All investments require investors but not all investors are the same. In this article, we’ll take a look at the differences between sophisticated investors vs accredited investors. We’ll define what they are and how they relate to passive real estate investments.
There’s a lot to cover, we will explore:
- The Difference Between Accredited vs Sophisiticated
- 506(b) and 506(c) Offerings
- Which Deals Are Safer
- The Deals I Prefer
- Why The Rules Matter
It’s natural to assume that anyone can invest in a deal. After all, if you trust someone with your money, that’s enough, right?
Well, not exactly.
We make investments with hopes of the rewards, but all investments involve risk. That risk can affect people differently depending on their particular situation. Categorizing investors as sophisticated or accredited is required by the SEC. It can help determine the impact of that risk on someone’s life should the investment not go as planned.
Before we go deeper into the definition of sophisticated vs accredited investors, let’s take a look at why they’re necessary.
By default, any investment offering in the U.S. is considered a security. Securities have to go through the Securities and Exchange Commission (SEC) for approval, and that can take months or years.
To legally sell a security, a person needs to be a registered broker-dealer. This means having a license and being registered with the SEC. Any investment itself would also need to be registered.
While Real Estate doesn’t move as fast as something like day trading, most transactions don’t have the time to go through the lengthy and expensive SEC approval process. Also, the sponsors of most syndications do not have a broker-dealer license.
So, for the majority of sponsors like me, we need another way of doing things — and that means looking for exemptions.
Exemptions are detailed in the SEC code which provides rules that an offering can follow to not be considered a security. An extremely popular exemption used by real estate investment syndicators falls under the SEC’s Regulation D.
There are a few subsections under Regulation D, and most syndications comply with either 506(b) or 506(c):
- 506(b) is for accredited investors and up to 35 sophisticated investors.
- 506(c) is for accredited investors only.
Following the SEC’s rules means it becomes perfectly legal to have private offerings since they are not considered to be securities.
The Difference Between An Accredited Investor vs Sophisticated Investor
For such an important matter — investments are serious business, after all — you’d think the definitions of these terms would be crystal clear. But in fact, only accredited investors are well defined, so let’s look at that category first.
To be considered an accredited investor, you must meet one of these criteria:
- an individual with a net worth (can include a spouse) of more than $1 million, excluding their primary residence.
- someone who in each of the last 2 years has had an individual income in excess of $200,000 — or a joint income (with a spouse) in excess of $300,000 — and who reasonably expects to continute to reach that income level.
As of August 2020, the SEC also defined measures of professional knowledge, experience, or certifications in addition to the tests for income or net worth.
What counts for being a sophisticated investor isn’t as well defined.
Sophisticated investors are deemed to be those people 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.
One person’s view of “sufficient knowledge and experience” might differ from another’s, which is why I say it isn’t as well defined.
Also, unlike an accredited investor, the SEC does not have financial thresholds for someone to qualify as being sophisticated.
This doesn’t mean that simply anyone counts as being sophisticated. The SEC wants the investor to be able to understand the investment, how to evaluate it, and the risks involved.
In my business, I determine sophisticated status through conversations with investors. For example, if I were dealing with you, I might ask the following questions:
- How many deals have you been involved in before?
- Have you ever been in a deal that’s lost money? (It’s happened to everyone at one time or another.)
- Do you know there’s no guarantee that a deal will generate a profit?
Depending on the answers to these and other questions, I can be confident (or not!) that the investor is sophisticated.
And even though these questions are all covered in documents that my investors sign, I still want to know that they know this beforehand.
Details On 506(b) and 506(c) Offerings
OK, now that you know a little bit more about accredited investors vs sophisticated investors, it’s time to look at the types of deals they’re allowed to get involved in.
506(b) offerings are open to both accredited and up to 35 sophisticated investors. However, a 506(b) offering can be offered only to people who have a pre-existing and substantive relationship with the sponsor.
- pre-existing: if a sponsor has a deal under contract, they can’t simply meet someone for the first time and in that same moment offer the investment. They have to have met the person prior to getting the property under contract.
- substantive: the sponsor can’t just meet the person at a crowded networking event, receive their card, and start emailing them deals. They need to follow up with that person, get to know them, understand their financial situation, and learn about their investment goals and risk tolerance.
A 506(c) offering can be offered only to accredited investors.
The investor’s accredited status needs to be verified. This is usually done by a third party such as a CPA or attorney. The trade-off here is that a 506(c) offering can be advertised because a pre-existing, substantive relationship is not required.
That means that a 506(c) offering could be presented to someone immediately when a sponsor meets them.
Are Certain Deals Safer?
One might wonder: If everyone’s an accredited investor, is a 506(c) offering a safer bet? You’re dealing with accredited people, right?
The exemption an offer is using has no effect on the level of risk in the deal. We don’t make sure that the wealthiest people get access to some kind of deal that’s guaranteed to work and leave the less solid deals for the 506(b) offerings. In this respect, all deals are treated the same way.
The Deals I Prefer
As a deal sponsor, I prefer 506(b) offerings. It means I need to get to know the people I’m dealing with and develop a substantive relationship with them (not just getting their business card at a networking event). That’s important to me.
Also, the ability to allow up to 35 sophisticated people in on 506(b) deals helps to level out the playing field, and that’s important to me too. I’ll talk more about this “democratization of wealth” in a future article.
When people join the Picheny Investors Club, I spend time getting to know them, understanding who I’m helping, and making sure that we’re a good fit for each other. I want to personally ensure that each investor understands the risks before they take part in my real estate investments.
But I don’t do that only for sophisticated investors. To be clear, everyone in the Picheny Investors Club is vetted by me, even people who are accredited. It’s essential for me to be comfortable that I’m dealing with the right people, regardless of how much money they have.
So Many Rules — Do They Really Matter?
No one ever says, “let’s have more bureaucracy!” But it makes sense that there are checks and safeguards whenever financial deals are involved.
Knowing that rules are in place means I get to see people’s integrity in action. It’s a big red flag when people bend the rules.
If someone’s going to bend the rules, what else will they bend on that you don’t know about? Maybe something in the underwriting? How about the exit cap rate? Or the rental growth? If someone’s playing fast and loose, there’s more risk — and I’m not here to gamble like that.
Integrity matters to me and I do deals that have the best chance of working by ensuring I work with the right people.
Am I willing to turn a deal down if I don’t have 100% trust in the people I’m partnering with? You bet!
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