Understanding TICs
The formal definition of a TIC is as follows
“A form of vesting title to property owned by any two individuals in undivided fractional interests. These fractional interests may be unequal in quantity or duration and may arise at different times. Each tenant in common owns a share of the property, is entitled to a comparable portion of the income from the property and must bear equivalent share of expenses. Each co-tenant may sell, lease or will his/her heir that share of the property belonging to him/her.”
TIC Structure
There are typically three TIC structures: Direct sell, Master Lease, and Put/Call structures.
Direct Sell
This structure is used when there is a single exchanger.
Master Lease
Under the master lease structure, TICs are paid a fixed rent, typically, with possible annual increases. The Sponsor typically keeps all or a significant portion of the property’s cash flow over and above the master lease rent amount. At least one Sponsor sets aside this excess cash flow in a reserve account until the property is either sold or refinanced.
It should be noted that The Master Lessee may not be a credit entity but rather an entity set up specifically for this single purpose by the Sponsor. Therefore, the Master Lessee’s ongoing ability to pay the rent due to the TICs rests in the property’s economic performance.
Put/Call Structure
Under this structure a Put/Call agreement takes the place of the Master Lease. Here a co-owner (TIC) may issue an option to purchase its undivided interest (Call option) at fair-market value. The put option is when a co-owner has an option to sell an undivided interest to the sponsor, the lesse, another co-owner, the lender or any person related to any of the parties.
Advantages/Risks
Advantages of TICs |
Risks of TICs |
Unless the offering does not have a debt component, the financing will have been pre-arranged by seller/sponsor. Debt coverage is most often in the 55% - 65% range. Non-recourse financing is the norm but all aspects of the note should be investigated and evaluated. While no secondary market currently exists for TIC interests, the terms of the note, especially as it relates to the requirement for lender approval prior to a sale, may have a profound effect on the future liquidity of the investment.
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Advantages/Risks
Increased Potential for Cash Flow
Many investors have owned property for many years and are not earning a decent rate of return on their equity. This can be especially true after deducting the fair market value of their day-to-day management responsibilities.
Take the appreciated four-plex example. If the property were located in an area that experienced high real estate appreciation, unless rents and net income have increased along with the value, chances are the return on equity is low. It is not uncommon to see investors earning only 2% or 3% on their equity, and they often don’t even realize it.
If you wish to determine the return on equity for your current investment, simply perform the following calculation:
Cash Flow* / Equity = Return on Equity
* It is important to note that Cash Flow is defined as “the cash generated by the property after debt service and expenses (including the fair market value of your own involvement in the day-to-day management of the property) but before depreciation and taxes”.
Tenant-in-common offerings typically begin with a cash-on-cash return of approximately 7% to 8%. Of course, this is real estate, so the cash flow can fluctuate, up or down, based on many factors such as changes in tenant occupancy, expenses, market conditions, environmental issues, etc.
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Advantages/Risks
Each offering will have a minimum equity investment that has been determined by dividing the total equity by the maximum possible number of TIC interests. While the Rev Proc allows for a maximum of 35 co-owners, sponsors and their lenders may set lower limits, most often between ten and twenty-five. So long as the amount to be invested meets the minimum requirement, the equity reinvestment requirement of the 1031 exchange can then be matched exactly.
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Advantages/Risks
Most of the sponsors have internal management departments, and property management services are a component of the offering. This is accomplished through the provisions of a management agreement, which can be cancelled by the TIC investors should the need arise. The size of most properties in which TIC interests are sold justify and support professional property management, thereby relieving the TIC owner of the responsibility for day-to-day involvement with tenants, vendors, etc.
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Advantages/Risks
TICs allow an investor more choices. While you could sell your highly appreciated property and purchase another in a traditional 1031 exchange transaction, a TIC allows more options.
For example, let’s assume a person sells the four-plex they’ve owned for 15 years and in which they have equity of $400,000. Depending on the amount of debt put in place on the new property, the purchase price of the replacement property could be around a million dollars. While a million dollars is a lot of money, in the real estate world, it isn’t sufficient to allow for the purchase of a really top notch property.
In the alternative, that same $400,000 of equity could purchase a million dollar TIC interest in a $30,000,000 institutional grade property. Chances are that the $30 million dollar property would be of higher quality, have professional management and enjoy a superior tenant profile when compared to a property purchased for $1,000,000. In essence, a TIC purchase allows an investor to purchase an outright interest in a quality of building that they could not otherwise afford to purchase on their own.
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Advantages/Risks
TICs can often be diversified into more than one property. Each TIC agreement is different and has benefits and risk associated with it. Be sure to read each agreement carefully.
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Advantages/Risks
If the offering is structured properly and the investor’s individual circumstances and actions, such as adhering to the 1031 rules, are correct, the investor may sell their highly appreciated property and defer (not avoid) the capital gains tax, including the depreciation that has been taken that would otherwise be recaptured.
