COVER STORY, OCTOBER 2004

TIC INVESTMENTS SWELL WITH INVESTOR INTEREST
Faron G. Thompson

Thompson

Individual real estate investors are riding a new wave of investments. TIC investments, or tenant-in-common ownerships, are becoming an increasingly popular choice among investors seeking replacement property for their 1031 tax-free exchanges. A typical TIC investment in real estate involves a number of individuals, each with as little as a few hundred thousand dollars of capital gains from a sale of a property to invest. Through a TIC promoter, these individuals are able to pool their money and buy a larger commercial property, realizing the tax advantage afforded by a 1031 like-kind exchange.

While TIC investments have their advantages and disadvantages, a clear dilemma is emerging, as the lending community has not yet gotten on board. While TICs are building momentum on the real estate front, lenders are responding slowly to finance these types of investments.

The growth of this area is significant. According to Omni Brokerage Inc., which tracks the TIC industry and its sponsors, the marketplace has grown from placing $167 million in pure (no limited liability company monies included) TIC equity in 2001 to a projected $2 billion in 2004.

Some lenders fear that TIC deals are the 1980s version of syndicators, which paid top dollar, often more than the properties were worth. Investors were more motivated by the tax consequences of sheltering capital gains from income taxes than the performance of the property. This activity contributed to the downfall of the real estate market in the late ‘80s and no one wants to repeat that scenario.

For property owners looking to sell, TIC buyers will likely be some of the highest priced buyers out there. But the owner should be aware that the TIC buyers are not easily financed. At the Mortgage Bankers Association’s Commercial Real Estate/Multifamily Finance Board of Governors’ Meeting in February 2004, it was reported that some lenders and special servicers/ investors are very opposed to TICs.

“Freddie Mac has not yet gotten comfortable with syndicated TIC structures primarily because of the bankruptcy issues, but also due to some of the variables surrounding the management of the property, the cumbersome nature of the borrower structure and the economics of the tax motivated transactions,” said Michael Meers, southeastern regional director for Freddie Mac.

TIC advocates claim that these properties offer huge advantages by allowing investors to invest in substantial, institutional-grade properties through a tax-free exchange. Since investors are freed from the management issues, they feel a price should be paid. They say investors are paying retail for these institutional properties, which are marked up by the intermediate parties, but everyone makes some money in the process.

Generally, the individuals involved in a typical TIC investment are unknown to each other. And this makes it more difficult for some lenders.

According to Meers, "Freddie Mac has worked with limited tenants-in-common structures in the past where there are relatively few TIC borrowers, where there is some commonality among the parties, and where we believe that the borrowers are experienced and capable owner-operators of multifamily property.”

In 2002, the Internal Revenue Service set out 15 requirements for TIC transactions. When these guidelines came out, TIC deals began to take off. While it is a highly regulated business, it offers a new emerging market, which isn’t found very often in real estate.

“These guidelines have opened up the 1031 market and provided smaller investors with the opportunity to exchange into investment grade real estate,” said Alan Vaughn, partner of the southeastern regional accounting firm Habif, Arogeti & Wynne, LLP.

Last summer, the $148 million Puente Hills Mall in City of Industry, California, was cited as the largest acquisition made by a TIC group to date. It was positioned as a model for individual investors to compete for major pieces of commercial real estate. Thirty-two individuals pooled $56 million in a TIC structure and Greenwich Capital committed a $92 million, 5-year CMBS loan.

Greenwich was the only CMBS lender to pursue the deal, and the $92 million loan would rank as the largest loan in the CMBS securitization pool that Greenwich was assembling. Had problems arose with the unusually large TIC loan, Greenwich would have split the loan in two and sold one of the notes outside the pool at a higher interest rate, although at a lower profit for Greenwich. However, the rating agencies and GMAC accepted the full loan for the pool and the acquisition was made.

Investing in a TIC comes with a cost, stated Vaughn, and that cost is a loss of control. The individual owner has absolute control over all decisions, while in a TIC, all owners must agree on major decisions.

“Investors should be careful about focusing only on the tax deferral aspects of an exchange. With capital gain tax rates at today's low levels, in some cases it may make more sense to pay the taxes rather than overpaying for the real estate,” said Vaughn.

There are some firm guidelines with TIC exchanges. The co-owners cannot exceed 35 and the exchange must be set up in the proper business format (LLCs have been the most successful). Investors must be certain the exchange qualifies for the tax deferral. And unless the exchange obtains a private letter ruling from the IRS, its tax status is not certain.

“We are going to see more large deals going forward as larger properties become available,” said Marc Goldstein, principal with Creekstone Companies, a TIC sponsor in Houston, Texas. “The challenge will be that investors have only 45 days to identify their 1031 property and 180 days to complete their transaction, and there is a finite number of investors with $1 million or greater to invest in these large deals.”

Goldstein adds that many investors don’t have that many gross dollars to invest or they want to diversify into more than one deal. Typically they collect $400,000 to $800,000 per investor and are currently filling two to five deals at any one time.

At the TIC Real Estate Symposium in March 2004, attendees didn’t agree on the loans involved in TIC transactions, which in most cases are sold through the CMBS market. It was stated that the goals of the lenders are much different than the goals of the investor and the sponsor. One lender said that TICs want it both ways — they want the ownership of real estate, but they don’t want the responsibilities of real estate.

The IRS recently issued a ruling on the tax treatment of a Delaware Statutory Trust (DST), which enables TICs to be more easily financed. However, the circumstances are narrow, for use only with triple-net leased property and certain master leases. But if a DST can be used, it protects the lender against serial bankruptcy.

“Prospectively, the Delaware Statutory Trust structure may help manage the bankruptcy risks of TICs, but the other risks remain and will need to be assessed on a case basis, including reaching a comfort level with the asset and property management experience of the TIC syndicator," said Meers.

From a lender’s perspective, the issue continues to be that while investors have their names on the title, they claim to be passive investors and don’t have control over issues such as negligence or mismanagement of the property. The investors say they cannot be held responsible. So who is the actual borrower? And where does that leave the lender?

These issues and more will need to be hammered out among the sponsors, financial planners and lenders in the coming months and years. As the industry continues to grow, it will become necessary for the parties to achieve a balance between investor and lender risk.

Faron G. Thompson is managing director of Primary Capital Advisors, a real estate finance firm headquartered in Atlanta specializing in income property debt, equity, and investment sales.


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