Perspective: Encourage Affordable Housing through “Community Investor” Crowdfunding Rules
Incentivize Affordable Housing through Crowdfunding Liberalization for Community Investors
In recent decades, increases in urban employment and population have outpaced residential development in U.S. cities. Nationwide, from 1974 through 2008, the number of new homes exceeded the number of new households. But since 2009, the construction of new homes has failed to significantly exceed the number of new households and housing prices have generally increased more than incomes.¹
Years of housing underproduction is attributable to: restrictive zoning, neighborhood opposition, increasing construction costs, high impact and linkage governmental fees,and a lack of communication between developers and the communities.² All of these factors have slowed and prevented residential construction and driven up prices as demand exceeds supply.³
Crowdfunding could, potentially, help solve this problem through reforms encouraging localized investment in affordable housing.
Today’s crowdfunding rules under Regulation A+ and Regulation D permit online crowdfunding from Accredited Investors, without extensive public registration and typical disclosures that accompany initial public offerings. However, there are legal risks and little incentive for developers to solicit investment from local residents. Reforms could serve a useful role in encouraging locally-funded affordable housing production.
One route would open a new source of affordable housing funding and promote residents’ investments in their communities: the Securities Exchange Commission (“SEC”) could provide Regulation D and Regulation A+ guidance and safe-harbors, creating a new category of “ Community Investors “. Community Investors could then invest in the modernization or development of qualifying local residential projects that meet or exceed local affordability requirements.
Under my proposal, projects funded by Community Investors would need to comply with a narrowly-tailored mini-disclosure program, including “ Form AH “ (Affordable Housing).
Form AH would likely be in addition to Form D if proceeding under Regulation D, or Form 1-A if under Regulation A+.
Projects funded by Community Investors would also need to meet or exceed affordable housing requirements to the SEC’s satisfaction. Without Community Investors, real estate will continue to be funded by less risky and established private placement models occurring through relationships and brokers, generally not subject to federal securities regulations, and which exclude local populations.
Existing Real Estate Crowdfunding Models
Regulation A+ and Regulation D have been updated by the JOBS Act of 2012 to exempt online real estate crowdfunding from registration and disclosures that would otherwise apply to online securities investments. Registration is expensive and time-consuming, with recurring mandatory disclosure. Registration also brings heightened civil liability exposure.
Regulation A+ permits offerings up to $50 million and requires reporting similar in depth to public company reporting. Accredited Investors (as defined in Regulation D), and unaccredited investors (up to a maximum of 10% of income or net worth) can invest in Regulation A+ offerings. Companies like Fundrise, which manages 16 “eREITS”, operates under Regulation A+. Fundrise only offers common shares in its eREITs to investors whose investment does not exceed the 10% threshold.4
Like other emerging real estate investment platforms, (i.e. Lex Markets and Cadre) Fundrise does not encourage localized investment and does not specifically encourage affordable housing development.
Alternatively, crowdfunding may utilize Regulation D.
Rule 506 of Regulation D permits up to 35 non-accredited investors to participate in a Rule 506 offering. These non-accredited investors must have sufficient financial knowledge and acumen to assess the investment. Cadre uses 506(b) allowing an unlimited number of Accredited Investors, which includes individuals with income over $200,000 or $300,000 jointly with a spouse, or a net worth above $1 million.5
Accredited Investors are the preferred investors because fundraisers (issuers) have less responsibility to ensure investors’ sophistication. In accredited-only offerings, there is less potential for inadequate disclosure claims from non-accredited investors. Crowdfunding firms can receive investment from non-accredited investors. However, this reform would make fundraising from non-accredited investor access more realistic and less risky.
While Accredited Investor income limits have not been updated for decades (increasing the pool of Accredited Investors), real estate investment is still out of reach for many.
