Who gets to invest via crowdfunding? The evolving definition of ‘Accredited Investor’

Interview with Mark Roderick, attorney at Flaster/Greenberg specializing in crowdfunding

“Accredited investors” in the US control the funds for $800 billion of privately-placed investments annually. The SEC is reevaluating the requirements to be considered an accredited investor, potentially updating those criteria to the most significant degree in 30 years. Since most real estate crowdfunding currently is targeted to accredited investors, iFunding wanted to share thoughts about the future.

In this blog, iFunding interviews a legal expert on crowdfunding, Mark Roderick. He is an attorney at Flaster/Greenberg and author of the blog http://crowdfundattny.com. In a blog post coming soon, iFunding will share our own thoughts on where the definitions might be headed, and how investors should take potential changes into consideration.

First, here is background on “Accredited Investors” and potential requirements changes

Today, “accredited investor” is defined as someone whose income exceeded $200,000 in each of the past 2 years (and is likely to do the same in the current year); or whose income exceeds $300K jointly with one’s spouse, or who has a net worth over $1 million (individually or jointly with spouse, excluding the value of your primary residence). Representatives of banks and certain investment companies also qualify.

The Frank-Dodd financial regulatory reform act specifies the review of the accredited investor definition every four years. On the table this year is the possibility that the net income or net worth thresholds will be increased by a to-be-determined amount. The SEC also has asked for public comments on whether financially “sophisticated” individuals – CPAs, investment advisors, traders or chartered financial analysts, potentially even MBAs or lawyers – can achieve accredited investor status, regardless of their income & net worth.

Q&A with Crowdfund Attorney, Mark Roderick, of Flaster/Greenberg

The interview is best read in conjunction with Mark’s insightful blog post.

Q: Mark, why were the income/asset thresholds set at the levels they were several decades back?As you indicate in your blog, if adjusted for inflation today, then only the ‘very, very’ wealthy would be able to participate.

The provisions about placing private investments to accredited investors was addressed in the SEC’s Regulation D. Today we take ‘Reg D’ for granted. When it was adopted by the SEC, however, Regulation D was a very significant innovation in the direction of allowing individual investors to participate in private transactions. That why the SEC chose such high thresholds, i.e., $200,000 of income and $1,000,000 of net worth. Regulation D was brand new and the SEC didn’t know how the experiment was going to work out. They wanted to limit the experiment to the wealthy, those who would (i) have financial sophistication themselves, (ii) be used to hiring sophisticated advisors, and (iii) have the financial wherewithal to lose their money.

Q: Do you feel that investors are more sophisticated in making their own decisions now?

I believe that over the last 30 years consumers have become more financially sophisticated, although not necessarily by choice. Consumers are now asked to make investment decisions about their 401(k) plans, as well as financial decisions about things like health insurance plans and home mortgages, which was not the case in 1982.

But I don’t think the financial sophistication of consumers is the most important point. The most important point is that the SEC’s 30 year experiment with Regulation D has shown that the danger of opening private investment to individuals is far lower than many people believed. The SEC could have changed the definition of accredited investor at any time without Congressional authorization. The reason the SEC has left the definition alone is that Regulation D as a whole, and Rule 506 in particular, have been pretty “clean,” meaning free of fraud and other abuse, even as the $200,000/$1,000,000 limitations have grown smaller and smaller with inflation. There is no reason to believe that would change if the thresholds were lower.

As the SEC considers its options, it’s also important to understand that investors participating in Rule 506(b) offerings over the last 30 years have been pretty smart. You don’t hear about someone investing his entire life savings in a bad real estate deal. In a country where Walmart is the largest retailer, it turns out that people are pretty careful with their money, after all.

Q: The SEC may incorporate a measure of financial experience into gauging whether someone is an accredited investor. If you had your preference, how would you define experience in a way that’s workable with regulations?

It’s going to be hard for the SEC to draw bright lines. If I were writing the rules, I would reduce the income limitation from $200,000 to perhaps $110,000, a level where the individual is trusted by his or her employer with making management-level decisions. I would also assume that lawyers, accountants, licensed financial advisors, bankers, licensed brokers (including real estate brokers), and other professionals in the financial industry can make their own investment decisions. And to top it off, I would allow anyone to prove his or her financial sophistication to the issuer, perhaps pursuant to a educational program administered by FINRA.

