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WHAT IS A TENANT-IN-COMMON (TIC)?
“A form of vesting title to property owned by any two individuals in undivided fractional interests. These fractional interests may be unequal in quantity or duration and may arise at different times. Each tenant in common owns a share of the property, is entitled to a comparable portion of the income from the property and must bear equivalent share of expenses. Each co-tenant may sell, lease or will his/her heir that share of the property belonging to him/her.”
When an exchanger wishes to complete a §1031 exchange, but does not want to exchange into another management intensive property, one option available is for the exchanger to invest in a portion of a professionally managed, institutional grade property along with several other investors. This is an investment structure called “Tenant in Common” or TIC. Tenant-in-Common is a form of holding title to real estate that allows investors to own an undivided interest in property, and thus, if structured properly, satisfy the §1031 requirement for “like-kind” property to be exchanged. As the above definition states, each co-tenant owns an undivided fractional interest in the property and is entitled to their prorata share of the income, expenses, tax shelter, and appreciation.
Advantages of Undivided Tenants In Common Interest Ownership
It is often difficult in the short 45 day time frame to locate a property that has the right purchase price and debt ratio to meet the §1031 requirements, can be closed in a timely manner, and arrange for any financing that may be required. A Tenants In Common ownership interest has a number of advantages, such as:
- Flexible size to match your needs
- Pre-arranged financing
- No management hassles
- Potential increased after tax cash flow
- Economies of scale
- Can be identified & closed in a timely manner
- Investment can often be diversified into more than one property
How will a Tenants In Common §1031 Exchange benefit you?
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You may own management-intensive real estate. Although you are comfortable with real estate investments and have had good returns on real estate in the past, you do not like the daily headaches that can accompany real estate management.
You are ready to give up the hassles of dealing with tenants, maintaining facilities, paying property taxes, etc. You would like to sell your property but are faced with onerous tax consequences on the sale. You'd rather enjoy the income from the property and let someone else manage it.
Similarly, business owners are often told that owning the real estate leased by their company can be a wealth creation tool but at the outset, little attention is paid to the eventual exit strategy.
If the real estate is sold along with the business, deferring the capital gains tax may make a §1031 exchange an attractive option. But, what if the business continues to lease the real estate subsequent to the sale? It may not be prudent to remain the landlord for a business you no longer control.
In either case, with a TIC §1031 Exchange into an “institutional grade” property,, you no longer have to feel burdened by your real estate. Through your management contract, a manager will be retained to manage the asset while you enjoy all the benefits of income property ownership - with no active management duties.
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With a TIC §1031 Exchange, you no longer have to feel burdened by your real estate. Through your management contract, a manager will be retained to manage the asset while you enjoy all the benefits of income property ownership - with no active management duties.
Your income from the replacement property may be higher than what was being received from the original property. You can potentially earn cash flow that may be up to 60% sheltered by the depreciation of your new basis in your TIC purchase.
As with any §1031 exchange, the recapture of depreciation can be avoided and no capital gains taxes may be due until the replacement property is eventually sold. If you pass away while owning a property, your heirs will receive a stepped up basis, and the capital gains tax will be completely avoided
Suitability
On the first few pages of each Private Placement Memorandum (PPM) is the “Who May Invest” section in which the suitability requirements of investors is detailed. The vast majority of offerings are to accredited investors only. In a nutshell, this means that the investor must be sophisticated and meet certain financial criteria. The definition of "Accredited" is complex but here is a summary:
- Investor is an Individual: Investor must meet one of the following
- Have $1,000,000 net worth or more (can include house)
- Have had income of $200,000 for each of the past 2 years with a reasonable expectation of reaching it the next year
- Investor is an entity such as an LLC, Partnership, or Corporation: Investor (entity) must meet one of the following
- Have assets of at least $5,000,000
- If assets below $5,000,000 then EACH of the owners of the entity must be accredited as individuals. (Note that it does not matter how small an interest each owner has, they still must be accredited. It also does not matter how much money the General Partner or Managing Member has)
If the investor takes another form, such as a trust, etc., refer to the “Who May Invest” section of the PPM.