In December 2019, the SEC proposed amendments and sought comments for the expansion of its Accredited Investor definition. That proposal contemplated expanding the accredited category based upon “professional knowledge, experience, or certifications”.6 The Community Investor regulations align with movements to lessen stringent Accredited Investor definitions and would account for knowledge of respective neighborhoods and their trends.
Regulation D expansion could guide existing crowdfunders and better help build communities through broadened financing opportunities for more transparent and community-connected development and housing stock.8
Community Investor Process & Disclosure
A new SEC rule could allow Community Investors to qualify and benefit from Rule 506 and Regulation A+. Community Investors would need to provide proof of employment and income and meet a 2-year residency requirement. Developers would need to complete more narrowly-tailored, mandatory forms to provide to non-accredited investors and Community Investors.7
Congress granted the SEC the authority under Section 36 to exempt any person, transaction, or class from any SEC rules when necessary or appropriate in the public interest and consistent with investor protection. Production of affordable housing has consistently been found to be in the public interest in many government policies. Even if this Community Investor reform does not operate under Section 36 directly, it promotes and is consistent with the spirit of Section 36.
Existing issuer disclosure regimes do not easily map well onto crowdfunded digital asset offerings and blockchain technologies. Similarly, crowdfunding forms are not well suited for real estate development by non-reporting companies. Revised rules could provide more certainty, reduce litigation risks, and promote broader fundraising.
Mandatory disclosure (modeled after the S-1 full IPO and the A+ mini-IPO systems) could be completed under the new SEC Form AH.
Form AH would include: description of the project and compliance with affordability requirements and projected construction costs as well as rent rolls. The new Form AH would also require narratives with industry and local market data, risk factors, and background covering other debt and equity participants.
Form AH would solicit developer-specific information including: other properties owned, development track record and pipeline, and a property-specific management plan. Form AH could require statements of expected economic and social impacts.
Finally, this real estate-specific disclosure should include expected financial returns and investment exit options, and state whether the return on the community’s equity materially differs from other deal participants’ returns.
The disclosure rules should be structured to solicit brief responses to increase the chances that developers fill them out, particularly smaller developers who do not have adequate resources to comply with extensive disclosure. Shorter forms also increase the chances that Community Investors read them fully. These forms would help better inform voluntary disclosures already provided to Accredited Investors and mandatory disclosures provided to non-accredited investors.
Many developers will be wary of becoming subject to securities laws’ jurisdiction. Thus, innocent and insignificant mistakes rules and related doctrines, which can prevent offerings from losing Regulation D protections, could apply to these new rules. Further, these forgiving rules should be extended more broadly.
Community Investor Participation
Residential developments often are blocked due to vocal opposition and a dearth of local support aside from developer and trade group support. Rule 502(b)(2)(v) requires issuers to provide investors answers to questions. For projects funded by Community Investors, 502(b)(2)(v) could be expanded to require community meetings (including virtual meetings) with question and answer sessions.
Even for compelling deals with numerous investors competing to invest and not needing crowdfunding, this process could help residential projects receive more community support in extensive planning and entitlement processes. Required meetings with Community Investors provide more transparency. This differs from the complexity and opaqueness that undermines coin offerings; this complexity increases the risks of fraud, misrepresentation and lawsuits. Community Investor rules are a channel to more community engagement and support.
The SEC could also provide Community Investor resources and guidance documents to help assess investments and Form AH itself. Materials could advise on industry standards and the importance of 3rd-party verification.
Advertising and Resale for Community Investor Interests
As part of this reform, the SEC could consider easing resale restrictions to allow investors to sell to other eligible Community Investors.
Community Investors should be required to provide all forms they initially received to secondary market Community Investors. Resale should only be permitted if material changes from the initial disclosures are disclosed. This would bring Regulation D resale policy more in line with Regulation A+.
Permissive resale, would reduce the liquidity discount, which lowers the value of holdings that can’t be freely resold. Requiring resale only through third-party online funding portals would provide another layer of project vetting and additional exposure.
