Thursday, October 12, 2017

Are Real Estate Syndications Available to Non-Accredited Investors (NY perspective)?

A real estate syndication, although a fancy term, simply means pulling money and expertise together to invest in real estate properties.  It often so happens that some people possess the wealth of knowledge about the real estate market and are great at spotting investment opportunities but don't have the money to invest, while others have the required cash but no real estate expertise or time.  Bringing the first group (sponsors) and the second group (investors) together allows them to purchase and manage far bigger properties than each group could manage on their own.

In a (simplified) real estate syndication transaction, typically an LLC or an LP gets formed, which conducts an offering of its securities and then purchases the property using the proceeds of the offering.  The Sponsor acts as the Manager or the GP of the entity.  Investors can expect to receive two types of income: one from the rental income, usually payable on a monthly or a quarterly basis, and the other one due to the appreciation of the property value at the time of its sale, about 5-10 years down the road.  Investors usually receive a preferred return (about 8%) on their investment, then their money back, with the remainder of the proceeds being shared with the Sponsor (usually 80-20%).

As I mentioned before, real estate syndications involve an offering of securities of the property purchasing entity, which means that it must qualify for a federal and state exemption from registration under the applicable securities laws.  It is relatively straight forward to conduct such an offering if the deal has only accredited investors.  Such transaction can meet the requirements of Rule 506(b) or Rule 506(c) and then be exempt from state regulation pursuant to the federal legislation enacted in 1996 (NSMIA) that preempts state regulation of Rule 506 offerings.  States can only require a notification of the offering and a filing fee along with such notification.  For example, in New York, issuers must file a notification form 99 and submit other documentation, as I previously explained on this blog. 

But which exemptions are available to non-accredited investors?  Here are some of them:

1.  Rule 506(b) and State Notification.  Offering and sale of securities can be made to up to 35 non-accredited investors using Rule 506(b) of Regulation D.  However, these investors have to be sophisticated (either alone or with their representative).  This means that they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.  Such offering has to be made pursuant to an offering memorandum that contains an enhanced level of disclosure (i.e., it costs more and takes longer to prepare it).  On the state level, Rule 506(b) offerings are not regulated by the states, so a simple notification and filing fee are enough (although in New York it is not that simple).  Remember that the issuer relying on a Rule 506 offering must file Form D with the SEC.

2.  Intrastate Offerings and NY Policy Statements 101 or 105.  If the sales are made only to investors who are residents of a single state where the property is located, the purchasing entity can qualify under Section 3(a)(11) of the Securities Act for an exemption from registration for intrastate offerings.  The Rule 147 and the new Rule 147A were promulgated by the SEC to serve as safe harbors for Section 3(a)(11) exemption.  Rule 147A intrastate exemption, that became effective in April 2017, allows the issuer to rely on the intrastate exemption even if it was organized in a different state (so, a Delaware LLC that is purchasing a property in NY and has all NY investors may qualify).  I previously wrote about the new Rule 147A here.    The issuer does not have to file Form D, but compliance with state securities laws is required.

In New York, the issuer could rely on a Policy Statement 101 (offerings to no more than 40 people) or 105 (no filing required) for an exemption from registration, although some disclosure would still need to be made.  Although investors in these small offerings do not have to be accredited, they still must be sophisticated, have sufficient means for the investment, and have a pre-existing relationship with the principals of the issuer.  The "no filing" required exemption described in Policy Statement 105 may be used only for offerings to no more than nine investors in total, each of whom is sophisticated, has sufficient means, and a pre-existing relationship with the principals of the issuer.

3.  Rule 504 and NY Policy Statement 100Rule 504 was amended effective in January 2017 to allow companies to raise up to $5,000,000 in any given 12-month period but without the use of general solicitation and advertising.  Such offerings must be registered with the states or comply with applicable state securities law exemptions.  In certain circumstances, companies may use general solicitation and advertising, such as when they conduct the offering "exclusively under one or more state laws that require registration, public filing and delivery to investors of a substantive disclosure document before sale".  Form D has to be filed.

In New York, companies can rely on Policy Statement 100 to apply for a  corresponding exemption from state registration. The application asks for very detailed disclosure.  The current filing fee is 2/10th of 1% of the amount of the offering of securities, with the minimum fee of $750 and the maximum fee of $30,000.  The use of general solicitation and advertisement is not permitted.

4.  Regulation A+ and NY Policy Statements 101 or 105Regulation A+ (Regulation A was amended in 2015 and became known as Regulation A+) allows companies to raise up to $50 million, and is divided into Tier 1 and Tier 2 offerings.  In a Tier 1 offering issuers can raise up to $20 million but must comply with the registration procedures in every state where the company plans to sell its securities.  Any investor can participate in these offerings.  A Form 1-A that requires detailed disclosures and financial statements must be filed with the SEC.

Tier 2 offerings (up to $50 million) are exempt from state regulation, but have limits on how much non-accredited investors may invest.  Tier 2 offerings are very involved, and are considered like "mini-IPOs".  They are significantly more expensive and time consuming to prepare than a Rule 506(b) private placement.

5.  Section 4(a)(6) of the Securities Act / Regulation CF and State Notification.

As you know, the SEC adopted Regulation Crowdfunding (or Regulation CF) to implement Title III of the JOBS Act.  It became effective on May 16, 2016.  (Side note: have you noticed how many of these rules/regulations have been updated just recently?? The securities law is probably one of the fastest developing areas of law nowadays.  Just wait for regulations relating to crypto-tokens).  I will not bore you with all the details here because you can read about it in detail in my other blog post.  Although non-accredited investors can participate, the overall size of the offering is limited to $1,000,000, which is probably too small for a typical real estate syndication deal.  Also, there are limits as to how much individual investors can invest based on the investors' income and net worth.  Just like with Rule 506(b), states are preempted from regulating Section 4(a)(6) offerings.

In conclusion, as you can see from this (simplified) analysis of current securities laws, it is quite possible for non-accredited investors to participate in real estate syndication deals, but participation of non-accredited investors requires extra legal and other fees and time to complete the deal.  Each of the rules mentioned above contains a myriad of exceptions, provisos, special circumstances and requirements, all of which have to be accounted for in order to complete a successful real estate syndication transaction.  Sometimes, inviting just a few non-accredited investors may not be worth the extra expense.

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the co-founder of Ross & Shulga PLLC, a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate and securities law.

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