IRA's & Pension Plans
Investing in Real Estate in Your Retirement Plan
With lower interest rates on fixed-income investments and a volatile stock market, many individuals and companies are seeking alternative investments for their retirement plans. You may want to consider a TIC interest in debt-free real estate for your IRA, Keogh, Profit Sharing, Money Purchase or Defined Benefit Plan.
Most custodians for IRA accounts do not allow direct ownership of real estate or mortgages as an investment alternative. Most likely, you would need to do a tax-free trustee-to-trustee transfer of your IRA to a self-directed IRA account. Even if you think you have a self-directed IRA you probably don't! Your self-direction is almost certainly limited to investments the sponsoring custodian offers.
Self-direction of retirement plan investments means that you decide on the investments you wish to make in your retirement plan. Truly self-directed plans permit you to direct the trustee or custodian of your IRA or Keogh plan to make any investment permitted by law. In a self-directed retirement plan, you can allocate your funds between stocks, bonds, certificates of deposit, mutual funds, annuities, and real estate--all in one account. To receive information on custodians of self-directed retirement plans, please
E-mail your request.
TIC STRUCTURE
There are several aspects to the TIC structure that require a closer look:
Special Purpose Entity (SPE)
One thing that you will notice about the ownership structure is that there are no individual investors listed as owners. This is because when a real estate owner exchanges into a TIC structured replacement property, they are often required to form a Special Purpose Entity (SPE), often in the form of a bankrupt remote single-member limited liability company, to purchase and own the TIC interest. This entity provides an extra layer of liability protection for the individual, the other co-owners and the lender.
Tenant-in-Common Agreement
TIC structured offerings are formed with an in-place TIC Agreement. This agreement describes the relationship between the investor and all of the other TIC owners. The rights and obligations of the Tenants-in-Common are governed by this agreement.
In addition to the TIC Agreement, offerings are structured with an additional document signed by each TIC owner providing the sponsor with the ability to handle the day-to-day activities of the property. Thus the TICs have little required of them in the way of management. This ability is conferred in one of two ways:
Master Lease – a variety of Tenant-in-Common structures where the TICs act as the landlord, or Master Lessor, of the property, collecting rent from the tenant, or Master Lessee, who then subleases the individual suites to the tenants in the property. With a master lease structure, the sponsor typically oversees the management of the property (leasing, collecting rents, upkeep, etc.).
Under the master lease structure, TICs are paid a fixed rent, typically, with possible annual increases. The Sponsor typically keeps all or a significant portion of the property’s cash flow over and above the master lease rent amount. At least one Sponsor sets aside this excess cash flow in a reserve account until the property is either sold or refinanced.
It should be noted that The Master Lessee may not be a credit entity but rather an entity set up specifically for this single purpose by the Sponsor. Therefore, the Master Lessee’s ongoing ability to pay the rent due to the TIC’s rests in the property’s economic performance.
Management Agreement – a variety of Tenant-in-Common structures where the TICs sign an agreement with the sponsor allowing an affiliate company of the sponsor to manage the property for a predetermined period of time, usually needing to be renewed after one year.
The TICs pay the Management Company an annual management fee. Normally, the structure is a full pass thru arrangement with the TIC owners receiving 100% of the property net operating income, after debt services.
REAL ESTATE VS. PARTNERSHIP
(FOR §1031 PURPOSES)
As a purchase of a TIC interest is the purchase of real property along-side other investors (the other TIC investors), how does it differ from a partnership? This question has been considered by the Internal Revenue Service and is of key importance. The issue boils down to this: If §1031 exchanges only work for the “like kind” exchanges of real property, then the TIC interest must be real property, but what is the difference between a partnership with a sponsor managing the property and a TIC interest with a sponsor managing the property? Since the sponsor in TIC transactions does many of the same functions that a general partner would for the limited partners, what’s the difference? If the TIC interest is a partnership, then it does not qualify for §1031 exchange since it is not like-kind.
