FEATURE ARTICLE, NOVEMBER 2005

SUPPLY AND DEMAND
Can the TIC boom sustain the number of sponsors?
Charles “Duke” Runnels

Runnels

As a result of the burst of popularity, the TIC industry is satisfying the needs of about 5 percent of the total 1031 exchange demand currently. Industry sources predict that the total amount of TIC investments for 2005 could top $12 billion, with about $4 billion in equity attributed to securitized TICs. That is a sliver of where the industry should be, given that this solution delivers institutional quality investment performance to individual investors. Glen Esnard, vice president of real estate for FORT Properties, a Los Angeles-based provider of TICs, predicts that the industry could viably grow more than double its size to $25 billion in 2006.

Growing Pains

Clearly, the TIC industry is in the midst of a growth spurt, one that is expected to continue for many months to come at the very least. However, just as more and more investors are entering the TIC investment arena, so are the private providers, known as TIC sponsors. In fact, the number of securitized TICs (sponsors that sell TICs as securities in accordance with SEC regulations), is now hovering around 60-plus. This is about six times the amount of sponsors in 2001. That doesn't account for the potentially hundreds more that are non-securitized TIC sponsors.

The question going into 2006 is not whether the TIC boom will continue. The question is whether the boom can sustain the ever-growing number of sponsors entering the market. After all, the greatest challenge for TIC sponsors is competing with other capital sources such as pension funds, REITs, advisors and other TICs for quality real estate product. Because real estate continues to be an outstanding hedge against inflation, institutional investors (such as retirement funds) are increasing their real estate holdings. Real estate tends to be a very diverse investment — offering not only regional diversity but diversity in product type — increasing its reputation as a safer investment option. Institutional investors are very interested in safety due to the uncertain interest rate environment and world political instability.

Simply put, the market appetite for institutional type property (investor demand) has driven prices so high that the available supply of real estate at reasonable prices has become very limited. In fact, many sponsors have a waiting list of investors and this demand continues to grow. There just is not enough quality product with attractive returns around for many of the TIC sponsors to meet the needs of all their investors. Therefore, the “consolidation” of TIC sponsors may begin as early as 2006 since the ability to compete on the acquisition side of the equation has become more difficult with the number of competitors and larger, institutional players expressing their desire to enter the market as well.

Esnard, who is responsible for property acquisition for FORT Properties, agrees that the biggest challenge for his firm and TIC sponsors as a whole is obtaining property that meets their strict criteria. “With each institutional quality property that we identify, there is more competition to buy than the deal before it,” explains Esnard. “Sellers hold all the power and as a result they have become very selective when choosing a buyer. They want a buyer with cash in hand and in many cases will only work with TIC sponsors who are ‘institutional' in their approach to acquisition — two factors that gratefully have given us an edge when we come to the table.”

Forced to Exit

There are three market forces at work that could cause consolidation in the TIC sector. The first market force is competition to acquire new product as previously stated. The second market force that may push some TIC sponsors out of contention is the certainty of close. This is an issue that is continuing to rear its head with sellers, frequently in a derogatory tone in reference to selling to TIC sponsors. Many sellers have simply had bad experiences with long transaction timeframes and the need to raise capital during the transaction. This often results in a higher failure rate than other buyer types. TIC sponsors that want to stick around for the long term will need to come to the table with the capability to execute under the same tight structures that other institutional buyers commonly utilize. In a competitive market, if a TIC sponsor cannot go non-refundable in two weeks and close in 20 to 30 days, they will find themselves off the list of acceptable buyers for quality real estate, and ultimately out of business.

The third market force at work is the real estate market itself. Cap rate compression has made everyone a hero for the last several years. In fact, for the last 5 years, asset performance has had a negative impact on value across the investment landscape while virtually all valuation gain has been from cap rate compression brought on by the favorable interest rates. If the future provides stable or rising cap rates and marginal improvement in rental rates and market vacancy rates, many real estate assets, including those being sold under TIC programs, will fail to perform as the investors anticipate. Given some of the aggressive exit pricing found in PPM's developed by several sponsors, it is likely that TIC investors will experience loss of equity in those offerings. While pension funds and REITs have the ability to balance a non-performing asset with others that perform according to expectation, many TIC investors have a significant percentage of their personal wealth in individual assets. TIC asset failures will be less forgiving of the sponsor and much noisier in their resolution. Any sponsor with more than a very small handful of problem assets will soon be out of the game.

Charles Runnels is president and CEO of Los Angeles-based FORT Properties, Inc.


©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.