Accredited Investor vs. Sophisticated Investor
What Is the Difference between an Accredited Investor and a Sophisticated Investor?
Interested in building your wealth through savvy real estate investments? Pursuing your passion to live your life on your own terms, without being tied so tightly to a 9-to-5 job, or seeking to recession-proof your income?
Multifamily real estate syndication can be an excellent option. It offers the chance to own real property, to achieve something that would be impossible on your own, and the ability to enjoy a passive stream of income for decades to come. However, it does not come without a few caveats – things that you need to know in order to make the most of this investment opportunity. One of those is that you need to work with other investors.
Of course, smart partnerships are essential here. A misstep, a single missed vetting session, and you could be in a world of trouble. For those considering multifamily real estate syndication, it’s vital to know the difference between the various types of investors out there, particularly an accredited investor and a sophisticated investor.
The Role of Investors in Real Estate Syndication
Real estate syndication is different from buying into a real estate investment trust (REIT). With an REIT, you invest money into a trust that then purchases real estate. You own a share of the company doing the investing. With real estate syndication, that’s not the case. You own an actual share of the property itself – real property. As such, there is a difference in the players within syndication, including the role played by investors, or limited partners as they are sometimes called.
There are three general parties in the syndication setup. One is the sponsor (or KP - key principle) – this is the person who helms the investment initiative, and who is usually responsible for locating the market where the investment will take place, as well as for underwriting the property and for handling all the administrative issues.
Then, there is the property management group. This group handles day to day operations of the property, including maintenance, securing or removing tenants and the like. They also handle unit renovations, unit marketing and more.
Finally, there are the investors. With real estate syndication, investors are individuals who provide the funding to make the investment in the first place. Often, there is a requirement from the sponsor that the investors be accredited.
So, what is an accredited investor? How might these individuals differ from a sophisticated investor?
Accredited Investors vs. Sophisticated Investors
When it comes to buying into real estate investments, you’ll find that the SEC has a lot of control. The term “accredited investor” was coined by that government agency, which sets the following definition:
- An individual who has “earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years and reasonably expects the same for the current year, or,
- Has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence).
The SEC goes on to say that an accredited investor might not actually be an individual. It can also be a trust, a bank, a partnership, or a nonprofit depending on the situation.
The reason that this definition is important is that the SEC requires individuals to meet these baseline requirements in order to take advantage of certain securities offerings that are exempt from SEC registration requirements.
So, what, then, is a sophisticated investor? Again, we turn to the SEC. The SEC requires that these investors, “have enough knowledge and experience in business matters to evaluate the risks and merits of an investment,” according to Market Watch. Both sophisticated investors and accredited investors are related, but accreditation is a more restrictive designation than sophistication. With that being said, “accredited” status stems from what is today a relatively low net worth, as the values were set in the 1980s when $200,000 per year was much more of an achievement.
This is an important dividing line between the two designations. Because, while related, they are different. Yes, the SEC requires that a sophisticated investor have the knowledge and experience necessary to navigate their way through the world of investments on their own, but that does not always mean that they exercise that knowledge. Often, they trust in their brokers to steer them straight, and suffer the penalty, as noted by US News and World Report.
Muddying the Waters
There’s a lot of variance between the definitions applied to the word “sophistication”. As mentioned, as an investor class, the SEC’s definition places accredited investors higher than sophisticated investors. However, the SEC itself notes that accredited investors can be led by “sophisticated persons”, in the case of a trust, bank, nonprofit, or other non-individual sense of the word “investor”.
So, how does this affect your own real estate syndication efforts?
A lot of the impact will vary depending on which party you represent. For instance, if you are an investor only, then you want to make sure that the sponsor focuses on attracting other accredited investors. If you are the sponsor of the syndication, you should avoid sophisticated investors for the most part, and focus on attracting accredited investors instead.
There is no guaranteed way to ensure that passive real estate investors have the knowledge and experience necessary to be valuable additions to your strategy. However, focusing primarily on accredited investors is a good place to begin.
Source:
https://www.sec.gov/fast-answers/answers-rule506htm.html
https://www.marketwatch.com/story/definition-of-sophisticated-investor-varies-2010-04-26
https://www.sec.gov/files/ib_accreditedinvestors.pdf
https://www.investopedia.com/terms/a/accreditedinvestor.asp
https://www.investopedia.com/terms/s/sophisticatedinvestor.asp
https://www.biggerpockets.com/blogs/10191/68640-what-is-apartment-syndication
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