Introduction
In 2004, I accompanied a friend to a real estate networking event held at a local country club. As my friend and I made our way through the room looking for our assigned seat, we were approached by a middle-aged man. He politely introduced himself and then quickly asked if we were “accredited investors.” Being fresh out of college, my friend and I chuckled and responded “uh, no, no we’re not.” The man gave a disappointed look and then walked away, apparently looking for others to accost. “What the hell was that about?” I asked my friend. “I think he’s trying to raise capital,” my friend responded.
I can’t imagine such a bold approach was particularly successful, but back then this was more or less how small real estate entrepreneurs found equity partners. Such face-to-face solicitation was necessary because any company seeking to raise capital outside of public markets was precluded by the Securities and Exchange Commission (SEC) from advertising their offering. The equity sponsor – i.e., the firm seeking to raise capital – had to have a “preexisting relationship” with accredited investors (although a limited number of non-accredited investors could participate in the offering under certain conditions). The term “accredited investor” means an investor meeting certain income or net-worth requirements. And yes, offering partnership units to outside investors is considered a security offering under the jurisdiction of the SEC. The SEC requires that a security offering either be registered under the 1933 Securities Act or offered under an exemption specified in the Act. Given that securities registration is an incredibly costing and complex process, it is easy to understand why most private placements are made under an exemption from registration. However, securities laws at the time meant that someone looking to raise meaningful capital had to have a lot of rich friends and professional acquaintances. It also meant that investing in private deals, which could be very lucrative, was only available to affluent families and institutions.
The JOBS ACT
This all changed in April of 2012 with the passage of the Jump Start Our Business Startups (JOBS) Act. This legislation directed the SEC to create exemptions for businesses to raise capital online from both accredited and non-accredited investors.
Over the next several years, the SEC rolled out several provisions which greatly expanded the ability of small companies and real estate sponsors to raise equity capital.
The first provision of the JOBS Act to become effective was Title II. This amended the previous Rule 506 of Regulation D of the 1933 Securities Act. Rule 506 of Regulation D was the most widely used exemption for private offerings. The amendments, which became effective on September 23, 2013, essentially spit Rule 506 into two: Rule 506(b) and Rule 506(c).
Rule 506(b) was more or less the previous Rule 506, where sponsors cannot advertise the offering. Under this rule, sponsors can allow up to 35 non-accredited investors if (a) those investors (or their representatives) are considered sophisticated enough to evaluate the offering and (b) the non-accredited investors are given additional disclosures both at the time of offering and throughout the investment holding period. All other investors in the offering must be accredited. Under Rule 506(b), the investors self-certify their accredited investor status.
Under Rule 506(c), the sponsor can advertise the offering. However, all investors in the offering must be accredited, and the sponsor must verify each investor’s accredited status. The verification requirement was a hiccup for some time. I remember speaking to an attorney specializing in securities law back in 2016. This attorney stated that he was hesitant to recommend a 506(c) offering to his clients because he felt that improper verification could be grounds for regulatory enforcement or civil litigation. This has changed in recent years as third-party verification services have become prominent and have relieved equity sponsors from much of the burden of verification. In the last several years, 506(c) offerings have become a major source of funding for real estate equity sponsors. The real estate operator that I mentioned in the beginning of this post could today advertise his offering on LinkedIn, Twitter, Facebook, etc., rather than trying to engage in cold solicitation at a networking event.
While Rule 506(c) has greatly expanded the pool of equity capital for real estate sponsors, these offerings are still only available to affluent families. The more revolutionary aspects of the JOBS Act come from Titles III and IV, which allow non-accredited investors to participate in private offerings.
Title III, also known as Regulation Crowdfunding (CF), became effective on May 16, 2016. Regulation CF allows for sponsors to raise capital through an SEC registered funding portal or broker-dealer. The sponsor may issue up to $5 million in capital (as of October 2024). Accredited investors are not subject to investment limits. However, non-accredited investors are subject to the following limits within a 12-month period:
- If the investor’s annual income or net worth (excluding primary residence) is less than $124,000, the investor may invest the greater of $2,500 or 5% of the greater of annual income or net worth
- If the investor’s annual income and net worth (excluding primary residence) are greater than or equal to $124,000, the investor may invest up to 10% of the greater of annual income or net worth, not to exceed $124,000.