The Rev Proc
This issue was considered in the late 1990s and into early 2002 by the IRS. While many in the industry expected or hoped the Service would provide a safe harbor for TICs, what was delivered was a bit less clear. Revenue Procedure 2002-22 was issued in March of 2002. The document has become known in the industry as “The Rev Proc”. Specifically, The Rev Proc states “This revenue procedure specifies conditions under which the Internal Revenue Service will consider a request for a ruling that an undivided fractional interest in rental real property (other than mineral property as defined in section 64) is not an interest in a business entity…”
Click here if you wish to review the full text of Rev.Proc 2002-22.
In a nutshell, The Rev Proc states that if a sponsor wishes to get a private letter ruling from the IRS to get a definitive answer for a specific offering on whether it is not a business entity (and therefore presumably real property), the sponsor must submit a bunch of information in a specific format. In addition, the structure of the offering should meet 15 points specified in section 6 of The Rev Proc.
In discussions with the authors of The Rev Proc, the authors noted that not all of the 15 points must be met. Indeed, this is borne out by the issuance of one Private Letter Ruling to AEI (a sponsor) in which not all of the 15 points were met. However, there are several that are considered very important to the Service. One is that there is no sharing of income or profits between the sponsor and the investor. If this were to occur, the Service would likely consider the offering “partnership-like”, and the exchange may be at risk in the event of an audit.
It is important to note that the IRS stated in The Rev Proc, that “…the guidelines are not intended to be substantive rules and are not to be used for audit purposes”. So it is clear that The Rev Proc is not a statement of law (since that is determined by Congress and the courts) and it also is not to be used by the IRS in conducting their audits. Despite the inherent problems with whether or not to rely upon it, The Rev Proc has become a guideline in the industry, and since its issuance, many sponsors have changed their structures in an attempt to meet as many of the 15 points as possible.
In conducting due diligence on TIC programs, investors should weigh the sponsors conformity with The Rev Proc very heavily since a deal that deviates substantially from The Rev Proc would subject the investor to their exchange possibly being disallowed by the IRS.
Legal Opinions
Sponsors have begun providing legal opinions as to whether or not a purchase of a TIC interest in a property offered under that sponsor’s offering structure would qualify for exchange under section 1031. These opinions range in “level”:
- More Likely than Not. This opinion level indicates that the law firm feels there is at least a 51% chance of the opinion being upheld if challenged in the courts.
- Should. Different law firms place different percent values on this opinion level, but a should opinion typically is considered to indicate range of probability in the minds of the law firm from a 70% to an 80% probability of being upheld in the courts, according to the authors of the opinion.
- Will. This level of opinion also varies in terms of opinion probability of being upheld, but typically ranges from 85 to 90%.
Points to consider in legal opinions also include: 1) whether the client can rely on the opinion; and 2) whether the opinion has so many qualifications and assumptions in place as to make the opinion of little or no value.
No Tax Advice
It is now clear that the issue of whether or not a TIC interest qualifies for §1031 exchange is a legal matter and is quite complicated. Therefore, it is very important that you not rely on the information presented on this Web site but rather discuss tax matters with your accountant, attorney, or other qualified person.
SECURITY VS. REAL ESTATE
(FOR SALES PURPOSES)
Since, if structured properly by the sponsor, the TIC interests are real property for tax law purposes, why can they be sold by securities reps? The answer is that the interests are, with few exceptions, considered securities for securities law purposes.
The issue of whether an investment is a security can sometimes be complex. The Securities and Exchange Commission, the Financial Industry Regulatory Authority (FINRA - Created in July 2007 through the consolidation of NASD and the member regulation, enforcement and arbitration functions of the New York Stock Exchange), state securities acts, federal law, and both federal and state cases all influence the determination of whether an interest is a security. It should be noted that both FINRA and the Division of Securities in various States have been quite clear in their opinion that the vast majority of TIC investments are a security. While a detailed discussion is beyond the scope of this presentation, one landmark case is worth discussing.
The Howey Test
In 1946, the SEC brought suit against Howey and others for selling fractional interests in an orange grove in Florida. Arguing that the interests were real property, the defendants claimed that the interests were not securities. This case provides an often-quoted “test” as to whether an investment is a security.
