Crowdfunding is a fairly new concept that entrepreneurs are utilizing to fund start-up businesses. Can this approach be utilized for real estate investors? The answer is yes, but it is complicated.
What exactly is crowdfunding?
Crowdfunding is defined as the practice of soliciting investment funds from a large number of people, which is mostly done online.
Types of Crowdfunding
There are essentially two types of crowdfunding;
- Non-financial returns – such as charities or pre-orders for products
- Financial returns – where equity or bonds are offered with an expectation of return on investment.
On the surface, it seems logical to use crowdfunding to obtain financing for a real estate investment. The process of crowdfunding for non-financial returns is relatively straight forward, however, when it comes to soliciting the sale of shares in a start-up company or real estate investment, it is substantially more complex. Let’s look at the background of public funding.
The Securities Acts of 1933 and 1934
After the crash of the stock market in 1929, the government realized that the public needed to be protected from fraudulent investment securities and those who sold them.
There were two basic objectives:
a) To require the sellers of securities to receive financial and other pertinent information concerning securities being offered for sale to allow the public to make informed decisions.
b) To forbid deception, misrepresentations, and other fraud.
What is a security?
Section 2 (1) of the Securities Act defines a security as;
In 1990, the Supreme Court expanded the definition of a security to encompass any instrument that might be sold as an investment to a passive investor.
The JOBS Act
In January 2012, Congress passed the Jumpstart Our Business Startups Act (JOBS) in order to promote job creation and economic growth by helping businesses to raise funds in the capital markets by minimizing regulatory requirements. The full text of the act can be read here.
Crowdfunding for real estate investment is commonly referred to as syndication. If you decide to solicit funds for a real estate investment, you are defined as the “sponsor”.
Types of Syndication
Syndication is usually one of three types:
1) Fully Specified
This type of syndication identifies the property or properties that the investors will have an ownership interest. The fully specified option is usually the easiest way to solicit investors.
Again the property or properties are specifically identified but a provision is made to raise additional funds from the investors to purchase other properties that might become available.
3) Blind Pools
Blind pools solicit the funds before any property is identified. The strategy of investment needs to be well defined. Blind pools usually require registration under the securities laws as advertising and general marketing may be required to draw a sufficient number of investors.
A legal structure is required to syndicate any kind of real estate investment. There are essentially 4 types of structures used to solicit and structure investment funds for the purpose of real estate investment.
1) Tenants In Common (TICS)
One of the easiest ways to pool investment funds for the ownership of commercial property is where two or more investors take the title in a partial deed in exchange for their equity in the property. This is referred to as a “fractionalized” interest.
In this form of syndication, investors invest funds in exchange for shares in a corporation that will hold title to the property or properties.
There are two types of partnerships, general partnerships, and limited partnerships. The primary difference is that in a general partnership, all the partners (investors) share equal liability. In a limited partnership, the managing partner assumes all the liability, while the investors are deemed passive investors and as such have no liability.
4) Limited Liability Corporation (LLC)
The limited liability corporation is an extension of the limited partnership, where ALL partners have limited liability, including the managing partner.
Which structure should you choose?
Each one of these structures has advantages and disadvantages. To determine which structure is bested suited for the investment and the investors a number of questions have to be answered.
a) What are the investment objectives of the investors?
Are they seeking regular income?
Are they more interested in tax shelters to offset taxes on other income?
Is capital appreciation the primary goal?
b) What level of liability is acceptable to the sponsor as well as the investors?
As mentioned previously, some investment structures have greater liability risk to investors than others.
c) What is the term of the investment?
This ties into question (a). Some investors are looking for long-term investments with a steady income while other investors are looking for a short term investment of fewer than 5 years.
d) Are any of the investors foreign nationals or using their own investment structure to make the investment?
Some of the investment structures limit investments to individuals and/or citizens.
Once you have answered all these questions, you need to consult with an attorney and a CPA who can structure the investment that will meet the ownership, liability, and investment objectives of all the parties involved in the group.
