| COVER STORY, OCTOBER 2007
TIC SECURITY
What to do to preserve a 1031 exchange in a difficult capital market.
Michael Franklin and Robert Alter
In recent years, rising property values and the growing popularity of real estate as an investment option have spurred interest in what is becoming an increasingly common approach to real estate investing and wealth building — the 1031 exchange. Named for section 1031 of the Internal Revenue Code, 1031 exchanges provide investors the opportunity to defer capital gains taxes on a real estate sale, provided that the proceeds of the sale are reinvested in a like-kind asset.
Tenant-in-common (TIC) investments, an innovative and popular choice for many 1031 exchanges, provide an alternative to sole ownership of real estate and make it possible for individual investors to invest in the types of larger, typically more expensive commercial properties that would otherwise only be attainable by institutional investors. A TIC investment provides an opportunity for a group of co-owners to own an institutional-quality asset, each with a deed for a percentage interest in the property.
The advantages of participating in a TIC format when selecting the like-kind asset or replacement property in a 1031 exchange include an additional measure of security and convenience that comes from a stabilized revenue stream, and from an investment structure that eliminates the need for property management and day-to-day oversight responsibilities.
But for all of its potential benefits, a TIC option is not without risk. While TIC investments open up a broader range of possibilities and enhanced investment flexibility, they are also inherently more complex and pose what can be daunting challenges with coordination and timing. Simply put, with more parties involved and more moving pieces, there is more that can go wrong.
It is always a helpful exercise for potential investors to determine what they can do if things do not go precisely as planned. What preemptive steps can an investor take to mitigate risk and minimize exposure? What are the early warning signs that their exchange may be at risk? And what options are available to investors if a TIC deal appears to be going south
Benjamin Franklin’s famous quote that “an ounce of prevention is worth a pound of cure” may be a centuries-old cliché, but it is advice that certainly holds true for investors looking to reduce their exposure and safeguard their TIC investment. The most significant step that a potential investor can take before moving ahead with a TIC investment for a 1031 exchange is to ensure that due diligence has been performed and appropriate financing is in place. The best way to do this is to work with a sponsor that is pre-capitalized. Unlike some sponsors, which may be raising equity from potential TIC investors to purchase the property, a pre-capitalized sponsor purchases the property or properties before they sell the fractional ownerships.
Savvy investors are able to reduce their risk by working with pre-capitalized TIC sponsors; however, what some investors may not realize is that even if a sponsor is pre-capitalized, that does not necessarily mean that the financing relationship is securely in place. Particularly in the context of today’s challenging capital markets landscape, asking the question “is your financing in place?” is not just appropriate, but should be a fundamental prerequisite for any potential TIC investor.
Even with the financing in place, investors should investigate the details of the financing agreement. Examining the makeup of the in-place financing is not always easy, but it can provide critical information that can help avoid poor decisions and future difficulties. The financing structure can be relevant; if a group of investors form a real estate syndicate, for example, a common sticking point is that group dynamic is a potential inability to come to an agreement or fail to secure the financing.
The track record of the TIC sponsor is vitally important information. With what is often a very significant investment at stake, investors need to have confidence that sponsors are not just looking at the investment in a vacuum. They need to be sure the sponsors are reviewing all information in the context of local, regional and national markets; the site history; demographics; tenant specifics; and all relevant information. Beware of casual projections; an unrealistic forecast is a recipe for potential disaster. For example, if market rental rates and resulting net operating income (NOI) are projected to grow at 6 percent or 7 percent, when historically or comparatively they have grown at something closer to 2 percent, there may be cause for concern. Watch out for the hockey-stick-shaped graph, with a gently sloping “blade” that represents past NOI growth and a suddenly accelerating “shaft” that shows overly optimistic future projections.
The private placement memorandum (PPM) is a valuable document for TIC investors, providing complete and full disclosure of the proposed transaction structure, risk and reward potential and company details. It outlines not only the investment projections, but the assumptions upon which those projections are based. Taking the time to double-check those assumptions and making sure that they are reasonable and make sense in the specific marketplace is another good way to reduce risk. While an experienced TIC sponsor might be able to readjust financial assumptions to mitigate lease rollover, rate changes and other factors, an investor can be exposed to increased and unexpected costs if a TIC offering is under-reserved. Without sufficient reserves, a TIC sponsor may have to ask for additional capital from the TIC owners, and these “cash calls” may be used for tenant improvements or other expenses. In general, investors should look to identify well-rounded TIC sponsors with a corporate profile that includes substantive real estate experience, proven investment expertise and legal and accounting capabilities.
TIC replacement properties typically are chosen because they allow investors to step away from the day-to-day management requirements as well as provide a compelling combination of security and reliable income. Perhaps the biggest challenge to investors, and the best way to avoid potential 1031 exchange pitfalls, is to identify and, if necessary, secure the maximum number of suitable possible replacement properties in the event that one falls through. The obvious priority is to identify the best possible replacement property, as well as quality back-up options – but also to ensure that these are properties the investor has a reasonable shot at acquiring. Investors should familiarize themselves with 1031 Identification Rules used to identify those properties. Most investors adhere to the Three Property Rule, where up to three potential options are identified. Some exchangers may use the 200 percent rule, which potentially allows for more than three identified properties, provided that the fair market value does not exceed 200 percent of the value sold.
Because Section 1031 of the Internal Revenue Code mandates that investors have 45 days to identify the property or properties they are looking to acquire as potential replacement properties, and a total of 180 days to close the deal and formally reinvest the equity or profit — time is very much of the essence. Within 45 days, investors have a reasonable degree of maneuverability, but outside of that timeframe, some tax consequences may become unavoidable. Because transactions are channeled through a Qualified Intermediary who coordinates and facilitates the 1031 exchange, and because of the sometimes cumbersome and slow-moving nature of real estate transaction on this scale, it may be wise for investors to allow at least 90 days leeway to purchase and close. If a potential property is not secure within 90 days, it is critical to have other possible options in place.
Preparing for every eventuality is, of course, impossible. But fully understanding the requirements and the risks, as well as the rewards, of 1031 exchanges that include a TIC property, is a big step in the right direction toward assuring a more secure, profitable real estate investment experience.
Michael Franklin is executive vice president and Robert Alter is vice president, real estate, with FORT Properties.
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