The “prongs” of the Howey Test are:
- An investment of money in a common enterprise.
- The investment is made with the expectation of return.
- The return is based on the entrepreneurial efforts of another.
If all 3 “prongs” are satisfied, it is quite likely that a court or regulatory body would consider the investment a security.
In a TIC investment, all three prongs of the Howey test are met since there is certainly an investment with an expectation of return. The final prong requires some more examination. Nearly all industry participants feel that the actions by sponsors, which include forming the LLC and structure of the offering, negotiating the sale price, negotiating the loan, managing the property, etc. are “entrepreneurial efforts”. Therefore, nearly all in the industry feel TICs are a security.
The Triple Net SEC Letter
One more fact also acts to clear the air as to whether TICs are a security. In 2000, Triple Net Leasing’s attorneys wrote to the SEC asking for a “no action” letter. The request letter asked the SEC to confirm that the TIC interests described in the letter are not securities and the SEC would not take action against Triple Net if they are not registered as securities. The SEC responded:
Based on the facts presented, the Division disagrees with your view that the real estate interests described in your letter are not securities within the meaning of Section 2(a)(1) of the Securities Act of 1933. As a result, the Division is unable to assure you that it would not recommend enforcement action to the Commission unless the offer and sale of the real interests are registered under the Section Act or exempt from registration.
While the letter from the SEC applies only to the specific facts in the Triple Net Leasing request letter, the letter is often quoted as strong assurances that the SEC views TIC interests as securities.
Steinhause Memo
Due to the evolving industry and entrance of new participants that may not be informed on the issues of “Security vs. Real Estate” and “Real Estate vs. Partnership”, Darryl Steinhause, of the law firm Luce Forward, has written a memo to address these issues. Mr. Steinhause is a very well respected attorney who writes memorandums and represents several sponsors in TIC and other real estate offerings. He is considered to be the inventor (at least from a legal standpoint) of the “TIC as a security” concept, having structured the first offering of this format for TMP Properties in the early 1990’s.
In his memo, Mr. Steinhause puts forth the following question:
“Is the sale of a tenant in common interest in real property offered with or taken subject to, a management contract a security (i) under applicable federal and state securities law and (ii) under applicable federal tax law?”
His answer to the above question, in part, reads as follows:
“If properly structured, a tenant in common interest will be treated as real estate under real estate law and under tax law; however, it will be treated as a security under securities law but will not be treated as a partnership or a security under tax law.”
In conclusion, Mr. Steinhause notes the following:
"We believe that the offering of tenant in common interests subject to a management contract would be considered a security under both federal and California securities law. Although arguments can be made that tenant in common interests subject to management contracts are not securities, such arguments are not persuasive. Further, the consequences of failing to comply with applicable securities regulations outweigh any potential benefit of not complying."
Real Estate Brokers
TIC sponsors have a built-in incentive to market TIC offerings through real estate brokers. After all, real estate brokers are generally involved in the sale of the relinquished property and marketing TIC offerings through those same real estate brokers would seem to be the most efficient way of identifying a prospective investor.
A conflict arises because FINRA has historically prohibited its members from paying persons, not registered as associated persons, a commission or fee derived from a securities transaction. Thus, payments that are transaction-based made by members who are registered broker/dealers to non-registered persons, including real estate agents, are prohibited under FINRA Rule 2420, "Dealing With Non-Members."
Given that real estate brokers have a long history of paying referral fees for client referrals, the FINRA rule prohibiting the payment of such fees has caused great consternation. It is unfortunate that the rule, intended to protect the investor, instead serves as a disincentive for real estate brokers with respect to making their clients aware that TICs can be a viable option for the down-leg of a §1031 transaction.
A possible solution lies with the National Association of Realtors who have been working with the SEC and other stakeholders to change that situation, and now it looks like a breakthrough may be close at hand. It should be noted that NAR’s request has been submitted in the form of an “Exemption Request” which would provide much stronger guidance from the SEC than the typical “No Action Letter.” Click here for a detailed analysis of this Exemption Request.
