A fair amount of buzz is surrounding a quickly growing but largely overlooked aspect of the real estate industry.
Since late 2002, when the Internal Revenue Service issued guidelines to validate an ownership structure that allowed capital gains tax deferment on property exchanges, a previously little-known investment arrangement transformed into a lucrative industry.
During the past three years, such tenant-in-common, or TIC, transactions have taken the market by storm, increasing 400 percent nationally from 2002. Notably, market participants estimate at least 60 percent to 80 percent of the billions of dollars in TIC investments are concentrated in Southern California, and 16 out of 50 TIC buyer groups nationwide are in San Diego, Orange County and Los Angeles.
“These days we’re finding that investors are over their heads in money and up to their ankles in good deals,” said Lewis Feldman, a real estate attorney and managing partner at Pillsbury Winthrop Shaw Pittman LLP in Los Angeles. “There is an abundance of capital out there and you have people that despite making money think taxes are the worst thing since Saddam Hussein so the volume of 1031 exchanges is high. You have a similar circumstance with tenant-in-common properties.”
Investing in TIC properties, also known as fractional ownership properties, enables investors to buy into portions of an investment property. The TIC approach, when combined with a 1031 exchange , an investment strategy that enables owners of real estate to first sell their property and then buy other similar property of equal or greater value without having to pay capital gains taxes , provides the additional advantage of tax breaks to real estate investors.
No Place Like Home
San Diego is the birthplace of the modern-day TIC.
The initial template for the structure of a contemporary TIC investment can be traced back to San Diego, where a local attorney, Darryl Steinhause, first produced the legal model in 1994. According to Steinhause, a partner at the San Diego office of Luce Forward Hamilton & Scripps LLP, the concept of a TIC “had been around forever, but to sell them as a security through a broker-dealer was not at all certain.”
But 11 years ago, a large syndicator, TMP Investment, Inc., of Orange County approached Steinhause, imploring him to develop a structure to bring a group of investors into a syndicated LLC. Steinhause’s legal documents justifying the ownership structure of the Upland Square property in Orange County in 1995 are still used in most of the TIC deals today, he said. The IRS officially validated the structure in Revenue Procedure 2002-22 seven years later.
“This is a very unique animal. It’s real estate for real estate purposes and it’s securities for securities purposes and it’s real estate and not a partnership for tax law purposes,” said Steinhause.
In May, the second largest TIC transaction in history, according to Steinhause, took place in Downtown San Diego, when Santa Ana-based Triple Net Properties, LLC, a tenant-in-common buyer group, arranged for the acquisition of Emerald Plaza at 402 W. Broadway for a syndicated price of $111 million. The deal raised $43 million in equity in an industry in which the average equity raised per transaction typically does not exceed $10 million or $11 million, according to Taylor Garrett, the director of marketing for Omni Brokerage, Inc. of Salt Lake City, which brokered about 10 percent of all TIC transactions nationwide last year.
The acquisition, which included two other high-rise office buildings, was Triple Net Properties’ largest acquisition to date, according to a broker who represented it, and increased the market value of its portfolio to more than $2.5 billion.
An Enticing Market
The local market is so enticing for TIC investors that in the next 60 to 90 days, one of the foremost players in the TIC industry will expand its corporate presence into San Diego. Los Angeles-based SCI Real Estate Investments plans to open an office in either La Jolla or North County to gain “a window into the San Diego market for acquiring TIC properties and a window into the investor community” here, said CEO Doug Johnston.
“The TIC industry, which is essentially a three-year-old industry, is offering a new and relatively high-tech product within the broader real estate industry one of the oldest and best known industries in America, which is not exactly known for offering new and innovative products,” Johnston said.
As one of about 50 sponsors of this type of transaction, SCI acquires the property on behalf of its investors, arranges the debt financing (usually at 50 percent loan to value) and sells the equity to a maximum of 35 TIC investors, in substantial compliance with the general conditions set forth in Revenue Procedure 2002-22.
The total value of equity invested in TIC properties at the end of last year was close to $1.8 billion, according to Omni Brokerage. In 2004, that number is expected to more than double to $4.2 billion. Thus far, in the first three months of the year, equity investment in TIC properties increased 121 percent compared to the same quarter last year.
