online.
A real estate crowdfunding campaign always begins with online marketing for those with weaker personal networks but otherwise substantial reach. Still, Regulation 506(c) may make more sense regarding legal structure.
When in doubt, real estate sponsors should consult attorneys. “It’s vital to follow the law, and these are tricky laws,” Sidoti says during our conversation. When launching a crowdfunding campaign, even the most experienced sponsors can make a mistake or forget something.”
How do I start a crowdsourcing campaign?
Investor education is the cornerstone of any successful real estate crowdfunding campaign. Sponsors wanted to invest in robust educational materials that distribute their network, network, and so on to broaden their reach and maximize exposure.
Investor education can take many different forms. Sponsors regularly release articles, podcasts, videos, newsletters, and other forms of media. It includes the significance of cap rates and the reasons they are optimistic about particular markets. Another example is the potential of a particular product category or asset class, how they repositioned a property, the returns it brought in for investors, and so forth.
“Whatever it is, you should explain why you invest the way you do,” Sidoti says. “That is the first thing you want to start with and the last thing you want to stop with.” “You should never stop learning.”
Indeed, investor education contributes to the trust required to convert prospects into active investors.
What is the “tipping point” between investor education and active solicitation?
Transitioning from investor education to active solicitation is a standard stumbling block for many sponsors.
Assume you have a 25,000-person email distribution list. Some of these people will have a personal relationship with a sponsor, but not all. The sponsor has sent robust educational materials to this mailing list for several months, describing their investment philosophies, market trends, and more.
The sponsor now has a fantastic investment opportunity that they want to highlight.
It is the point at which the sponsor will want to switch to an active solicitation. In other words, you’re requesting that the investor take action.
Can a sponsor send an email blast to all 25,000 people highlighting that opportunity, including details such as the minimum investment amount and projected IRR, along with a “call to action” encouraging them to invest right away?
Sidoti responds, “It depends,” making a joke about how “lawyerly” that is.
She goes on to say that it all depends on how the crowdfunding campaign is set up. Suppose the offering falls under Rule 506(c). If so, you can send this to everyone on your email list as long as they later confirm that the people who want to invest are accredited investors. This email would also be acceptable in a Regulation A offering, provided the sponsor has received SEC approval.
This type of email, however, would be prohibited with an offering under Rule 506(b), which prohibits general solicitation. Rule 506 requires sponsors to have a substantial pre-existing relationship with investors (b).
“A substantial pre-existing relationship means you have intimate knowledge of someone’s financial ability to invest,” Sidoti explains. “And this requires someone to be a sophisticated or accredited investor. The only two types of people who, according to the SEC, can make money under this rule”. (Note: a “sophisticated” investor may not be accredited but understands the risks associated with investing).
What should sponsors know about “conditioning” the market?
We warned you that the rules were complicated. Here’s an example. Assume a sponsor wishes to publicize a deal only open to accredited or sophisticated investors. Rather than providing deal details in their email blast, they state that they have a unique opportunity for select investors and say, “click here to learn more.” On the following page, the sponsor provides details about the deal, such as the minimum investment amount and financial projections, with the caveat that only accredited or sophisticated investors can invest.
It appears to be harmless enough, especially with the appropriate caveats. However, some may consider this “conditioning” the market because the sponsor has provided enough information to entice the investor. They now know a deal to be had, which in some rare cases may be considered market conditioning.
How can you establish a “pre-existing” relationship with prospective investors?
Creating a pre-existing relationship with many potential investors may be difficult to overcome. Still, Sidoti explains that there are ways to do so.
Assume you have a once-in-a-lifetime opportunity. You’re raising funds for a Houston project under Section 506(b). “You should begin by continuing your investor education,” says Sidoti. “For example, your materials could state, ‘We have a fantastic deal coming up in Houston.’ We’re still very optimistic about the Houston area for XYZ reasons. If you want to learn more about why we’re so optimistic about Houston, click here.’ And all of this without making any specific offers.”
When the investor “clicks here” and gets past the firewall, the sponsor can ask them to complete an investor qualification form with enough detail to create a pre-existing relationship conceivably. The form will ask if the person is an accredited or sophisticated investor, as well as their income, education, and other information. According to Sidoti, having this information in writing is preferable to asking the investor to call you because it creates a paper trail for tracing. If anyone questions whether the sponsor had a prior relationship with that person (calls are harder to trace).
While these investors may not be able to invest in the Houston transaction right now, the sponsor will be able to contact them about future investment opportunities.
What are some marketing ideas for sponsors launching crowdfunding campaigns?
Sidoti provides three helpful marketing tips for sponsors launching successful real estate crowdfunding campaigns.
1. Make it a point to communicate with investors regularly. “Treat your investors with reverence and respect,” advises Sidoti. “Treat them as you would your grandmother on a Sunday afternoon.” On Sunday afternoons, always call your grandmother.”
While calling each investor weekly is impractical, her point is well taken. Investors expect you to provide them with regular updates, whether monthly or quarterly. If a sponsor promises to do so, they must follow through.
The same concept applies when communicating with your target audience. Even if you are not actively offering a deal, continue distributing educational materials to develop relationships further and build trust. It will aid in the conversion of more prospects into actual investors.
2. Remember that anything you post on the internet will live perpetually. Too many real estate sponsors have posted inappropriate material on their personal or business accounts, which they later regret. Building a positive reputation can take months, if not years. Reputational damage can occur in a matter of seconds. Sponsors should refrain from posting anything too divisive or political online. Sidoti claims that when you start to lose credibility as an issuer. Even if a sponsor deletes the content, it is possible that someone has seen it, and it will live on in perpetuity.
3. Have regard for others. It is obvious, but many people misunderstand it when marketing their crowdfunding campaigns. If someone comments on social media post or asks for feedback on something, take a few moments to respond. Be considerate of their time, thoughts, and feelings. “I always try to consider a person’s feelings,” Sidoti says. “Even if feelings are fleeting, they are the soul of the person on the other side of that computer screen.” Wise words to remember, indeed.
The Conclusion
As we’ve seen today, the laws governing real estate crowdfunding campaigns can be complicated, but that shouldn’t deter sponsors. Real estate crowdfunding is a powerful tool for raising debt and equity for projects, especially at a time when traditional sources of capital may be scarce. A well-planned campaign based on robust investor education can produce long-term results for sponsors looking to expand their network of partners.
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