What Is an "Accredited" Investor? Why Does It Matter?
If you're considering passively investing in a private investment like a syndicated real estate transaction, it's likely one of the first questions you'll be asked: "are you an accredited investor?" What does this mean and why does it matter? We'll explain everything you need to know below.
First, let's start with what it means to be an accredited investor. As defined by the Securities and Exchange Commission (SEC), accredited investors are considered financially sophisticated individuals or businesses defined by at least one of the following:
Individual with earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and who reasonably expects the same or more income for the current year.
Individual or married couple with a net worth over $1 million (not including the value of their primary residence).
A trust, with total assets in excess of $5 million, not formed to specifically to purchase the subject securities, whose purchase is directed by a sophisticated person. The SEC defines a sophisticated person as one with sufficient knowledge and experience in financial and business matters to evaluate the merits and risk of the prospective investment.
Any entity in which all of the equity owners are accredited investors.
Now, let's discuss why and when it matters. When raising capital from passive investors for a private investment, the deal is not required to be registered with the SEC due to a number of legal exemptions allowed. However, there are specific rules that must be followed to qualify for these exemptions, depending on how the sponsor structures the deal. Below are the most common exemptions to federal securities laws typically used for real estate syndications:
506(b): Utilizing this exemption requires the deal sponsor to strictly raise capital from those they had a pre-existing relationship with (friends, family, coworkers, business acquaintances, etc.), and the deal cannot be openly advertised to anyone that doesn't fit this criteria. Why would a sponsor choose to utilize this exemption? The main reason is that it doesn't require the investors to be accredited. While not being able to openly advertise the deal would make it difficult to raise large sums of money quickly, this can be the preferred option for smaller deals and newer syndicators since it allows the sponsor to present the investment opportunity to those that are most likely to invest in them but may not meet the accreditation requirements: friends and family. As the sponsor builds a history of successful transactions, it's very common that they will eventually pursue larger deals and utilize rule 506(c) instead.
506(c): An investment utilizing this exemption is only allowed to raise capital from accredited investors, regardless of whether they have any personal relationship to the sponsors of the deal. Why would a sponsor choose to utilize this exemption, since it vastly narrows their potential investor pool? The answer is simple, unlike rule 506(b), this exemption allows the sponsor to openly advertise the deal to anyone. This is particularly beneficial for large deals, as the sponsor will need to raise millions of dollars quickly, and needs to present the opportunity to as many potential investors as possible so that the deal can close on-time.
The reason for these federal securities laws is quite simple: since syndicated real estate deals are typically not registered, the SEC doesn't want inexperienced investors getting involved in unregulated investments that they don't understand. Participation in an unregulated investment brings about unique risks and less protection, so the SEC made these rules to ensure the potential investor can navigate these riskier investments appropriately, and at worst can understand and sustain the risk of loss.
As always, please feel free to reach out to us with any questions or concerns.