This is a strong motivation for many investors in TIC properties but you should always seek the guidance of a qualified attorney, accountant and/or other advisor before proceeding.
If an investor exchanges into a TIC using section 1031 to defer capital gains tax, the amount of the deferred tax is then put to work in the replacement property. With more money invested, rather than being paid to the government, the cash-on-cash return noted above will be applied to a larger equity investment.
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Advantages/Risks
TIC RISKS
Since tenant in common is a form of ownership that requires unanimous approval to take a major action such as a re-finance or sale, getting that unanimity may be difficult when 10 or 20 investors are involved. Two methods are used to get the unanimous consent when a major decision is faced.
1. The sponsor sends a letter to each TIC investor detailing the proposed sale or other action. If all agree, they sign the approval notice and the action takes place. The drawback to this approach is if one person is a “hold-out” and does not approve.
2. To address the “hold-out” issue, many sponsors have inserted call provisions into the offering documents and tenant in common agreements. In essence, they say that if the owners of X % of the interests in the property vote yes for the proposed action, the minority interest party that is dissenting from the vote may be bought out at market value. Typical percentages range from 66 to 80%. Call provisions are specifically allowed under Revenue Procedure 2002-22, as long as they are at market.
In addition to the unanimous consent issue and how it impacts liquidity, the very nature of real property is that it often takes a while to market, sell, and close.
There is no established secondary market for TIC interests.
A prospective investor should never consider a TIC interest as anything other than a long-term hold and should understand that their money could be tied up for a long time.
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Advantages/Risks
Since owning a TIC interest is, by definition, owning real property, all of the benefits and burdens of real estate ownership also apply. For instance, if the property performs poorly or some problem arises, it is possible that a capital call may take place whereby the TIC owners are required to put more money into the deal or risk losing the property. For instance, if a major tenant vacates and the rent being collected goes down enough that the net operating income from the property is not enough to meet the mortgage payment, the owners will be faced with the decision to either give the property to the bank or infuse additional cash to meet the loan until a new tenant is found.
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Advantages/Risks
A non-recourse loan is one in which the lender may not go after the borrower’s other assets. The lender’s security in the loan is limited to the value of the property. However, lenders have begun requiring non-recourse carve-outs or so-called “bad-boy” carve-outs. One example of a bad-boy carve-out is that a lender may require someone to sign for liability to cover the lender in the event the rents from the property are not used to pay the loan and instead are diverted. More recently, some lenders have begun requiring TICs (and sometimes the individual borrowers) to guarantee the lender against environmental issues. Thus, it is possible that the investor could be subject to liability far in excess of their original investment. Investors are strongly urged to read the PPM that discusses these areas as well as to carefully read the loan documents.
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Advantages/Risks
Sponsors purchase properties and then mark them up to cover costs and make some money and then sell them through the security industry's broker-dealer community to investors. The markup or load factor is typically around 12% but can range much higher. This markup covers various costs such as:
- Loan Points
- Legal Fees
- Appraisal, Property Condition, Environmental, and other reports
- Fees to the Sponsor
- Commissions to Broker/Dealers
- Closing Costs
- Organization and Offering Costs
Some of these costs would be paid in any real estate transaction involving a loan while other fees are as a result of the TIC structure and marketing through broker-dealers. Based on the studies performed by at least one broker-dealer, the additional expenses of a TIC verses a traditional real estate transaction range between 6 and 7% or so. Since a premium is being paid, the product may not be right for all investors. However, if an investor feels the benefits of a TIC investment are worth the premium and the investment is otherwise suitable, a TIC investment may be right.
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Advantages/Risks
As a part of the offering, TIC investors sign various agreements such as the management agreement or master lease and the tenant in common agreement. These agreements authorize the sponsor to control and manage the property. Thus, one TIC investor cannot assert the same control as he/she did on their relinquished property, such as hiring and firing vendors, etc. Nearly every structure in place in today’s market allows the TICs or even one TIC to fire the management company of the sponsors. However, be cautioned that sometimes the loan documents state repercussions if the manager is terminated, such as the loan accelerates (needs to be paid at once). This can make it difficult to fire the manager in some instances.
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Advantages/Risks
A typical model of sponsors is to tie up a property with a purchase and sale agreement and then begin preparing the offering documents, or Private Placement Memorandum (PPM). Once the PPM is completed, the offering is marketed through broker-dealers, and the property closes some time later. This model subjects the investor to some risk that the property may not close and there will be no transaction at all. This could happen for many reasons including lender issues, environmental issues, problems with paperwork, incorrect information from the sellers, etc. While no money has been lost since there was no transaction, the client may have identified the property as one of their three choices for exchange. If the client is outside of his/her 45-day identification period and the other two options will not work, the client could be subject to paying the tax.
A few sponsors close on the property before marketing it, but this is more expensive due to carrying costs and is not the norm in the market.
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Advantages/Risks