To say this type of ownership structure, which has become an important aspect of the local real estate market, is experiencing dynamic growth would be an understatement.
The TIC structure, however, has remained largely underutilized by “mom and pop” investors, who may stand to gain the most from implementing it.
“Consider that the entire volume of real estate transactions in a year is about $600 billion, so the TIC industry as it stands now , is less than 1 percent of the total industry,” said Johnston , mostly because the public is unaware it even exists, he added.
TIC properties allow fractional ownership or shared equity ownership of real estate, so that investors can buy into portions of large investment properties which in some cases would sell for hundreds of millions of dollars , for as little as $250,000.
SCI, which was formed in 1994 and transitioned into a TIC-focused investor in 2002, is capitalizing on the exponential growth of the industry and instituting an aggressive national expansion plan this year. Johnston and Marc Paul, the president of SCI, said they plan on adding more than $500 million in real estate assets to their $750 million portfolio in 2005.
Johnston said the TIC industry, which took root in Southern California, is now slowly spreading eastward. SCI’s plans to open 15 regional offices in the next six months from Orlando to Boston is an attempt to stay abreast of that trend, “to provide broader geographic coverage,” Johnston said.
According to John Harvey, a broker at Orange-based Cornerstone Exchange Services, a branch office of Omni Brokerage, TIC transactions have largely been a West Coast phenomenon.
“It may have something to do with property values in California being so high, or it could be because East Coast investors are just more attuned to the securities market,” said Harvey.
Johnston also points to an education gap, which he says prevents many eligible investors from participating in TIC investments.
“So what you have is a scenario where the average American has never heard of the TIC structure, is not aware of the tax savings and is not aware of the advantages,” he added.
Small Investors, Big Properties
Just how substantial are those advantages?
Among the benefits to investors who participate in TIC property investments are the low equity requirements, which allow smaller individual investors to invest in large institutional properties.
When combined with a 1031 exchange, TIC properties become even more attractive.
In a 1031 exchange, sellers typically prefer to acquire mature, institutional grade properties that offer stable yields and low downside risks in the exchange. TIC properties enable small investors to locate such opportunities within the stipulated 45 days permitted for identifying a replacement property.
“The client gets the best of both worlds: tax breaks from the 1031 exchange and depreciation pass through that shelters about 50 to 60 percent of rental income from federal and state income taxes,” Harvey said.
TIC properties can often be tax sheltered through using depreciation and interest deductions.
Steinhause estimates that 80 percent to 85 percent of investors in any given TIC transactions are 1031 exchangers.
Harvey profiled the TIC investors he has encountered as “average Joes coming into retirement who have held residential properties or other small rental properties which have appreciated over the years and are coming into TIC properties with between $200,000 to $500,000 they are looking for a more passive investment, so this industry is giving them access to an incredible institutional investment with many layers of due diligence going into the property purchase, from the sponsor, from the lawyer, from the broker.”
But there is far from a consensus surrounding the characterization of a TIC interest.
“Should the investment be considered real estate or a security?” said Harvey. “The investor is getting all the tax advantages of real estate with the full disclosure of security regulation.”
There is an important and related divergence of legal opinion pertaining to who has jurisdiction over the transaction. Harvey said although to some degree the industry is fragmented, about 96 percent of TIC sponsors structure the transaction as if the TIC interest is a security, issuing title through a broker dealer.
SCI is in the minority. “Our TIC product is unique; it is based on a real estate platform and we are selling the TIC interest purely as real estate, as a conscious decision,” said Johnston.
Johnston estimates SCI saves its investors 5 percent to 10 percent by avoiding a broker’s commission that is a requirement in the security world.
Johnston sums up the value of SCI’s strategy and the value of expanding into San Diego by saying, “in a nutshell, you could say that the average American has never heard of a TIC, but once they hear about it, they are intrigued because it works. The average broker does not necessarily know that he can defer taxes for his clients through a TIC transaction, and once they hear about it they use it.”
In San Diego, which is the home of one of the most ubiquitous TIC attorneys, Steinhause, and one of the most well-known TIC transactions, Emerald Plaza, SCI is hoping to capture a larger piece of a rapidly growing market.