Real Estate Continued to Favor Rule 506(b) Offerings During the Pandemic | Whitman Legal Solutions, LLC
Orchestras don’t survive on ticket sales. They also rely (and some rely primarily) on grants and donations to pay their bills.
For this reason, during the pandemic, professional orchestras have struggled financially. With public gatherings banned, ticket sales have plummeted. Orchestras hoped donors would step in to keep them afloat. But based on the experience of the New York Philharmonic, this source of income has also been insufficient.
The Philharmonic’s annual gala concert, a major fundraiser, has been forced to go virtual. With no caterer, florist or waiter to pay, the virtual gala costs less than traditional live galas. And the virtual gala reached 90,000 people compared to a peak audience of 2,700 at the gala concert. Yet the virtual gala only raised $1.1 million, less than a third of the $3.6 million raised in the year before the pandemic.
Many orchestras sold subscriptions to broadcast old and sometimes new concerts. However, revenue from subscriptions failed to
During the pandemic, the performing arts have struggled to secure donations from even their most loyal patrons. Faced with seemingly more pressing needs, such as hunger and racial justice, and a lagging economy, donors have been stretched thin.
Interestingly, the pandemic has not brought the same challenges to commercial real estate. Although mortgage processing slowed as employees transitioned to remote work, there was no shortage of mortgage funds.
Since mortgage lenders were still not lending 100% of the purchase price, developers continued to need equity investors. Some sponsors continued to raise equity to co-invest with them, but many continued to use real estate funds to provide at least some equity. This article discusses the types of securities offerings that real estate funds have used and how that has changed during the pandemic according to data from the Securities and Exchange Commission (SEC).
Securities law exemptions for real estate funds
Under the Securities Act of 1933 (1933 Act), all offerings of securities must be registered with the SEC, unless exempt. Securities registration is a time-consuming and expensive process that requires SEC review and approval. Thus, most real estate funds offer securities under an exemption and sell securities without SEC review.
Most real estate securities use the private placement exemption under Rule 506(b) of Regulation D (Reg D), enacted under Section 4(2) of the 1933 Act. 4(2) is a private placement exemption, Rule 506(b) prohibits general advertising and general solicitation of investors. One advantage of Rule 506(b) offerings is that there is no requirement that the offering be qualified under state securities laws.
Several years ago, the SEC adopted Rule 506(c) of Reg D, which is gradually becoming popular with real estate funds. Like Rule 506(b) offerings, Rule 506(c) offerings do not need to qualify under state securities laws. Unlike Rule 506(b) offerings, Rule 506(c) offerings may be publicly advertised. However, Rule 506(c) offerings may only be sold to qualified investors who meet the net worth, asset, or income requirements. And, unlike Rule 506(b), Rule 506(c) does not allow investors to self-certify their accredited status. Thus, 506(c) offerings require a more thorough examination of investors’ financial circumstances than 506(b) offerings.
Additionally, part of Reg D, Rule 504 allows a company to raise up to $10 million over a 12 month period. However, unlike Rule 506 offerings, Rule 504 offerings must qualify under state securities laws, which increases the cost and time required to bring the offering to market. As a result, real estate funds rarely rely on Rule 504 for their offerings.
Another relatively new exemption is Regulation CF (Reg CF), which allows equity crowdfunding. Reg CF can only be used to raise capital for operating companies, so it cannot be used for a blind real estate fund. And Reg CF offerings must be sold only through an authorized investor portal. Like Rule 504, Reg CF limits the amount the issuer can raise. During the pandemic, the limit was increased from $1 million to $5 million over a 12-month period, making it more likely that real estate investments can raise funds using Reg CF. Additionally, dollar limits on individual Reg CF investments have been relaxed, so there is no limit on the amount an accredited investor can invest in Reg CF.
Rather than being a registration exemption, Regulation A (Reg A) is best seen as offering a less cumbersome registration process. Sometimes called a “mini-IPO”, Reg A offers two tiers of offerings under which companies can raise up to $75 million over a 12-month period. Because Reg A offerings require SEC review, they generally take longer and cost more than Rule 506 offerings. Reg A also limits the amount that non-accredited investors can invest to the greater of 10 % of investor’s net worth or annual income.
Small Business Capital Formation Advocate Report
In December, the SEC’s Small Business Capital Formation Advisory Committee (SBCF) released its 2021 Annual Report (2021 Report), which provided data on how small businesses raised capital amid the COVID-19 pandemic. July 2020 to June 30, 2021. Although the focus is on small businesses in general, real estate businesses are included in the report.
According to the 2021 report, Rule 506(b) remains the overwhelming choice for capital raises among small businesses, with a total supply of $1.9 trillion from July 1, 2020 to July 30, 2021 and a median raise of 1 .8 million. Rule 506(b) global offerings even outpaced public offerings, which totaled $1.7 trillion, despite a median increase of $350 million for public offerings.
The second most popular exemption, the 506(c) rule, was used to raise just $124 billion over the same period, with a median increase of just $850,000. The remaining options were far behind with $1.7 billion, $755 million and $313 million for Reg A, Rule 504 and Regulation CF, respectively.
In real estate, the top three avenues for raising capital (excluding mutual funds) were public offerings ($97 billion), Regulation D ($45 billion) and Regulation A ($755 million). The real estate sector had more Reg D offers than any other industry. While Reg D real estate listings have increased from 2020 to 2021, Reg D listings in other sectors, including technology, banking and financial services, and even healthcare, have declined.
Additionally, although Reg A real estate offerings declined (from $923 million to $755 million) from the prior year, real estate continued to dominate the Reg A market. Unlike Reg D offerings, however, Reg A offerings in the technology, banking and financial services, and healthcare sectors increased from 2020 to 2021. These same three industries saw a significant increase in IPOs from 2020 to 2021, which perhaps explains why Reg D bids declined.
Why Rule 506(b) Offerings Still Dominate in Real Estate
Although Rule 506(b) offerings cannot be advertised, they allow an issuer to raise an unlimited amount of money at a reasonable cost without review or reporting by the SEC. Generally, there are only costs associated with the private placement memorandum and notice filing requirements for Rule 506(b) offerings.
506(c) offers are also among the cheapest. But there is a compromise. Although Rule 506(c) offerings may be advertised, they may only be sold to accredited investors. And the verification process, while not difficult, can increase costs and discourage investors who want to keep their financial situation private. Reg A offers offer an even heavier regulatory burden and higher costs for property developers, explaining their third place.
Established sponsors with existing investor relationships that do not require advertising may favor Rule 506(b) offerings. But 506(c) offerings provide an opportunity for less established sponsors to build an accredited investor base through advertising.
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