In the past, commercial real estate investing felt out of reach for many individuals because the required capital far exceeded what most people could individually contribute. Because of this, commercial real estate was an investment vehicle that was only accessible to wealthy and well-connected people. However, the Securities and Exchange Commission (SEC) passed rules that make commercial real estate investing more accessible to the general public.
There are two rules in particular that you should know if you’re interested in any kind of commercial real estate private offering in the United States: Rule 506(b) and Rule 506(c). The rules are similar to one another, but the differences are crucial as a prospective investor regardless of whether you want to be an active investor or a passive investor. We’ll start with the background contest of the SEC regulations, and then get to the bottom line of the two rules by exploring a direct comparison chart.
What’s the Purpose of Rule 506(b) and Rule 506(c)?
Every rule has a purpose, and 506(b) and 506(c) are no different. Therefore, in order to understand how they function and why they’re written the way they are, it’s important to understand the context around why these two rules exist.
It all starts with Section 5 of the Securities Act, which states that all offers and sales of securities must be registered with the Securities and Exchange Commission (SEC) unless there is an available registration exemption.
An exemption from registration may not seem like a big deal at first, but registering an offer to sell securities with the SEC requires a lot of money, paperwork, time, and legal counsel. If every commercial real estate deal had to be listed with the SEC, it would create a massive amount of work for the commission to review and approve, likely creating a gigantic backlog and long delays for investors to receive approval. Given how quickly real estate can move, requiring every real estate deal to be registered would become prohibitive to investing and the industry at large.
There are two common places where registration exemptions exist: Section 4(a)(2) of the Securities Act which was redesignated in Section 4(a)(2) by the Jumpstart Our Business Startups Act (JOBS Act) and Regulation D. Here’s a brief overview of each:
Section 4(a)(2) exempts offers and sales by an issuer that do not involve a public offering or distribution (think of a listing on the stock market) from registration. These private offerings are commonly considered private placements, and an issuer is commonly considered to be any person who issues (or proposes to issue) a security.
While Section 4(a)(2) is helpful, it’s fairly ambiguous in regard to what qualifies as a public offering or distribution, and it doesn’t provide much clarity to the issuer regarding whether or not their offer and sale of a security would be classified as a private placement that is exempt from registration. Therefore, the SEC adopted Reg D to provide a safe harbor mechanism that helps reassure issuers their offer and sale of securities is exempt from registration.
Regulation D provides two safe harbor exemptions from Section 5 of the Securities Act registration requirements (and state-level blue sky laws) for commercial real estate investments under Rule 506(b) and Rule 506(c).
There are key differences between the two rules that should be heavily considered before you start to raise capital, so let’s look at each rule individually, and then we’ll look at a direct comparison between Rules 506(b) and 506(c) of Regulation D.
What is a 506(b) offering?
Rule 506(b) allows a real estate syndication to raise an unlimited amount of money from an unlimited number of accredited investors and up to 35 nonaccredited investors. The offering can’t be publicly advertised, and the issuer can only present an offer if they have a pre-existing relationship with the investor, but accredited investors may “self-accredit” themselves in a 506b, which means the syndication may take the investor’s word that they’re accredited.
Since no general advertising is allowed, the issuer can’t make a social media post on social media platforms that promote a specific deal, place an ad in the newspaper, run a commercial on television, or use any other form of advertising.
What is a 506(c) offering?
A 506(c) offering allows a real estate syndication to raise an unlimited amount of money from an unlimited number of accredited investors (but no non-accredited investors). The offering can be publicly advertised without restriction, but all investors must be verified accredited investors. The verification requirement can be carried out by a third party, such as verifyinvestor.com, or through a written declaration from the investor’s CPA or financial adviser with supporting documentation such as a W-2, tax returns, financial statements, credit reports, financial documents, bank statements, brokerage statements, etc.
The prohibition on general solicitation was always in effect under Regulation D, but the new Rule 506(c) was created in 2012 as part of Title II of the jobs act JOBS Act to help a general partner or syndication raise money through the use of general solicitation to support economic growth.
What’s the difference between Rule 506(b) and Rule 506(c)?
The main two differences 506(b) and 506(c) is that in a Rule 506(b) offering, a real estate syndication can raise money from accredited and unaccredited investors and can take the investor’s word that they’re accredited, but the issuer cannot advertise the deal at all without a pre-existing relationship. In a 506(c) offering, a real estate syndication can raise money from accredited investors even if they don’t have a prior relationship, and they can promote the offering publicly, but the issuer must take reasonable steps to create a quality verification process to verify the accreditation of the investors.