Unregistered TIC Offerings
It is not surprising then that a few Sponsors in the marketplace continue to sell TIC interests as real estate and do not consider them securities. An in-depth discussion of the issues that surround TIC offerings that have not been registered with the Securities and Exchange Commission (SEC) is beyond the scope of this presentation. Suffice it to say that an investor considering the merits of an unregistered TIC offering should pay particular attention to the risks outlined below.
However, it should also be noted that to our knowledge, no sponsor has been able to secure a “No Action Letter” from the SEC. So we strongly suggest that real estate agents take note. There are significant penalties that could be imposed by the SEC on those who participate in the sale of an unregistered security, including the return of equity plus statutory interest to the investor. For most real estate brokers, such a result would be a devastating, life changing event.
Participating in a securities transaction includes more than just making a sale. It also includes referring customers, introducing customers to the issuer, arranging and/or participating in meetings between customers and the issuer, or receiving a referral or finder's fee from the issuer or promoter.
As a result, the prudent real estate broker would request that the sponsor provide a legal opinion as to whether or not the SEC would respond adversely to the issue of whether that specific TIC real estate transaction involved the offering of a "security". The real estate broker should then have that opinion evaluated by their own attorney.
WHAT ARE THE BENEFITS OF A TIC?
As noted above, a Tenants In Common ownership interest has a number of advantages, including no management hassles, can be identified & closed in a timely manner and the investment can often be diversified into more than one property. Other advantages and benefits include:
Flexible Size to Match Your Needs
Each offering will have a minimum equity investment that has been determined by dividing the total equity by the maximum possible number of TIC interests. While the Rev Proc allows for a maximum of 35 co-owners, sponsors and their lenders may set lower limits, most often between ten and twenty-five. So long as the amount to be invested meets the minimum requirement, the equity reinvestment requirement of the §1031 exchange can then be matched exactly.
Pre-arranged financing
Unless the offering does not have a debt component, the financing will have been pre-arranged. Debt coverage is most often in the 55% - 65% range. Non-recourse financing is the norm but all aspects of the note should be investigated and evaluated. While no secondary market currently exists for TIC interests, the terms of the note, especially as it relates to the requirement for lender approval prior to a sale, may have a profound effect on the future liquidity of the investment.
Larger, Perhaps Institutional Grade Property
TIC’s allow an investor more choices. While you could sell your highly appreciated property and purchase another in a traditional §1031 exchange transaction, a TIC allows more options.
For example, let’s assume a person sells the four-plex they’ve owned for 15 years and in which they have equity of $400,000. Depending on the amount of debt put in place on the new property, the purchase price of the replacement property could be around a million dollars. While a million dollars is a lot of money, in the real estate world, it isn’t sufficient to allow for the purchase of a really top notch property.
In the alternative, that same $400,000 of equity could purchase a million dollar TIC interest in a $30,000,000 institutional grade property. Chances are that the $30 million dollar property would be of higher quality, have professional management and enjoy a superior tenant profile when compared to a property purchased for $1,000,000. In essence, a TIC purchase allows an investor to purchase an outright interest in a quality of building that they could not otherwise afford to purchase on their own.
Professional Management
Most of the sponsors have internal management departments, and property management services are a component of the offering. This is accomplished through the provisions of a management agreement, which can be cancelled by the TIC investors should the need arise. The size of most properties in which TIC interests are sold justify and support professional property management, thereby relieving the TIC owner of the responsibility for day-to-day involvement with tenants, vendors, etc.
Possible Increase in Cash Flow
Many investors have owned property for many years and are not earning a decent rate of return on their equity. This can be especially true after deducting the fair market value of their day-to-day management responsibilities.
Take the appreciated four-plex example. If the property were located in an area that experienced high real estate appreciation, unless rents and net income have increased along with the value, chances are the return on equity is low. It is not uncommon to see investors earning only 2% or 3% on their equity, and they often don’t even realize it.
If you wish to determine the return on equity for your current investment, simply perform the following calculation:
Cash Flow* / Equity = Return on Equity
* It is important to note that Cash Flow is defined as “the cash generated by the property after debt service and expenses (including the fair market value of your own involvement in the day-to-day management of the property) but before depreciation and taxes”.
