In 2016, 506(c) private real estate offerings grew to 17% of all Regulation D offerings. The ability to advertise offerings under rule 506(c) is dramatically changing the way operators raise funds and is enabling them to acquire new investors, do more deals and reduce their long-term cost of capital, all online. But despite the significant year-over-year growth, 506(b) offerings continue to dominate the Regulation D market. In the SEC’s Division and Economic Risk Analysis (DERA) recent report to Congress on Access to Capital, they suggested that this is due in part to uncertainty surrounding the appropriate levels of verification needed for the accredited investor status of all purchasers. This uncertainty is preventing many real estate operators from capitalizing on this emerging investment landscape. Below I will explore some the confusion around the investor verification needed for 506(c) offerings.
SEC’s ‘Reasonable Steps’ to Accredited Investor Verification
With the elimination of the general solicitation prohibition and general advertising condition contained in 506(b) offerings comes the requirement that all investors in a 506(c) offering be accredited and that the issuer takes reasonable steps to verify their investor status. The definition of an accredited investor is the same as in 506(b), however the issuer cannot take on up to 35 other purchasers (unaccredited sophisticated).
The SEC’s Entity Compliance Guide states that “Rule 506(c) sets forth a principles-based method of verification which requires an objective determination by the issuer (or those acting on its behalf) as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction.” These consideration factors include the nature of purchaser and offering, type of investor, and amount of information. Further, the SEC provides “a non-exclusive list of verification methods that issuers may use when seeking greater certainty that they satisfy the verification requirement with respect to natural person purchasers”. Specific to commercial real estate operators, these include: Schedule K-1 of Form 1065, written confirmation from a Registered Investment Advisor (RIA) and investors in 506(b) offerings prior to 2013.
Transitioning 506(b) Investors to 506(c) Investments
PricewaterhouseCoopers (PwC) through the Urban Land Institute optimistically estimate real estate crowdfunding market activity to reach $5B in 2017 as investor opportunities are no longer restricted to country club networks. Top real estate crowdfunding platforms are raising institutional levels of equity capital for operators in the same amount of time that it takes to line-up debt financing. This has strengthened the argument for filing 506(c) offerings for investor retention purposes just as much as investor acquisition. An aging investor base and pressure from early adopting competitors is creating a more efficient private capital market where new relationships are being formed, brands are being established and cost of equity is decreasing.
As to the verification of these new investors, the recent DERA report states that there is high usage of intermediaries in 506(c) offerings as compared to 506(b) offerings because issuers rely on outside entities, including third-party online platforms, for verification. Third party investor verification providers like VerifyInvestor take the “reasonable steps” on behalf of the issuer to provide an independent stamp of approval for accredited investors, which saves issuers time and reduces headaches. Operators also rely on outside entities for investor relationship management capabilities to track documentation and transactional history of their existing 506(b) investors.
So what about verifying the accreditation status of existing investor relationships? Former Division of Corporate Finance Keith Higgins sheds some light on SEC’s thinking on the matter in a 2014 speech,:
“Although the verification method must be objectively reasonable, the principles-based method is intended to provide issuers with significant flexibility in deciding the steps needed to verify a person’s accredited investor status and to avoid a “one size fits all” approach…this is an area where issuers and other market participants have the flexibility to think about innovative approaches for complying with the verification requirement of the rule and use the methods that best suit their needs…I also believe the staff will not be quick to second guess decisions that issuers and their advisers make in good faith that appear to be reasonable under the circumstances.”
As an addition to 506(b) investments, the 506(c) generally solicited offering is a powerful capital raising tool for sponsors who take reasonable steps to verify their investor accreditation statuses. Success in this regulatory environment requires partnering with a trusted third-party provider to verify new investors and an investment management solution to manage all investor interaction in accordance with SEC guidance. Including the ability to control documentation, verification protocols and segment these 506(b) vs. 506(c) investors. Most importantly, tracking the ‘reasonable steps’ taken on existing investor accreditation, which includes SEC outlined K1 documentation, (RIA) affiliations and pre-2013 transactional history.
In October 2017, the U.S. Treasury Department released JOBS Act Reform recommendations to the President which included an expansion of the accredited investor definition to any individual who is advised by a fiduciary (RIA) on the merits of the offering and including components of the sophisticated investor definition.
If these recommendations are adopted, it will once again dramatically change the accessibility of commercial real estate investing online. Those investment firms who have taken advantage of online fundraising through 506(c) will be best positioned to fully maximize these new capital sources and succeed in this changing regulatory landscape.
As 506(c) continues to evolve into a meaningful contributor to the private real estate capital market, and as more and more individual investors enter the market, the more imperative it becomes to manage all investors and their investments in one place. CrowdStreet’s online fundraising and investment management platform is specifically built to help you acquire new investors, raise capital online and manage all your investors and investments in one place, lowering overhead, cost of capital and enabling you to scale. Explore how other companies are using CrowdStreet to accelerate their growth, hear their stories.
Benjamin McFarland is responsibility for new business development initiatives at CrowdStreet where he enables real estate operators to raise capital online and modernize their investment management infrastructure through technology. Benjamin served under House Majority Leader Kevin McCarthy (Financial Services Committee) during JOBS Act passage during the 112th Session of Congress and holds his MBA in Entrepreneurship and Commercial Real Estate Finance from Pepperdine University.