Investing in a private equity commercial real estate (CRE) transaction involves some level of risk.  Depending on the property type, holding period, and professional knowledge of the manager, risk exists on a spectrum.  On one end, a  Class A, single-tenant, net-leased property is generally considered to be relatively low risk, on par with a corporate bond.  On the other end is a ground up development project where any number of variables could derail the project and cause investors to lose some or all of their investment capital.  For this reason, a governmental body known as the U.S. Securities and Exchange Commission (“SEC”) limits the availability of unregistered securities in private offerings to individuals who are “accredited” or “sophisticated.”  

Accredited and Sophisticated Investors – Defined 

To understand exactly what it means to be an accredited or sophisticated investor, it is first necessary to understand how a typical private market equity transaction is structured.

When a private equity firm decides that they are going to acquire a commercial real estate asset, one of the first things that they do is create a Limited Liability Company that will act as the acquisition vehicle for the property.  To fund the transaction, they will arrange debt financing for some portion of the purchase price (typically 60% – 80%) and raise the remaining funds by selling shares in the company to investors.  These shares are a securitized investment and are regulated by and must be registered with the Securities and Exchange Commission.

But, the SEC carves out an exemption for these registration requirements as long as securities are sold to investors who are either accredited or sophisticated as defined in Regulation D.

Accredited Investor Definition

Under the language in Regulation D, the definition of an accredited investor is as “any person who comes within any  of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of securities to that person:

1. Any bank; savings and loan association; broker or dealer; insurance company; investment company; Small Business Investment Company licensed by the U.S. Small Business Administration; plan established and maintained by a state; or employee benefit plan with total assets in excess of $5,000,000 
2. Any private business development company
3. Any organization described in section 501(c)(3) of the Internal Revenue Code, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
4. Any director, executive officer, or general partner of the issuer of the securities being offered or sold
5. Any natural person whose individual net worth, or joint net worth with that person’s spouse (or spousal equivalent), exceeds $1,000,000 (NOTE:  The person’s primary residence shall not be included as an asset)
6. Any natural person who has individual annual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.
7. Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person 
8. Any entity in which all of the equity owners are accredited investors

Most private equity transactions solicit individual investors who call into category 5 or 6 of the list above.

Sophisticated Investor Definition

If an individual does not have the financial resources to be accredited, they can still invest in a private equity transaction if they can prove that they have a certain degree of financial sophistication.  These requirements are also outlined in Regulation D, which states that a company may sell their securities to a maximum of 35 non-accredited investors as long as they are “sophisticated,” meaning someone who “has sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.” 

In both cases, the intent of these exempt offerings is to implement some regulatory guardrails to protect individual investors by mandating that companies can only sell non-registered securities to individuals who have the financial resources to recover from a loss or those who have the knowledge to assess the risk in a given transaction.  

But, not all transactions are the same.  SEC guidelines allow for two different types of non-registered transactions and there are specific rules that go along with each.

506(b) vs. 506(c)

There are two types of “syndicated” transactions allowed under SEC rules and they are commonly referred to as “506(b)” and “506(c).”  The major difference between the two is that one allows sophisticated investors and the other does not and they must follow specific rules around advertising the offering.

506(b)

Under Rule 506(b), a company can be assured of its exemption by satisfying the following requirements:

• The company cannot use general solicitation or advertising to market the securities.
• The company may sell its securities to an unlimited number of “accredited investors” and up to 35 sophisticated investors. 
• Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws.
• The company must be available to answer questions by prospective purchasers.

Because of the limitations on advertisement, the 506(b) is typically not the preferred vehicle for most private equity companies.

506(c)

Under Rule 506(c), a company can broadly solicit and generally advertise the offering and still be deemed to be in compliance with the exemption’s requirements if:

• The investors in the offering are all accredited investors; and
• The company takes reasonable steps to verify an individual’s qualifying accredited investor status , which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.

Because advertising is allowed, the 506(c) structure is typically the preferred offering for most private equity firms.  However, this type limits the transaction to accredited investors only.

Risks and Benefits of Being an Accredited or Sophisticated Investor

Becoming an accredited investor opens up a new world of possibilities for investment that goes beyond the traditional public markets.  This includes opportunities to invest in the securities offerings of  private funds, hedge funds, venture capital deals, crowdfunding deals, private placements, family offices, or in individual deals with private equity real estate firms (like ours) and other alternative investment categories that have an established history of outperforming public markets.

However, those same investments also move up the risk/return spectrum and often involve lengthy holding periods, increased fees, illiquidity, and significant due diligence requirements before investing.

Interested In Learning More?

First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets – including middle-market service-oriented retail shopping centers – well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.

To learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.