Commercial real estate deals require a lot of cash. Most deal sponsors cannot cover those cash requirements on their own. Instead, sponsors typically raise funds from outside investors. Between a sponsor’s contribution and the funds provided by investors, a deal can happen. But, to avoid fraud and protect investors, the federal government imposes strict rules when sponsors offer the sale of stakes in a deal. In particular, the SEC’s Rule 506 of Regulation D provides fundraising guidance that real estate sponsors should intimately understand. As such, we’ll use this article to discuss Regulation D and a 506b versus 506c offering.
- Securities Law and Regulation D
- 506b Offerings
- 506c Offerings
- Final Thoughts on 506b vs 506c Offerings
Securities Law and Regulation D
A security is a financial instrument that allows holders to profit off the managerial efforts of others. For example, stocks qualify as securities, because shareholders expect to generate profits off of the managerial efforts of the issuing company. In commercial real estate, when a deal sponsor sells stakes in a deal to investor-members or limited partners, those stakes are securities. The investors seek to profit off the managerial efforts of the deal sponsor.
In the midst of the Great Depression, the federal government decided that it needed to regulate the sale and trade of securities to protect investors from fraudulent activity. Among other items, the Securities Acts of 1933 and 1934 established the Securities and Exchange Commission (SEC) and empowered it with a variety of anti-fraud mandates. Of note, these new laws stated that any offer or sale of a security needs to be registered with the SEC unless it meets an exemption.
Registering securities with the SEC can be an onerous, costly process. To avoid discouraging smaller offerings, Regulation D of the Securities Act allows for certain exemptions from this SEC registration. If an offering meets one of these exemptions, companies can sell their securities without needing to register the offering with the SEC.
Underneath Regulation D, two rules outline exemptions frequently used by real estate deal sponsors to raise funds: Rule 506b and Rule 506c. In the next sections, we’ll provide an overview, pros, and cons of both of these exemption categories.
506b Offerings
Overview
The 506b exemption allows deal sponsors to raise an unlimited amount of money from investors, but the sponsors cannot publicly advertise the sale. That is, a deal sponsor couldn’t take out radio or digital ads promoting the sale.
Pros
506b provides sponsors significant flexibility regarding potential investors. Sponsors can raise funds from an unlimited number of accredited investors and up to 35 non-accredited investors, so long as the latter category are “sophisticated.” However, raising funds from non-accredited investors requires more cumbersome informational filings with the SEC.
Another major benefit to 506b is who bears the responsibility for verifying whether or not an investor is accredited. With this exemption, investors self-certify accreditation, easing the administrative burden on the deal sponsor.
Cons
The primary drawback to 506b is the prohibition on publicly promoting an offering. If a sponsor lacks a wide personal network of accredited investors, he or she will likely struggle to raise funds for a deal.
506c Offerings
Overview
Like 506b, the 506c exemption allows deal sponsors to raise an unlimited amount of money. But, under the latter, sponsors can publicly promote the offering. 506c also states that all investors must be accredited.
Pros
The major advantage to 506c is the public promotion clause. Deal sponsors can use any type of advertising they like to spread the word about their offering. For individuals without a large personal network of accredited investors, this ability to advertise dramatically increases the likelihood of connecting with potential investors.
Cons
Whereas investors self-certify accreditation status with the 506b exemption, the verification onus falls on the deal sponsor under 506c. Verifying that someone is, in fact, accredited costs time and money. Furthermore, sponsors expose themselves to potential liability if they fail to properly certify an investor’s accreditation status.
Final Thoughts on 506b vs 506c Offerings
Deal sponsors can use both of the above exemptions to avoid the onerous process of registering a security offering with the SEC. But, under both 506b and 506c, investors receive “restricted” securities, meaning they cannot resell them for six months to a year without actually registering them. For sponsors deciding which exemption to use, the primary consideration is whether or not you want to publicly advertise. With 506c, you can promote the offering to anyone, but you must verify that all investors are accredited. Conversely, with 506b, you can only promote an offering to your personal network – accredited and non-accredited – and the accredited investors can self-certify.
If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – and the associated fundraising implications.