Private Placement Memorandum
If you as the sponsor determine that what you are offering is deemed as a security, you must prepare a disclosure document and present it to each and every investor prior to the investor making his investment. This disclosure document is commonly referred to as the private placement memorandum or PPM.
An attorney with experience in the securities must be used to prepare this document. The purpose of the PPM is to provide full disclosure and transparency as required by SEC regulations. You cannot draft this document on your own!
The PPM consists of four parts;
The basic disclosure includes:
- The summary of the offering
- The suitability standards for the investors in the group
- A summary of the use of investment funds
- The compensation structure to you, the sponsor
- Any conflicts of interest that you as the sponsor may have
- The fiduciary responsibilities of you, the sponsor
- Risk factors inherent in the investment
- A history of prior performance by you, the sponsor
- Summary of the management structure of the investment
- Summary of federal and state tax treatment of proceeds
- Distribution plan at such time the investment is sold
The Legal Agreement
The legal agreement itemizes how the group will be run. This would be either the operating agreement for the LLC, or limited partnership agreement in a limited partnership, or a shareholder’s agreement in the case of a corporation.
Subscription Agreement and Questionnaire
The subscription agreement is basically a form that the investor completes indicating how many units, shares, or percentage of the total investment he wishes to purchase.
The questionnaire is completed by the investor in order to help you, the sponsor, to determine if the investment is suitable for this particular investment.
You should provide a full analysis of the investment property. Perhaps extra cash will be needed to make repairs or improvements to the property and that cash will be borrowed. It could be that the area is likely to be rezoned that will allow uses that substantially increase the property value. Anything that could possibly affect the future value of the investment should be disclosed.
As you can see, the drafting of these documents can be daunting, if not intimidating. They are best left in the hands of the professionals.
Marketing and Advertising Restrictions
You have identified the property, determined the best investment structure, and prepared the PPM. Now you can advertise the investment opportunity to the general public. WRONG!
In order to sell investments to the general public, you would have to register the offering with the SEC and only a securities broker would be allowed to sell the investment to the public. This is an expensive procedure and certainly not worth the time and expense for a relatively small investment.
By complying with Regulation D, Rule 501 of the Securities Act, you can forgo the registration process.
The most important component of Regulation D is the definition of “Accredited Investor”.
An accredited investor is defined as someone who
a) Has a net worth of $1 million, excluding the value of his personal residence, or
b) Has an income in excess of $200,000 per year for the previous 2 years.
Under Regulation D you can promote your investment offering to accredited investors without registering with the SEC. It is your responsibility to determine if a potential investor is an accredited investor.
Because your offering is a “private placement”, general solicitation is not allowed. So how can you promote your investment offering?
One method often used is hosting a seminar or webinar. However, the seminar or webinar would have to be general in nature and no specific investment can be promoted. You can invite participants to contact you for more information.
The same rule can be applied to the internet. You could set up a website that discusses the advantages of group investment in real estate. If a potential investor replies, you would send him a questionnaire to determine if he is an accredited investor. Once you have confirmed that he meets the definition, you can forward the PPM for his consideration.
Since no advertising or general solicitation is allowed, what else can you do to get investors for your project? If you are a real estate broker, you can contact current or previous clients.
Essentially, you can contact anyone who you have or had a previous relationship with. This applies if you are not a broker. As long as the people in your network qualifies as an accredited investor, you are allowed under the law to solicit your investment offering.
The Bottom Line
Crowdfunding on its face sounds pretty simple and straightforward. However, when it comes to real estate investment, it is a much more complex procedure. In this post, I have only given a brief overview of what is involved in the process. The legal and tax considerations are significant and go far beyond the scope of this post.
Given the time, cost, and effort of real estate syndication, syndication is best suited for substantial investments where the ROI would totally justify the process. Check out my previous post for other financing options.
The information provided here is for educational purposes only and is not to be construed as professional legal, tax, or financial advice. Every situation is unique and you should consult with an attorney, tax accountant, or financial adviser to determine the best options for your personal situation.