The risks of crowdfunding your real estate deal
Luckily today’s real estate investors have expanded tools at their disposal for sourcing, qualifying and closing real estate capital transactions. Unlike business securities the collateralized nature of real estate has always proven beneficial for real estate issuers looking to bolster or garner additional investors into a specific project.
While real estate is a bit more benign than business securities when it comes to raising capital, there are still significant risks associated with crowdfunding your real estate deal. The risk differ in scope and complexity, depending on the type of real estate crowdfunding transaction in which you engage. To fully understand each of the associated crowdfunding risks, it is first critical to comprehend the structure of the different types of equity crowdfunding that can be employed to raise capital for your real estate investing deal.
Types of Crowdfunding
When the JOBS Act was released in 2012, it included several provisions for securities investors that differ depending on the size and scope of the offering a real estate issuer may be intent on pursuing. Understanding each in at least a high level will be critical for both properly structuring a deal as well as keeping with the rules of advertising and collecting investor dollars. Here is a basic outline of each of the sections outlined in the JOBS Act. In providing these, please keep in mind that by no means is this list exhaustive nor does it include all the rules required for each offering type. Consulting a knowledgeable attorney is advised to properly perform any such offering.
- Title II. Title II of the JOBS Act, also referred to as accredited investor equity crowdfunding under the new Regulation D 506(c) of the Securities Act, allows for general solicitation among both accredited investors and non-accredited investors. However, issuers are only allowed to collect investment capital from accredited investors who have third-party verified their accredited investor status.
- Title III. Also known as Regulation CF under the JOBS Act, Title III allows real estate and securities issuers to collect up to $1,000,000 per year from both accredited an non-accredited investors in an offering. There are additional restrictions based on income that one can collect from individual non-accredited investors in a deal. This is what is typically referred to when people think of “equity crowdfunding.”
- Title IV. Also known as Regulation A+, Reg A+ or the mini-IPO, Title IV allows for up to $50,000,000 in investment to be collected from both accredited and non-accredited investors in any 12 month period for a single private company. The difference is the legal and reporting structure is a bit more onerous and includes the requirement of an Offering Circular to be filed with the Securities and Exchange Commission.
Titles II, III and IV are not one-size-fits-all solutions. Understanding the nuanced differences of each will be critical in how you seek to raise capital for your next real estate deal.
The Benefits of Crowdfunding for Real Estate
The JOBS Act had at least two major impacts benefiting the real estate investing world as it relates to private offerings.
First – and as long as the deal is properly structured by a knowledgeable securities attorney – both securities offerings and equity crowdfunding for real estate issuances are not restricted by the previous general solicitation rules. That is, issuers can generally advertise their offerings to both accredited and non-accredited investors within some limitations.
This is a huge boon to those looking to raise capital in the private markets. For almost 80 years the Securities and Exchange Commission (SEC) precluded issuers from soliciting to general retail investors that were either considered unsophisticated or did not fall within the definition of an accredited investor.
Second, non-accredited investors could be included in some of the investment structures. The general solicitation rule applied to any and all potential investors, but in the case of Title II (or Regulation D 506(c)), non-accredited retail investors could be solicited for an offering, but actual investors in a deal are required to third-party verify their status as an accredited investor.
Some of the Risks of Real Estate Crowdfunding
The benefits of equity and debt crowdfunding for real estate issuances should not be completely overshadowed by the many risks that abound in using crowdfunding as a means to solicit investor dollars on even the smallest of real estate transactions.
While it is likely impossible to enumerate all the potential risks associated with real estate crowdfunding here, we will attempt to address some of the biggest potential issues that could arise if you are looking at using this method as a means to solicit from both accredited and non-accredited investors.
First, the quality bar is higher for retail investors. Anytime you solicit funds from retail investors, whether they are unsophisticated or not, there is a higher bar on quality and filtration that is expected from both the investors themselves and the regulators that serve them. As such, anyone contemplating a retail offering using equity crowdfunding should consult a knowledgeable securities attorney in order to structure the offering appropriately as well as stay within the rules and regulations. This alone can significantly increase the upfront cost of your offering, but it well worth it to help protect you against downside risks.
Second, not having a previous business or personal relationship with investors in your property or properties may prove your deal’s downfall. One of the big benefits in the barring of general solicitation from the Securities Act of 1932 was the fact that you would have a strong or semi-strong connection with the individual investors in your deal before you pitched them anything about the transaction. The benefit here is that you and the investors would already have an assumed mutual relationship of trust.
If someone were to ask you after a Reg D 506(c) offering, “do you trust all of the investors in your deal?” most would likely answer, “no” or “I don’t know.” That can be problematic. Some would-be investors in some such deals have simply used the lack of previous personal or business trust to phish for lawsuit opportunities alleging fraud, even in cases where none previously existed.
Such cases are unfortunately out of an issuers control. Investors could come into a deal with malicious intent at the outset and only simply be looking for you to make the slightest error, only to pounce with a team a lawyers. Real estate issuers beware. Phishing schemes of these types do exist.
Finally, using one of the crowdfunding exemptions tends to make deals appear “cheap.” That is, they may look a bit more desperate and hard-up for cash. If an issuance is not performed at the highest level of professionalism, the deal could kill itself, especially when compared to the myriad of other private offerings across all the available crowdfunding platforms on the market today.
Understanding all the potential pros and cons of using equity crowdfunding to source capital for your real estate deal can certainly not be fully enumerated here, but hopefully a few of the items discussed will prove beneficial to those looking to raise capital using some of today’s uniquely structured and legal methods for sourcing more investors. If you are comfortable with the risks and understand rule restrictions on investors, advertising and structure then, equity crowdfunding can be a quality tool in bringing in more outside investors to your commercial or residential real estate deals.