Tenant-in-common offerings typically begin with a cash-on-cash return of approximately 7% to 8%. Of course, this is real estate, so the cash flow can fluctuate, up or down, based on many factors such as changes in tenant occupancy, expenses, market conditions, environmental issues, etc.
Tax Deferral, if Structured Properly
If the offering is structured properly and the investor’s individual circumstances and actions, such as adhering to the §1031 rules, are correct, the investor may sell their highly appreciated property and defer (not avoid) the capital gains tax, including the depreciation that has been taken that would otherwise be recaptured.
This is a strong motivation for many investors in TIC properties but you should always seek the guidance of a qualified attorney, accountant and/or other advisor before proceeding.
More Money at Work
If an investor exchanges into a TIC using section 1031 to defer capital gains tax, the amount of the deferred tax is then put to work in the replacement property. With more money invested, rather than being paid to Uncle Sam, the cash-on-cash return noted above will be applied to a larger equity investment.
WHAT ARE THE NEGATIVES OR RISKS ASSOCIATED WITH A TIC?
Risks are addressed in each private placement memorandum (PPM) and should be reviewed by the investor. However, here are some general issues related to many TIC formats.
More Expensive than Traditional Transactions
Sponsors purchase properties and then mark them up to cover costs and make some money and then sell them through the security industry's broker-dealer community to investors. The markup or load factor is typically around 12% but can range much higher. This markup covers various costs such as:
- Loan Points
- Legal Fees
- Appraisal, Property Condition, Environmental, and other reports
- Fees to the Sponsor
- Commissions to Broker/Dealers
- Closing Costs
- Organization and Offering Costs
Some of these costs would be paid in any real estate transaction involving a loan while other fees are as a result of the TIC structure and marketing through broker-dealers. Based on the studies performed by at least one broker-dealer, the additional expenses of a TIC over a traditional real estate transaction amount to between 6 and 7% or so. Since a premium is being paid, the product may not be right for all investors. However, if an investor feels the benefits of a TIC investment are worth the premium and the investment is otherwise suitable, a TIC investment may be right.
Liquidity Issues
Since tenant in common is a form of ownership that requires unanimous approval to take a major action such as a re-finance or sale, getting that unanimity may be difficult when 10 or 20 investors are involved. Two methods are used to get the unanimous consent when a major decision is faced.
- The sponsor sends a letter to each TIC investor detailing the proposed sale or other action. If all agree, they sign the approval notice and the action takes place. The drawback to this approach is if one person is a “hold-out” and does not approve.
- To address the “hold-out” issue, many sponsors have inserted call provisions into the offering documents and tenant in common agreements. In essence, they say that if the owners of X % of the interests in the property vote yes for the proposed action, the minority interest party that is dissenting from the vote may be bought out at market value. Typical percentages range from 66 to 80%. Call provisions are specifically allowed under Revenue Procedure 2002-22, as long as they are at market.
In addition to the unanimous consent issue and how it impacts liquidity, the very nature of real property is that it often takes a while to market, sell, and close.
There is no established secondary market for TIC interests.
A prospective investor should never consider a TIC interest as anything other than a long-term hold and should understand that their money could be tied up for a long time. If liquidity is of major concern, investigating the The §1031 Exchange - §721 "UPREIT" Opportunity may prove to be of value to the investor.
Limited Control
As a part of the offering, TIC investors sign various agreements such as the management agreement or master lease and the tenant in common agreement. These agreements authorize the sponsor to control and manage the property. Thus, one TIC investor cannot assert the same control as he/she did on their relinquished property, such as hiring and firing vendors, etc. Nearly every structure in place in today’s market allows the TICs or even one TIC to fire the management company of the sponsors. However, be cautioned that sometimes the loan documents state repercussions if the manager is terminated, such as the loan accelerates (needs to be paid at once). This can make it difficult to fire the manager in some instances.