Q: What should many investors dive deeper into about crowdfunding platforms? In your experience, do these investors underestimate or not pay enough attention to certain factors?

As an investor myself, I am interested in (1) the record of the sponsor whose project is listed, (2) the record of the portal in selecting projects, (2) the industry experience of the portal operators, and (4) whether the portal and/or its affiliates are co-investing in the project. Personally, I think most of the early adaptors are pretty sophisticated folks.

Q: How would you suggest investors become even more sophisticated about investing, especially crowdfunding and real estate? Some learning comes with experience over the long haul of cycles, true?

I think education is very important for the future of the industry. As the trickle of investors becomes a flood, the market is going to demand and produce a mechanism to educate investors.

With that said, we know that very few crowdfunding investors will have the tools to evaluate individual projects with the expertise of a real estate professional. In response, the market will offer “mutual funds” of projects – for example, a fund consisting of apartment complexes in the Southwest. Most individuals invest in mutual funds rather than individual stocks today and there is every reason to believe the Crowdfunding market will develop in the same way.

Investors should familiarize themselves with the basics of real estate investing – the terminology, the risks, the relationship with the deal sponsor, the historic ups and downs of the real estate market. Like it or not, however, for most investors the decision will come down to one variable: the track record of the portal. That places an enormous burden on the real estate portals. Providing transparent reporting of investment progress and results is a valuable step in the right direction.

Understanding ‘Net’ versus ‘Annualized’ Returns with Real Estate Investments

Though there are many factors that should be considered when evaluating real estate deals, predicted financial returns are near the top of most investors’ lists.

iFunding recently has begun posting non-annualized (in addition to annualized) forecasted returns, to give our investors more visibility into an equity deal’s potential and the impact of time. With our debt investment opportunities, we are displaying the annualized rate, or APR, which is industry standard. These figures and other investment details can be reviewed when you log into the project area of our site.

Let’s look at how to incorporate these numbers into your deal comparisons. As an example, we’ll consider a home refurbishment whose all in cost is $200,000; projected sale price is $280,000; profit to the investor and developer is split 50/50; and estimated time from funding to sale is 9 months. After that example, you’ll read about the same project, but where the investment is a loan at 10% APR.

Stating returns for equity versus debt.

On equity investments (i.e., sharing of profit or loss), it’s most common to state the return on a non-annualized, or absolute % basis. In the above example, the return to investors is 20% (50% of the $80K profit, divided by the $200K invested). This return is distributed upon sale of the home, that is, after 9 months. If one were to calculate the annualized (12-month) equivalent return rate, it would be 26.7%. That’s determined by taking 12 mo’s divided by 9 mo’s, and multiplying by the 9-month return of 20% to scale it up for a year.

On debt investments (loans), it’s most common to state the return on an annualized basis, or “APR” (annualized percentage return). So, if above our example instead involved lending $200,000 to the project operator for 9 months at a 10% APR, then the actual interested would be 7.5% (that’s 9 mo’s divided by 12 mo’s, then multiplied by 10%). This assumes there are no early repayment fees imposed on the project operator.

Time’s Impact on Return Estimates

Projects can take shorter or longer than expected, due to factors like receipt of building permits, using or not needing the buffer time built into a project plan, or time-to-sale on the market. Here’s a comparison of the impact of time on the above equity and debt examples, with that $200,000 investment.

Net (non-annualized) returns for the above equity and debt examples:

Invest. Type Project Duration: 7 months (ahead of schedule) 9 months
(on schedule)
12 months (behind originally estimated schedule)
Equity 20% non-annualized 20% 20%
Debt 5.8% 7.5% 10%

Now, here are the annualized returns for the above equity and debt examples:

Invest. Type Project Duration: 7 months (ahead of schedule) 9 months
(on schedule)
12 months (behind originally estimated schedule)
Equity 34.3% annualized 26.7% 20%
Debt 10% 10% 10%

Each type of investment, equity or debt, can be right for you as an investor after you consider all the factors, such as security/guarantees backing the capital and total potential return, not to forget reputation of the developer, the financial dynamics of the local and national markets and your own portfolio diversification needs. Just recall to use an apples-to-apples comparison of return rates in the process, either annualized or non-annualized.