When raising capital for a real estate project it is very important to understand which securities laws apply to your project, your duties under those securities laws, and how to comply with those requirements. Failure to do so could have severe consequences — from the SEC forcing you to return raised capital, the SEC labeling you a bad actor, or even worse, criminal prosecution.
To avoid any of these undesirable outcomes, let’s dive into a few important securities requirements and regulations that real estate investors should be thoughtful of as they trek forward in their real estate journey.
What Is a Security?
While many things in the securities world are vague, one thing the SEC has defined clearly is what a security is or is not. Before we dive into the fuller explanation, if you want the quick cheat code, ask yourself this: “Am I taking capital from passive investors?” If the answer is yes, it is likely that you are selling a security, or at the very least, the alarms in your head should be ringing and alerting you to conduct further inquiry.
The way to truly determine if you are selling a security is through the Howey Test. The Howey Test comes from a 1946 Supreme Court case where the court determined what qualifies as an “investment contract,” or essentially, a security.
The Howey Test asks four questions:
- Do we have an investment of money?
- Is that investment of money into a common enterprise?
- Is there an expectation of profit?
- Is that expectation primarily from the work of someone else?
If we go through the four prongs of the Howey Test, and your answers are, “Yes, yes…yes, yes,” then it is likely that you are selling a security.
If you are selling a security, you must either register that security or have an exemption from registration. Registering securities is both time-consuming and costly. In the real estate industry, if you have a pending acquisition, it is likely that public registration will take far too long to acquire the asset based on typical real estate acquisition timelines.
Typically, companies selling registered securities are public reporting companies, which report the ins and outs of their financials through online databases such as EDGAR — the SEC’s online portal — and often, these companies are public. If you are selling a security but do not want to register, you must have an exemption from registration if you want to remain in compliance. There are numerous exemptions for registering securities, but the two that often work well for real estate investors are Regulation D and Regulation CF.
Regulation D has multiple sub-parts, put two main sub-parts that serve as exemptions are 506(b) and 506(c), which differentiate between what the SEC calls “accredited investors” and “sophisticated investors.”
There are multiple ways to qualify as accredited, but typically accredited investors are accredited based on their income or net worth.
Income: Accredited investors are individuals who make $200,000 (or $300,000 for spouses or spousal equivalents) or more per year for the past two years and who expect to continue making that much or more in the current year.
Net worth: investors must show that their net worth, excluding their primary residence, is $1 million or more.
Determining whether someone is a sophisticated investor is not as clear-cut; the SEC wants to know if these investors are financially savvy. Do these investors possess the resources necessary to determine not only the potential upside of the investment but more importantly, the risk of the investment for themselves?
There are a few factors we use to determine if an investor is sophisticated: their education, their work experience, their current and past investments, and whether they are represented by a financial planner among other things. When making this determination, ask yourself: Does this investor have the resources to vet this deal and determine if it’s good for them?
Under Regulation D, 506(b), you are allowed to have up to 35 unaccredited but sophisticated investors and an unlimited number of accredited investors. The catch with a 506(b) raise is that you must have a pre-existing substantial relationship with all the investors, regardless of investor type.
Under Regulation D, 506(c), all investors must be accredited. The upside to a 506(c) raise is that you are not required to have a pre-existing substantial relationship with the investors. Additionally, you may do some general solicitation (making sure that you meet any marketing rules and requirements that are applicable). However, all of your investors must be accredited.
Regulation CF is an exemption that allows you to have accredited, sophisticated, and unaccredited investors. Everybody can invest, and accredited investors have no limitations. Unaccredited investors may invest but might be limited to 5%–10% of their net worth or income (depending on the amount of their net worth or income) in a 12-month period.
With Regulation CF, you are limited to a capital raise of $5 million in a 12-month period, and you must state a minimum raise amount and deadline for the raise. Funds you raise before you reach your minimum target will be held in escrow. If you do not meet your disclosed minimum raise amount within your stated deadline, then the escrow company will return those funds. Additionally, the offering must be hosted on an SEC-registered portal.
A Regulation CF raise requires deeper, more extensive background checks and requires you to work with several third parties (e.g., the escrow company and the SEC-registered portal). As such, a Regulation CF raise is likely to be more time-consuming than a Regulation D raise, which essentially allows you to start raising capital as quickly as you and your legal team can get everything together.
The SEC requires disclosures on all exempt securities. Under Regulation D, these disclosure documents are often called Private Placement Memoranda. Under Reg CF, these disclosures are often called Form C and the Offering Circular. These documents will be similar to an investment prospectus. These disclosures are required to name the executive team, the general business plan, and how any distributions and proceeds will be split.
Most importantly, these disclosures are required to talk about the risk factors. Every investment has risks; every investment could fail. Because these are private and exempt securities, which do not have the stringent reporting requirements of a public security, the SEC requires that we tell the investors about any skeletons in the closet or bodies under the floorboards. These disclosure documents give this important risk assessment information to the investors so they can make an informed investment decision.
SEC regulations can seem daunting to navigate, but once you know the basic requirements, your team can get started on raising capital. Once you have determined that you are selling a security, look at your investor pool and categorize your investors as accredited, sophisticated, or unaccredited.
If your investors are a mix of accredited, sophisticated, and unaccredited, you may want to use Regulation CF. If you have a few (no more than 35) sophisticated investors and have a pre-existing substantial relationship with all investors, Regulation D 506(b) might be helpful. And finally, if you have only accredited investors, Regulation D 506(c) might be a good exemption for you.
Securities laws are complex. This information is provided for educational purposes only. Be sure that you have a knowledgeable attorney providing advice based on your unique situation before taking action.
About the Author:
Nic McGrue is a tenured professor of law and the founder of Polymath Legal PC. At Polymath Legal PC, Nic helps real estate investors lawfully raise capital allowing them to generate passive income while creating generational wealth.
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.