Rule 506(b) vs. Rule 506(c) Comparison Chart
If you’re raising money for commercial real estate investment opportunities, you must comply with the following requirements of the SEC securities laws. Here’s a table showing the major differences and similarities between 506 b offerings and 506 c offerings:
| Rule 506(b) | Rule 506(c) | |
| Permitted Investors | • Unlimited Accredited Investors • Up to 35 Non-Accredited Investors who meet “Sophisticated Investor” requirements | • Unlimited Accredited Investors |
| Verification of Accredited Investors | The issuer can accept accredited investors who “self-accredit” themselves by providing a written declaration that they meet the requirements. The issuer must conduct due diligence to reach a reasonable belief that the written statement is true. | The issuer must verify that the investors are accredited. Often times a third party is used for the verification process to confirm accredited investor status. |
| Financial Limitations | • No limit on the amount raised • No limit on how much each investor can invest | • No limit on the amount raised • No limit on how much each investor can invest |
| Advertising | • No advertising of the offer is allowed • The offering may only be presented by the issuer if the issuer has a pre-existing relationship with the investor | • All advertising is allowed • No substantive pre-existing relationship with the investor is required (though it’s still a good idea) |
| Required Information | If the offering includes one or more Non-Accredited investor(s), the law requires that the issuer provide information. If the offering includes only accredited investors, no information is required by law. However, it’s likely a good idea to include information to inform investors and avoid Rule 10b-5 liability. The issuer must be available to answer questions from prospective investors. | No information is required by law. However, it’s likely a good idea to include information to inform investors and avoid Rule 10b-5 liability. The issuer must be available to answer questions from prospective investors. |
| SEC Registration | No | No |
| State Registration | No | No |
| Post-Sale Filings | • Issuer must file a Form D to the SEC • Issuer must file corresponding forms to each state where an investor lives | • Issuer must file a Form D to the SEC • Issuer must file corresponding forms to each state where an investor lives |
There are a few terms that we’ve discussed relating to investor protections, real estate investors, and investment offerings. Let’s take a moment to clarify what some of those mean.
What is an accredited investor?
The SEC provides a simple definition of an accredited investor. To earn accredited investor status, the SEC states you must be:
- A person whose gross annual income exceeded $200,000 in each of the two most recent years or whose joint income with a spouse or partner exceeded $300,000. Additionally, the person or couple has a reasonable belief they’ll earn the same or more income in the upcoming year based on a reasonable forecast.
- A person whose total net worth, exclusive of their primary residence, exceeds $1,000,000 either as an individual or jointly with their spouse or partner.
As you can see, the SEC guidelines lay out a clear accredited investor definition without making it overly complicated. You can learn more about different types of investors here.
What is a sophisticated investor?
A sophisticated investor is a high-net-worth investor who is considered to have a depth of experience and market knowledge that makes them eligible for certain benefits and opportunities. The SEC defines sophisticated investors as those who “have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”
You can learn more about sophisticated investors here.
What is a pre-existing substantive relationship?
The SEC defines a “pre-existing” relationship as a relationship that is “formed before the start of the offering or is established through a broker-dealer or investment adviser prior to that investment professional’s participation in the offering.”
The SEC defines a “substantive” relationship as a relationship that is “formed when the entity offering securities (i.e., the company or its broker-dealer or investment adviser) has sufficient information to evaluate and evaluates a potential investor’s status as an accredited investor.”
506(b) or 506(c): Which is better for me?
Like all real estate investment decisions, the only way to determine which is better for you is to heavily consider all of the factors within your situation and consult with local experts about the goals and challenges you have. That being said, here are some general guiding points:
Rule 506(b) may be your best choice if you intend to raise money from people in your personal network who may or may not be accredited investors. Many first-time real estate syndicators use Section 506(b) for their first agreement because they first rely on acquaintances.
If you’re looking for a broader reach strictly from accredited investors, a 506c syndication may be the best choice because you’ll be able to promote your offering to a larger network of investors than just those in your personal network.
Summary
Rule 506(b) or 506(c) both serve as a great private placement exemption to that are safe harbors from the registration requirements of the securities act. Both rules help you to invest in more deals as well as open up your deals to more potential investors. Each rule has its pros and cons, and this is not legal advice, so you should always do your due diligence and speak with your lawyer before making any decisions. The two rules are a win-win for real estate sponsors and passive investors.
