Because syndicated tenant-in-common ("TIC") and other real estate offerings typically are open only to accredited investors, the question of whom or what constitutes an "accredited investor" is crucially important. Recent indications from the Securities and Exchange Commission ("SEC") and the North American Securities Administrators Association ("NASAA") suggest an effort is underway to raise the individual criteria for accredited investor status for the first time since Regulation D was promulgated in 1982. This could eventually have a significant impact on the securitized real estate industry.

As a quick review, Regulation D establishes two separate financial thresholds for natural persons to qualify as accredited investors -- one based on net worth and the other based on annual income:

1. Rule 501(a)(5) – Any natural person whose net worth at the time of purchase exceeds $1,000,000 (either individually or jointly with his or her spouse); and

2. Rule 501(a)(6) – Any natural person who has an individual income in excess of $200,000 in each of the last two years (or $300,000 joint income with his or her spouse) and who reasonably expects to have individual income in excess of such respective amounts in the current year.

These standards have remained essentially unchanged for 25 years. If these criteria had been adjusted annually for inflation, the net worth standard today would be approximately $2.1 million, with an annual income threshold of approximately $430,000 (or $650,000 joint income with spouse).

As proposed by the SEC, Rules 509 and 216 would define a new category of accredited investor ("accredited natural person") that would apply only to offers and sales of securities issued by certain types of private investment vehicles (a term defined elsewhere in the proposed rules), such as hedge funds. A "natural accredited person" would be defined as any natural person who meets either the net worth or income test specified in Rule 501(a) or Rule 215, as applicable, and who owns at least $2.5 million in investments.

Fortunately for the syndicated real estate industry, these proposed rules, if passed, would be aimed squarely at the hedge fund industry (and certain other pooled investment vehicles) and should not have a direct or immediate impact on the syndicated real estate industry. It would be shortsighted, however, to ignore the potential impact this effort could have on real estate sponsors, investors, and their representatives. The SEC's supporting rationale for these proposed rules, while aimed at hedge funds, could readily be applied in the context of real estate syndications. For example, the SEC cited the following reasons in support of the proposed rules:

1. inflation and sustained growth in wealth and income have greatly increased the population of people qualifying as accredited;

2. hedge funds involve complicated investment structures, strategies, and risks;

3. hedge fund investors may find it difficult to understand and appreciate unique risks such as those concerning undisclosed conflicts of interest, complex fee structures, and the higher degree of risk associated with a hedge fund's anticipated returns.

The notion that inflation and economic growth have created a class of "nouveau riche" investors who need heightened protection is not unique to the hedge fund industry. Many would argue that TIC deals involve equally complicated investment structures and risks.

If one accepts the SEC's rationale as applied to the hedge fund industry -- which many do not as suggested by the public comments submitted to date -- it is easy to apply a similar rational to the syndicated real estate industry.

Adding further fuel to the fire, NASAA recently published its annual legislative agenda. Included among its top ten recommendations is a call to update the accredited investor definition under Rule 501(a). NASAA has urged the SEC and Congress on more than one occasion to increase the individual net worth and income criteria under Rule 501(a) to keep pace with inflation. As part of the public comment period on the proposed rules discussed above, NASAA is expected to formally recommend that both the net worth and income standards be updated and apply to all types of private offerings under Regulation D.

If the Rule 501(a) net worth and income standards were to be increased for individuals (i.e., applied across the board to all types of Regulation D private offerings), the impact on real estate syndications would be considerable. The market for securitized TIC offerings and other private real estate offerings would shrink as fewer investors would qualify as accredited investors.

Opening such offerings to non-accredited investors is possible under Regulation D, but the disclosure requirements are greater and, therefore, the related transaction and compliance costs would be higher. Smaller and newer sponsors, in particular, would quickly feel the squeeze and find it difficult to successfully raise capital from individual investors.

Broker-dealers and registered representatives would have greater difficulty marketing private real estate offerings and finding appropriate investment opportunities for many of their clients impacted by the heightened standards. Many investors suddenly would be precluded from investing in syndicated real estate deals. If TIC deals in particular become less accessible, then many owners of investment real estate will experience more difficulty structuring 1031 like-kind exchanges.

Published: September 7, 2007

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Eric C. Perkins is a member of the firm's Business Section and Real Estate Securities Practice Group. His practice focuses on real estate securities offerings, franchising, and tax-exempt organizations. Eric has assisted real estate sponsors raise over $800 million in Regulation D private offerings, including tenants-in-common, REITs, syndicated limited liability companies, real estate opportunity funds, and promissory note offerings. In addition, he specializes in advising entrepreneurs on franchising matters and related business issues. Eric also works regularly with tax-exempt organizations on a variety of corporate, tax, and compliance issues. Eric is an author and lecturer on a variety of securities and business law topics, including co-author of a Virginia CLE Handbook titled Contract Law in Virginia.