Commercial: Has Time Run Out?

Sales of tenant-in-common interests have plummeted, but don't count the securitized real estate industry out just yet.

Once the darling of commercial real estate, tenant-in-common interests have seen a sizeable decline in dollar volume over the past several years. Between 2007 and 2008, the total equity of TIC offerings fell by 56 percent to $1.24 billion, according to Omni Real Estate Services LLC in Sandy, Utah. Equity dropped another 85 percent in the first two quarters of 2009, compared with the year earlier, the latest data show.

TICs are so out of favor that the former Tenant-in-Common Association in June changed its name to the Real Estate Investment Securities Association, reflecting the wider spectrum of real estate securities-including REITs and mutual funds-that its members now offer, says President-elect Renee Brown.

There will always be a demand for a vehicle that will let small investors pool their assets in a large, professionally managed property, but I don't think that syndication will be done through a TIC structure. That train has left the station, says Michael Houge, CCIM, SIOR, CEO of the Chief Real Estate Cos. in Minneapolis, who completed $100 million in TIC transactions in the early 2000s with his former company.

While not all industry insiders agree that the days of TICs are over, most say that the TIC industry of the future will be smaller, with lower fees for sponsors and a greater emphasis on due diligence by investors.

Falling Along With the Market

So why have TICs lost their luster? To a great extent, the falling prices that have slowed commercial deal volume across the board are translating down to securitized real estate, says Randy Beckman, executive vice president of Grubb & Ellis Securities Inc. in Santa Ana, Calif.

TICs also face some unique challenges in the current environment of tight financing, says Richard Lipton, a partner at the law firm of Baker & McKenzie LLP in Chicago. TICs do very well in an up market, but [because of the large number of individual owners] they don't provide an easy means of raising new capital. If a TIC investment needs extra cash to offset vacancies or pay for tenant build-out, cash calls to investors are often the only option.

Refinancing also is difficult because many deals were originally financed through commercial mortgage-backed securities-the most frozen part of the financial sector. Recent Treasury discussions about how to make it easier for borrowers to restructure CMBS loans could provide a boost to TICs, Beckman says, but the market hasn't responded as of yet.

Another inherent challenge of TIC-owned properties is that you need a unanimous decision from all owners before a new strategy can be implemented. The one piece of advice I'd give TIC investors, regardless of how their investment is performing: Make contact with all your co-owners and have a contingency plan if the need arises, says Lou Weller, a principal with Deloitte Tax LLP and national director of real estate tax transaction planning. That plan should include a formula for converting the ownership structure to other types of securitized investments.

Turning to TIC Alternatives

These days, what action there is in the securitized real estate industry is mostly focused on private REITs and limited liability partnerships or corporations. An LLC creates a single point of management and makes it possible to infuse new capital into a struggling property by bringing in preferred investors, Lipton says. We're advising the sponsors of TIC investments to give serious consideration to working with investors to roll the TIC up into an LLC, he says.

The REIT exit strategy for TICs uses an UP-REIT structure, popular with loan-challenged developers in the early 1990s. In this umbrella partnership REIT, investors contribute a property to a partnership controlled by the REIT and in exchange receive operating partnership units. These units can be converted to stock in the REIT at a later date, although the conversion will trigger tax liability.

Collapsing TIC investments into a single bargaining unit such as a REIT provides access to capital markets beyond mortgage lenders and gives investors more property diversification, says Duane Lund, CEO of The Geneva Organization in Minneapolis. Otherwise, single property investors often have to time the sale to the loan due date. Lund's company recently launched a private UPREIT as an exit strategy for several hundred of its 1031 investor clients to transition from TICs into a private REIT.

The downside is that most alternatives to TICs, including partnership shares of an LLC, can't be used for a 1031 exchange.

One TIC alternative that does preserve the 1031 option is an increasingly popular securities product known as the Delaware Statutory Trust. Unlike TICs, management of a DST's properties is done by a trustee, who may also be the sponsor. Giving lenders only one name on the loan document makes them more willing to lend for initial property acquisition, says Grant Conness, president of 1031 Alternatives Group in Boca Raton, Fla.

DSTs also are appealing because each trust can have a larger number of investors than TICs-up to 499, compared with 35 for TICs, says Leslie Pappas, CCIM, CEO of Archer Investment Advisors in Indian Rocks Beach, Fla. I can put investors into four or five properties instead of one and increase their diversification, says Pappas, who holds licenses as both a real estate broker and a Registered Securities Principal.