Qualification for §1031 Exchange is Not Certain
Sponsors use terms like “Rev Proc Compliant” and imply strongly that their offering qualifies for §1031 exchange. While we are aware of no instances where an exchange in a TIC has been challenged, to say it is a slam-dunk for §1031 exchange is not proper. Sponsors have spent massive amounts of money on the best legal minds in the business attempting to structure offerings that will qualify, but with no safe-harbor from the IRS on how a TIC would qualify, a successful exchange is not a 100% certainty. For more on this topic, see the Real Estate versus Partnership section above.
Capital Call Potential
Since owning a TIC interest is, by definition, owning real property, all of the benefits and burdens of real estate ownership also apply. For instance, if the property performs poorly or some problem arises, it is possible that a capital call may take place whereby the TIC owners are required to put more money into the deal or risk losing the property. For instance, if a major tenant vacates and the rent being collected goes down enough that the net operating income from the property is not enough to meet the mortgage payment, the owners will be faced with the decision to either give the property to the bank or infuse additional cash to meet the loan until a new tenant is found.
Closing
A typical model of sponsors is to tie up a property with a purchase and sale agreement and then begin preparing the offering documents, or Private Placement Memorandum (PPM). Once the PPM is completed, the offering is marketed through broker-dealers, and the property closes some time later. This model subjects the investor to some risk that the property may not close and there will be no transaction at all. This could happen for many reasons including lender issues, environmental issues, problems with paperwork, incorrect information from the sellers, etc. While no money has been lost since there was no transaction, the client may have identified the property as one of their three choices for exchange. If the client is outside of his/her 45-day identification period and the other two options will not work, the client could be subject to paying the tax.
A few sponsors close on the property before marketing it, but this is more expensive due to carrying costs and is not the norm in the market.
Non-Recourse Loans
A non-recourse loan is one in which the lender may not go after the borrower’s other assets. The lender’s security in the loan is limited to the value of the property. However, lenders have begun requiring non-recourse carve-outs or so-called “bad-boy” carve-outs. One example of a bad-boy carve-out is that a lender may require someone to sign for liability to cover the lender in the event the rents from the property are not used to pay the loan and instead are diverted. More recently, some lenders have begun requiring TICs (and sometimes the individual borrowers) to guaranty the lender against environmental issues. Thus, it is possible that the investor could be subject to liability far in excess of their original investment. Investors are strongly urged to read the PPM that discusses these areas as well as to carefully read the loan documents.
Conclusion of Pros and Cons
Like most investments, there are both pros and cons associated with TICs. The weighing of the many factors of the offering, sponsor, and most importantly, the investor’s circumstances is extremely important. TICs will not be appropriate for everyone, but will be attractive and a good solution for others.
THE TIC INDUSTRY
As was noted earlier, the TIC industry began in earnest in the late 1990’s. With the issuance of The Rev Proc in March of 2002, a large number of new sponsors, broker/dealers, and registered reps have gotten interested in the TIC marketplace. This is both good and bad. As more interest is generated, the product is improved. IRS guidance is now in place (although not a safe harbor), several deals have gone full cycle to provide examples to the industry, sponsors continue to hone their structures, and the entire marketplace is getting more sophisticated, be they sponsors, security reps, broker-dealers or investors.
However, with the rapid growth also come some negatives. The demand currently outstrips supply, which creates an environment where deals are selling out in a matter of days. Due diligence shortcuts by some broker-dealers and some sponsors, security reps, and broker-dealers still allow pre-marketing of products, even before a Private Placement Memorandum (PPM) is printed.
The market forces, in which demand is stronger than supply, have created a seller’s market where sponsors are inching up their fees. Some wonder if some sponsors might be paying too much for the real estate since they are nearly assured of selling the product.
It can only be said that the shear velocity of the TIC marketplace is daunting. In response to growth in the industry and the need for improvement and education, two groups have been formed.
Tenant in Common Association (TICA), Steve Wennerstrom, Member
TICA was officially formed in June of 2003 and is continuing to gain momentum and membership. This group is a non-profit organization that is the public relations face of the TIC industry.
