Debt vs. equity crowdfunding
Crowdfunding comes in two basic forms: debt and equity. In either form, the developer still raises capital from private investors for their project. The main difference is in how the investors will earn a return. Both have their pros and cons for both the developer and investors, so choosing which type of crowdfunding to go with will depend on what makes the most sense for a specific deal.
With debt crowdfunding, the property developer promises to pay investors back their invested capital plus a specified interest rate. With this type of crowdfunding, the investors don’t receive any equity in the deal. Debt crowdfunding is similar to p2p lending.
Real estate developers may choose to go with debt crowdfunding to avoid diluting the equity in the project, especially when there are already other investors or partners involved. Some investors prefer debt investing over equity because they want to know what their return on the investment will be.
On the other hand, many investors choose to take on the added risk of an alternative investment like real estate crowdfunding because they want the potential upside that comes with an equity investment. Raising funds through debt investment can be more difficult for developers that don’t already have a substantial amount of assets and a solid track record.
With equity crowdfunding, the investors are buying a piece of equity in the project. Instead of agreeing to pay the investors back a set amount, the developer is allowing the investors to share in the profits on the deal, whether that’s through rental income, appreciation, equity build, or all three.
Equity crowdfunding is typically the riskier option for investors, but it also has the most upside potential. If the developer fails to complete the project, the investors could be out everything. On the other hand, if everything goes as planned with the real estate investment, the investors can make a substantial profit.
Since equity crowdfunding doesn’t involve a guaranteed payment from the developer to the individual investor, it can be less risky for the developer if there are delays in the project or it doesn’t produce as much cash flow as anticipated. However, it can also mean they’re sharing a lot more of the profits with the investors than they would be with debt.
Real estate crowdfunding regulations
The beauty of crowdfunding for real estate developers is that they can raise capital from investors without taking on the massive expense of becoming a publicly traded company.
While crowdfunding comes with a lot less red tape and legal bills than an initial public offering (IPO), there are still rules set by the Securities and Exchange Commission (SEC) that have to be followed. The exact rules that have to be followed depend on the type of exemption the real estate developer chooses to take.
Rule 506(c) is one of the most common exemptions that real estate developers use to get crowdfunding investments. These are the main aspects of this rule:
- The developer can solicit and broadly advertise their offering to the general public.
- All investors must be accredited investors.
- The developer must take reasonable steps to verify that investors are accredited.
- The developer can raise an unlimited amount of money.
- The developer can raise money from an unlimited amount of investors (as long as they’re accredited).
This means that the developer can solicit the general public for investments and even advertise their offering. They just have to ensure that anyone who invests in the project is an accredited investor.
Rule 506(c) offerings are often done through an online real estate crowdfunding platform. This makes it easier for the developer to take investments and simplify distribution payments and investor relations.
Rule 506(b) is another common exemption. The main differences between this rule and Rule 506(c) is that the developer can raise funds from non-accredited investors, but they can’t solicit the general public or advertise their offering. They're also limited to accepting investments from people they have an existing relationship with. The main aspects to this rule include:
- The developer cannot advertise their offering or solicit investments from the general public.
- The developer can receive investments from up to 35 non-accredited investors.
- A non-accredited investor must have sufficient knowledge and experience in financial and business matters.
- Can receive investments from an unlimited number of accredited investors.
- The developer must have a pre-existing relationship with investors.
- The developer can raise an unlimited amount of money.
This type of crowdfunding is mainly used when a developer is raising capital from friends, family, and people they already do business with.
Regulation A gives developers the ability to advertise their offering and raise capital from both accredited and non-accredited investors. This exemption also comes with a lot more regulator hurdles to jump through and up-front costs to the developer.
There are two types of Regulation A offerings: Tier I and Tier II. Both have additional disclosure requirements over Rule 506(b) and Rule 506(c) and require the developer to have their offering qualified by the SEC.
The basic rules of the two types of Regulation A offerings:
- The developer can raise up to $20 million in a 12-month period from accredited and non-accredited investors.
- The developer must file and have their offering qualified by state securities regulators in states they plan to sell securities.
- No ongoing reporting requirements.
- The developer can raise up to $75 million in a 12-month period from accredited and non-accredited investors.
- Not required to have an offering qualified by state securities regulators.
- Ongoing reporting requirements to be filed with the SEC.
- Regulation A offerings are also typically done through a real estate crowdfunding platform, which is almost necessary considering the additional regulatory requirements.
Regulation Crowdfunding (CF)
Regulation CF is the newest type of crowdfunding and is mainly used on smaller projects because the developer is limited on the amount of money they can raise. However, they can raise capital from both accredited and non-accredited investors and advertise to the general public without the expense and hurdles of Regulation A.
The basic rules of Regulation CF:
- The developer can raise up to $5 million in a 12-month period.
- All transactions must take place through an SEC-registered intermediary.
- Certain disclosure requirements.
Since the amount a developer can raise on a project through Regulation CF is much less than with other SEC exemptions, they’re limited on the types of projects they can fund through this type of crowdfunding. However, projects with multiple phases can be kicked off with a Regulation CF campaign and later completed with another type of crowdfunding exemption.
Since Regulation CF transactions have to take place through an SEC-registered intermediary, this type of crowdfunded real estate deal is either done through an online crowdfunding portal that's registered with the Financial Industry Regulatory Authority (FINRA) or through a broker-dealer.
This type of crowdfunded real estate deal also typically has the lowest minimum investment compared to the other types we've discussed.
The Millionacres bottom line on crowdfunded real estate development
The real estate crowdfunding market can be a great option for a real estate investor who wants to get involved with commercial real estate or another real estate asset class that may otherwise be out of reach. However, it's important for a potential investor to understand that this type of investment doesn't have the same level of oversight from the SEC as a publicly traded real estate investment trust (REIT) or other similar investment. This is why the SEC has placed strict limits on who can invest in which types of offerings and how much non-accredited investors are able to invest.
Before investing in a crowdfunded real estate development, be sure to do your due diligence on the project, the developer, and the investment platform itself.