Funding portals already offer location and community-centric crowdfunding opportunities. Startengine features Power2Peer which has fundraised under Regulation A+ (subject to Accredited and Non-Accredited investor rules) and Regulation CF. Power2Peer is creating a marketplace where users can support and buy local renewable energy. A Community Investor category would help localized projects succeed by providing more flexibility to solicit from their communities with fewer legal limitations while Form AH could provide pertinent disclosures.
Community Investor permissions don’t need to significantly alter Regulation D advertising and solicitation regulations. Currently, 502(c) limits general solicitation, except that broader advertising is permitted in 506 offerings exclusively with Accredited Investors. This guidance could provide safeguards for advertising to Community Investors, with solicitation permitted only in localized areas and with controlled community targeting.9
Non-Profit Trial Period
The SEC could potentially limit these community fundraising permissions only to existing non-profit affordable housing developers. Allowances only for non-profit affordable housing developers would make non-profits more competitive in accessing capital and broaden their impacts on cities. A non-profit trial period could show whether the Community Investor rules should expand to for-profit entities.
Additionally, a non-profit trial period could provide data to determine whether resale should be permitted only to other Community Investors, or to the broader public.
Community Investor participation in non-profit projects using Form AH could provide proofs of concept. These trials would demonstrate the benefits of community fundraising to established, sufficiently-funded developers who are wary of triggering additional regulations.
Established developers may then use Form AH in order to receive community support that can help with planning and zoning processes
COVID-19-related factors may reduce the amount of crowdfunding and real estate liquidity and investment in the long-term. Responses to COVID-19 have also stopped and slowed residential construction. April 2020 housing construction starts are 30% lower than the previous year’s rate.10 Investors may be less willing to invest in urban housing because of fears related to density, more teleworking opportunities, and uncertainty. The SEC could be proactive, giving residents options to make fully-informed direct investments with both appreciation and cash flow potential in their neighborhoods. Continuing the liberalization of securities offerings, with appropriate disclosure under Form AH and other safeguards, would offer more financing avenues for affordable housing while allowing individuals to contribute to their neighborhoods.
returned to Vornado Realty Trust for his summer after his first year at Georgetown Law. In the fall of 2019, Aaron interned at the
Aaron Reuben is Business Law Scholar at Georgetown Law, entering his final year. In the summer of 2020, Reuben is a Summer Associate at Paul Hastings LLP in San Francisco. Reuben grew up in San Francisco and graduated from New York University Summa Cum Laude. While in New York, Reuben interned at the Brooklyn District Attorney’s Office. He then worked at Vornado Realty Trust, a developer with a portfolio of over 35 million square feet. Reuben first interned for building management before moving to the headquarters, where as a Project Associate, he supported the office leasing, real estate development, and in-house counsel groups. Reuben U.S. General Services Administration, General Counsel’s Office.
3 From 2011 to 2017 the “low-rent” housing stock shrunk by four million units. The State of the Nation’s Housing, US Census Bureau & American Census Survey 1 Year Estimates. 5 Rule 501(a)(6). 7 Currently, 502(b)(2), (i)-(ii) provides varied disclosure requirements depending on the transaction. This reform could provide more robust and narrowly tailored disclosure for residential real estate. It would also help align the information provided to accredited and non-accredited investors. 502(b)((2)(iv) requires that issuers must give non-accredited purchasers a description of “any material written information provided to accredited investors. 8 Rule 508 forgives Regulation D violations where “failure to comply did not pertain to a term, condition or requirement directly intended to protect that individual or entity”. 508(a)(1). There must also be good faith effort to comply. 508(a)(3). The reasonable belief standard also provides protection when the violations arise out of objectively reasonable innocent mistakes. 501(h); 506(b)(2)(ii) 9 Real estate developers would need to ensure compliance with state and local solicitation and advertising regulations. 10 Monthly New Residential Construction, US Census Bureau, April 2020, https://www.census.gov/construction/nrc/pdf/newresconst.pdf