Over the past five years, tenant-in-common (TIC) offerings have become an accepted form of structured investment for like-kind exchange investors. In 2006 and 2007, well over $5 billion in real estate investor equity has been placed in such structures, representing more than $10 billion per year in total deal size. Although the majority of the investors are west of Mississippi, each year produces more TIC investors in the Northeast.
The characteristics of a TIC offering are fairly simple. A real estate company, or “sponsor,” conducts a securities private placement offering to accredited investors, which makes available to up to 35 of such investors a fractional interest in a designated piece of real estate. They are not partners in a partnership, but a loosely affiliated group of direct investors in a piece of real estate. Each investor receives a deed of his undivided interest and signs the mortgage on a non-recourse basis. Properly structured under Revenue Procedure 2002-22, a TIC offering allows investors to qualify for like-kind exchange treatment through buying a small percentage of a larger piece of real estate than they could buy if they simply purchased a replacement property by themselves.
Has the TIC offering proved to be a desirable and reliable investment vehicle? The answer is a resounding yes. Since the Revenue Procedure was published by the IRS in 2002, some $20 billion in investor equity has been placed in TIC investments through more than 1,000 offerings and involving more than 20,000 investors. The investors typically are baby-boomers entering their 60s who no longer want to be involved in speculative real estate investments or real estate that they have to actively manage. They have capital gains realized from the sale of appreciated real estate, and they want to defer the resulting capital gains taxes until the taxes are actually eliminated for their heirs by the step up in basis upon their death. They are looking for passive, secure, cash-flowing real estate investments.
Because of the restrictions of the procedure and the nature of TIC investors, TIC offerings to date have been conservative, low-risk investments. The properties typically are stabilized income properties, such as multifamily, fully leased suburban office or grocery-anchored retail, which, with low leverage (typically 50 percent to 60 percent of the fully loaded acquisition price) produce an initial cash return to investors ranging from 6 percent to 8 percent, and a projected IRR on disposition in the low double digits.
Given the conservative structure, most TIC offerings have performed exactly as projected or better. Although accurate statistics are difficult to find in this “private placement” environment, it appears that the vast majority of TIC offerings are performing at or above projections and only a handful of those that are below are sufficiently below to raise the specter of foreclosure by the lender.
The good track record of TIC offerings must be attributed in part to the positive commercial real estate market generally from 2002-2006. 2007 has been, and 2008 projects to be, more challenging. More TIC offerings, though still a low percentage, have become distressed. The most telling effect of the current market conditions is a slowdown of the pace of growth of the TIC industry, partly because fewer potential investors are selling appreciated real estate, and partly because more costly and restrictive debt terms have squeezed margins too thin for TIC sponsors. The slowdown does not appear to be based on investor concerns about the viability of TIC investments.
One restraining factor on the growth of the TIC industry has always been investor concern that even if a workout was unlikely, if the worst came true and a workout was required it would be exceptionally difficult to produce a successful resolution given the involvement of so many different “stakeholders,” including lenders, sponsors, master lessees, property managers, broker dealers, registered securities representatives and up to 35 accredited investors. The most pressing concern relates to the fact that the 35 investors who own the property presumably do not otherwise know each other or even know how to reach each other. Coupled with that are the restrictions in the TIC agreement the investors all sign at closing, which require a majority or even unanimous decision by the investors before taking such critical actions as renegotiating or replacing the debt, replacing the property manager, triggering capital calls or selling the property.
All of this seems ominous and potentially a serious impediment to the otherwise increasing acceptance of TIC investments. However, now that we are starting to have some real-world experience with a few TIC workouts, the challenges have generally proved manageable. If a few simple guidelines are followed TIC workouts do not have to be more difficult than any other commercial real estate workout. Some recommendations include:
• Communication. At the first sign of trouble, TICs must start communicating. This can usually be coordinated by the sponsor/master lessee or by the managing broker dealer. It may be impractical if the sponsor/master lessee is incompetent, dishonest or in bankruptcy, or if there was no managing broker dealer. Experience suggests that it is unusual for all of those conditions to exist, and that the problem that needs to be worked out is generally some unexpected event such as the loss of a tenant rather than, for example, misappropriation by the master lessee. There also typically is a managing broker dealer. At the first sign of declining performance, some or all of the tenants should insist on the creation of an e-mail mechanism that allows them to communicate with each other as well as the sponsor/master lessee and the managing broker dealer.
• Improved reporting. During any period of underperformance, the frequency and depth of property-level reporting must be increased and generated in a transparent manner.
• Delegation of authority. If the situation becomes more serious, the TICs must delegate authority to a small group, ideally no more than three, who, pursuant to powers of attorney, can take all actions on behalf of investors other than those actions where the authority must be exercised by the TICs themselves.
• Hire experienced advisors. The situation may require hiring legal counsel experienced in TIC offerings and workouts. A group of investors will need to raise a retainer. There typically are mechanisms in the TIC agreement allowing those who contribute to recover from those who don’t.
• Remove the master lessee. If the master lessee is incompetent, dishonest or distracted by other circumstances, it may be necessary to terminate the master lease or arrange for its assignment to another TIC sponsor. Any change in the status of the master lease or the identity of the master lessee without the lender’s consent may trigger an event of default.
• Stay close the lenders and the tenants. It is critical that the confidence of the lender and any tenants be maintained.
• Be patient. Take necessary actions but do not force the action out of fear of inaction. Real estate moves in cycles. If you hunker down, keep the lender current and the tenants happy, make decisions on a timely basis, are careful to maintain the integrity of the structure so the like-kind exchange benefits are not compromised, and wait for the market to bounce back, a big problem can turn into a minor annoyance.
TIC offerings are here to stay. Because of their conservative nature, it is unlikely that there will be a material increase in workouts or that any substantial portion of the workouts that does crop up will turn into a catastrophe.
