Liquidity Crisis Sparks Concerns for TIC Sponsors

MBA (4/7/2008 ) Murray, Michael
The liquidity crisis spread last year to the Tenants-in-Common (TIC) market for 1031 exchanges, leaving TIC sponsors trying to find options for investors, particularly in cases of refinance activity.

A 1031 exchange allows a property owner of investment property to exchange investment property and defer paying federal and state capital gain taxes—20 percent or more of applicable state taxes—in the event that they purchase a like-kind investment property, based on the Internal Revenue Service code.

Completing a 1031 exchange with a TIC interest ownership for an investment property allows property owners not only to defer their capital gains taxes, but to also upgrade their investment property into larger, institutional-grade investment properties, allowing property owners to use all of the proceeds from the exchange as leverage to gain access to more valuable investment property.

The TIC sponsor oversees the transaction—providing due diligence; financing; and possibly property management—all for a fee.

Clain Brandt, managing principal of BIHT Ltd. in the Channel Islands and former director of capital markets at TIC-sponsor DBSI , Meridian, Idaho, said the TIC model was predicated on the “easy availability of debt.”

“That debt is gone,” Brandt said, adding that TIC investors will not be able to refinance their properties, and guarantees backing them are negligible or nothing at all because the debt is mostly non-recourse.

“Lenders are dictating the terms a lot more than they had in the past,” said Aaron Cook, executive vice president, national sales manager and managing principal of Core Realty Holdings LLC, a Newport Beach, Calif.-based TIC sponsor. “We don’t have a lot of refinance risk.”

Core Realty Holdings has 10-year term financing on all of its TIC transactions except for one at five years, which closes in two weeks. Some TIC sponsors have five-year deals ready to mature, including “one of the largest sponsors out there,” Cook said. “That could be problematic in this environment. There are a number of other sponsors that have some short-term refinance risk due to the lack of liquidity in the market. Core is not in that position.”

During the first six months of 2007, the TIC market had a slight dip in equity, but TIC sponsors—including Core Realty Holdings LLC; DBSI; Triple Net and SCI—could sell TICs as securities in accordance with the Securities and Exchange Commission regulations.

These TIC sponsors raised $760 million in the first quarter and $875 million in the second quarter, based on data from Omni Consulting and Research, Salt Lake City.

The research firm also reported that as capital dried, the industry dropped 22 percent in available equity in the second to third quarters and 26 percent from the third to fourth quarters to reach a final equity close of more than $512.6 million for the year—the lowest equity amount raised since the third quarter of 2004.

Manuel Nogales, vice president at Omni Consulting and Research, said sponsors were challenged with three flare-ups in the capital markets.

“No one anticipated the CMBS vehicle to virtually dry up overnight; it has been a cornerstone for many sponsors to acquire financing. That financing made it possible to structure TIC programs that would be competitive enough to fit in the narrow bandwidth required by the TIC market,” Nogales said. “The TIC market does not share the luxury of REITs, pension plans and other institutional players whose predominate concern is exit IRRs [internal rate of returns], TIC programs need to satisfy investor demands for immediate income and a low risk tolerance. Any sponsor will tell you that they have not been playing on an even playing field.”

While 42 sponsors successfully closed a transaction in the second quarter, the number dropped to 23 in the fourth quarter. “Many sponsors were essentially forced to sit on the sidelines as their financing continued to be re-traded time after time,” Nogales said. “This was a very costly endeavor for sponsors and as a result, many sponsors are weighing their options on how to proceed. “

Core Realty Holdings had non-recourse financing through Wachovia Securities, Charlotte, N.C. “They were easily able to sell everyone of our loans up until just recently,” Cook said, adding that Wachovia has been selling off some of the CMBS paper it was unable to securitize at a discount and taking writedowns.

Indeed, Commercial Mortgage Alert reported Friday that Wachovia sold a 10-year, $30.6 million loan at a discount on two San Antonio office parks owned by Core Realty, originated between May and December last year.

For their most recent offerings, a number of sponsors have been looking for alternative financing, including Fannie Mae and Freddie Mac. However, industry analysts said the GSEs are reluctant to finance TICs and restrictions include seven to 10 slots for TIC investors.

“The revenue procedure accommodates 35 investors,” Cook said. “[The GSEs] are accommodating to some degree, but they are a little bit stringent on the requirements for TICs.”

And, in a credit tight market, investors require $800,000 to $1.5 million for a 1031 exchange, Nogales added.

Industry analysts said it now appears that sponsors could leave Tenant-in-Common investors with an investment property but without the management capabilities and the potential for property downfalls.

“I think that there will be some attrition in the industry,” Cook said, adding that smaller TIC sponsors and organizations will either exit the marketplace or consolidate. “Other larger sponsors will take over the investor reporting and the property management from the smaller sponsors. That’s certainly a possibility. I don’t think the investors will be left high and dry because there is intrinsic value there with reoccurring revenues on the property management side.”

"I could see where in the event a TIC sponsor was having troubles the others would sit back patiently for them to fail and then go after the failing sponsors investors and their properties," Brandt said.

Cook noted that some of the larger TIC sponsors—Grubb & Ellis; Inland and Core Realty—have property management affiliations and other sources of revenue aside from the TIC industry. Core Realty, for example, has an investment fund offering and a debenture offering collateralized by a $231 million portfolio.

“It can be problematic for some of the smaller organizations,” Cook added. “I think we’ll see some consolidation. You may see some consolidation of the big sponsors.”
Prior to the 1986 Tax Reform Act, Limited Partnerships had a meltdown, and Brandt said those LPs renamed themselves and are now working as TIC sponsors.

“The problems they caused then are the same problems they are going to cause now with tenants-in-common,” Brandt said. “Nobody is really paying attention to it.”