Investment Program Association (IPA) 1031 Committee
This association is made up of sponsors of Direct Participation Program offerings, both public and private. Each year, two meetings of the sponsor membership are held. Select broker/dealers are also invited to attend the event. The IPA has formed a 1031 committee made up of a group of active sponsors, broker/dealers, attorneys, and due diligence professionals to address legal, regulatory, and business issues faced by the industry.
I MAY WANT TO INVEST, HOW DO I GET STARTED?
The selection of a Registered Investment Advisor is an important first step. While there are many choices, Steve Wennerstrom, in association with
Pacific West Securities, Inc.(Pacific West), is a nationally recognized leader in the TIC industry. He knows that every property exchange and investment property is unique. His team offers a complete solution for your replacement property and real estate portfolio needs.
Shanon Ford, President of Pacific West, is actively involved in both the TICA and IPA organizations. Shanon actively works to improve the industry and is a frequent speaker at national meetings of both the IPA and TICA. This allows him to be at the forefront of knowledge in the rapidly changing TIC world. Another benefit of Shanon’s active role in the industry is the opportunity to improve the practices and knowledge of the industry as a whole. Of more importance to a prospective investor is the emphasis Pacific West places on due diligence.
Due Diligence Philosophy
It is Pacific West's belief that due diligence has three key elements:
- Sponsor Character: What is the character and business repute of the sponsor? What is the track record of the sponsor? What is the adequacy of the business infrastructure of the sponsor organization? Does the sponsor employ qualified staff and attorneys?
- Structure and Disclosure: Is the program structured well in terms of fairness to the investor? Is the offering structured well from a legal and mechanical standpoint, and are the proper disclosures to the client in place: Does the disclosure document adequately state the risks associated with investing in the program? Do the agreements of the program accomplish the objectives state in the disclosure document?
- Economics: Are the program and the asset(s) behind the program set up to have a high likelihood of meeting its projections: What safeguards (reserves, etc.) are in place? Are the projections of the offering reasonable in view of the facts?
Each of the three elements of due diligence are important, and tailoring the due diligence to meet the specifics of the individual offering is very important.
In evaluating an offering, Pacific West employs various methods, depending upon the specific circumstances. In some cases, all due diligence is conducted internally by Pacific West staff.
In other cases Pacific West use the services of outside due diligence consultants. One example is Snyder Due Diligence Services, LLC. An attorney, Todd Snyder is the leader in third party due diligence. In many due diligence reviews, Snyder is engaged to conduct a review of the sponsor and/or the specific offering. He conducts on-site visits, background checks of sponsor principals, litigation searches, reads minutes, reviews financials, reviews company formation documents, reviews specific offering documents, and many other functions. When an outside due diligence consultant is used, Pacific West's own due diligence is conducted with the third party report being but a part of the overall review.
At the end of the review, the determination of whether or not to sell the product is made. It is important to note that Pacific West does not sign all offerings. In the current environment of new and multiplying sponsors, this would certainly not be prudent. Each offering must stand on its own and be reviewed individually.
Pacific West's due diligence process begins before the private placement memorandum (PPM) even arrives at their office. Most sponsors email property reports, proformas and draft PPM's before the final PPM is printed. This allows Pacific West to begin working on the offering early. Since time is critical in these offerings, they have developed a very efficient approach to due diligence.
First, a spreadsheet of over 240 lines of information and analysis is filled in using information from the PPM. By abstracting the PPM into a consistent format, they are able to analyze the offering on an "apples to apples" basis with other prior offerings and also compare it to other competitive offerings. The analysis is broken down into various components including: Offering Information, Expense Information, Property Information, and Rates and Ratios. Applying consistent analysis, in a format developed over three years, allows Pacific West's security reps to thoroughly understand the structural and economic elements of each offering.
Upon approval of the offering, the Offering Summary Report is forwarded to Steve Wennerstrom for his
use in advising clients. This report includes the spreadsheet as well as maps and aerial photos that allow an investor to get a clear idea of the location and layout of the property. When available, information regarding tenant financial condition and strength is also independently researched and included, as are third party real estate studies of the property's market area.
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