Yet, DSTs come with their own challenges. They may work fine for a single-tenant, net lease property where nothing is going to change, but a DST trustee has no power to obtain refinancing or to re-lease a property. If you give the trustee that power, you've become a partnership for tax purposes, Weller says.

Some more experienced commercial investors also shy away from DSTs because investors have less control over the asset's management, says Larry Hausman, a broker with the Louisville, Ky., office of Marcus & Millichap, who also holds a securities license. They're used to being more hands-on in the deal.

Staying in the Game

The move from TICs to more complex, securitized structures like UPREITs might seem to leave few ways for commercial brokers to participate in these types of real estate transactions. But, in fact, there are several options.

The most straightforward is to simply sell properties to the sponsors of securitized offerings. After all, real estate held by TICs and other securitized products has to come from somewhere, and most of it comes from commercial real estate brokers, says Brown, managing director of Wildwood Wealth Management in Minneapolis. We're very broker-friendly-we've bought many of our properties through brokers and we use leasing brokers to fill our properties, Lund says.

Another option is to obtain a securities license so that you can sell securities in addition to selling real estate. The test for the Series 22 securities license is comparable in difficulty to completing your CCIM designation, says Bob Sorey, ALC, CCIM, of Best Real Estate in Mt. Juliet, Tenn. The education can be completed as self-study (see the Financial Industry Regulatory Authority Web site at www.finra.org for details), but you must have the broker-dealer you plan to work with sponsor you before you take the exam. Sorey, for instance, is registered with MICG Investment Management in Newport News, Va.

MICG Managing Director Ken Monroe bases his business model on associates that hold both real estate and securities licenses. We've discovered that commercial real estate practitioners can grow their businesses and strengthen their relationships with clients by expanding the investment discussion to include real estate securities, Monroe says.

He says that while most commercial property sales are languishing, securitized real estate deals that focus on distressed properties, distressed debt pools, oil and gas programs, and green energy tax credits are all attracting investors' attention.

When asked why more real estate practitioners don't go the securities route, Sorey suggests it's more an issue of control than difficulty. The compliance oversight and procedures in the securities world are more complex than in commercial real estate transactions. If you're a broker-owner who's used to running your own business, that kind of supervision can take some getting used to, he says.

Property managers, too, will find a welcome home in securitized real estate, especially as the market focus has shifted from frantic buying to survival. Many TIC sponsors are now looking for asset managers who are able to aggressively reduce operating expenses and retain tenants, says Tony Thompson, who recently launched Thompson National Properties LLC in Irvine, Calif., to provide just those services to TICs, institutions, and large private investors. Thompson believes that these down in the trenches skills combined with the ability to aggregate costs over a large portfolio are the market's biggest opportunity today.

Whether or not TICs make a full comeback, there will always be a need for securitized real estate as a way for investors to participate in the ownership of larger, institutional-quality buildings, Conness says. And as long as these securities include commercial real property, the special expertise of commercial practitioners will continue to be highly valued by those creating products for sale in the securitized real estate industry.

What's a TIC?

In a tenant-in-common structure of real estate ownership, multiple parties each hold title to a portion of a property. For buyers, particularly small investors, TICs are often seen as an attractive vehicle for investing in a large commercial property such as an office building or shopping center without having to purchase the property outright or participate in real estate management. After a 2002 IRS revenue procedure clarified the conditions by which TICs could be used in a 1031 tax-deferred exchange, TIC transactions grew exponentially. But demand has trailed off as the overall commercial market softened.

Matters of Compensation

Depending on how a tenant-in-common sponsor organizes the transaction, the TIC deal may be subject to federal and state securities laws. And that can pose a hurdle for real estate practitioners assisting buyers in such transactions who aren't registered with the Securities and Exchange Commission as broker-dealers.

The NATIONAL ASSOCIATION OF REALTORS® in late 2007 requested that the SEC approve an exemption from broker-dealer registration, allowing qualified commercial practitioners to earn a real estate advisory fee for their work on a TIC transaction. The request was later expanded to seek authority for referral fees to be paid to noncommercial agents who bring a client to a TIC transaction.

Although NAR continues to work with the SEC to finalize the request, right now the exemption has been pushed to the side as the SEC deals with the financial crisis, says Blaine Walker, who chaired the NAR Task Force that crafted the exemption request. Now is a good time for the SEC to approve the exemption so commercial practitioners can be compensated when TIC sales resume, says Walker, president of RealSource in Salt Lake City.