These investment limits can be a little complicated, so let’s consider two examples. If an investor makes $80,000 in annual income and has a $50,000 net worth, the investor can invest $4,000 in a Regulation CF offering in a 12-month period. The $4,000 is 5% of her income and is greater than $2,500. If an investor makes $150,000 in annual income and has a net worth of $500,000, she can invest $50,000 in a 12-month period. If an investor makes $400,000 and has a net worth of $2.5 million, she has no investment limit as she meets the standard for accredited investor status ($300,000 in household income or $1 million in net worth).
The use of Regulation CF for real estate deals has picked up in recent years. When the provision was first introduced, the funding limit was $1 million, and it was hard for equity sponsors to justify the legal expense of creating a Regulation CF offering when the equity amount was relatively small. However, the SEC increased the funding limits in November of 2020, making Regulation CF a more viable funding alternative for real estate equity sponsors. Since the increase in the funding limits, I’ve seen a number of sizable deals available on the various funding portals.
Title IV, also known as Regulation A+, became effective on June 19th, 2015. This amendment of a little-used section of the 1933 Securities Act makes it possible for real estate sponsors to raise tens or even hundreds of millions of dollars from non-accredited investors.
Of the three provisions in the JOBS Act mentioned here, Regulation A+ has by far the highest level of regulatory complexity and the greatest cost. However, for those sponsors who have a wide audience, Regulation A+ can be used to build sizable portfolios. For example, Cardone Capital, a real estate investment firm founded by social media celebrity Grant Cardone, has used Regulation A+ offerings to create a multi-billion-dollar real estate portfolio and allow “everyday investors” to invest in its funds.
Regulation A+ is split into two tiers. Tier 1 of Regulation A+ allows sponsors to raise up to $20 million within a 12-month period. Tier 1 offerings must be registered with state securities regulators. Tier 2 allows sponsors to raise up to $75 million in a 12-month period. With a Tier 2 offering, the SEC does not require the offering to be filed with state securities regulators. However, Tier 2 offerings are subject to higher reporting requirements than Tier 1 offerings.
With Tier 2 offerings, the SEC places investment limits on non-accredited investors. A non-accredited investor in a Tier 2 offering may only invest the greater of 10% of the investor’s annual income or net worth in a single offering in a 12-month period. Tier 1 offerings have no investment limits.
Opportunities and Perils of the JOBS ACT
The point of the above discussion is that the JOBS Act has both expanded the pool of equity capital for real estate entrepreneurs and brought investment opportunities to non-accredited investors which generally did not exist prior to the JOBS Act.
In our opinion, the possibilities afforded by the JOBS Act are just beginning. But wherever there are opportunities, there are pitfalls. When a real estate entrepreneur takes on equity partners, that real estate entrepreneur has become a money manager. And money managers should always have an appreciation for risk.
The social media world is full of real estate entrepreneurs who seem to only talk about the upside potential of real estate without an adequate discussion of risk. This is understandable. Optimism is always a stronger selling-point than caution. There is a reason why stock analysts issue far more “buy” recommendations than “sell” recommendations.
There is a saying in the investment world that “everyone is a genius in a bull market.” The creation of the JOBS Act paralleled a period of historically low interest rates. Many of the real estate entrepreneurs taking to the internet had never faced a tight credit market, and it was unclear how they would navigate a more challenging environment.
The flood of capital, partially stemming from the JOBS Act itself, created enormous competition for deals. Real estate entrepreneurs increasing turned to riskier forms of financing in order to stay competitive. The Federal Reserve, facing higher inflation, was forced to raise interest rates throughout 2022 and 2023. At the time of this writing, several trillion dollars of commercial real estate debt is coming due. Banks have been playing the “extend and pretend” game of deferring action against underwater properties, but if rates remain elevated for long, we could see a lot of commercial real estate supply hitting the market in the near future.
One of the reasons why we started the Fundamental Investment Institute is that while there are ample educational resources showing budding real estate entrepreneurs how “they too can become real estate millionaires using other people’s money (OPM),” there is very little material focusing on teaching investment analysis to these “other people.” Our hope is to create a more sophisticated investor class who can not only do better financially for themselves, but also keep many of these real estate entrepreneurs honest. We believe that more intelligent capital allocation will benefit everybody.
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