What is TIC - Tenants in Common?
Tenants in common (TICs), are a form of fractional real estate ownership for commercial properties. Unlike an entity that holds real estate as limited partners or as a sole owner, TICs are individual owners with a fractional interest in an entire property that shares in the property's portion of the net income, tax shelters, and growth. Each TIC investor receives a separate deed and title insurance for the percentage interest in the property and have the same rights as a single owner. This element of the investment structure puts no individual owner (or group of owners) in direct control of the property over any other investor(s).
The purchase of a TIC (or undivided fractional interest) structure allows investors to purchase an interest in a significant real estate asset, perhaps larger than they could obtain individually. The investor acquires a percentage ownership (title and deed) and receives passive rental income while receiving the tax benefits of traditional real estate. The investors own and control the properties, not a third party. Because the investor owns a fraction of the property the amount of equity (cash) needed is considerably less than what would be required to own the entire property outright.
Tenants-in-common real estate ownership originated in Old England in the 1600's when it became possible for the commoner to own land. The quality farming acreage was too expensive for the former serfs to purchase on their own so several joined together as "tenants-in-common" to purchase land.
In 2002 the Internal Revenue Service released Revenue Procedure 2002-22. This set of 15 guidelines reduces the risk of an IRS challenge if an investor wished to do a 1031 exchange from a sole ownership property to fractional ownership. The offshoot of Rev Proc 2002-22 was the birth the Tenant in Common industry. By March 2002, about a dozen real estate sponsor firms had taken advantage of this niche, which permitted up to 35 small to midsize investors to take title to potentially institutional-quality and professionally managed properties. As a result, the TIC format became a favorite vehicle for property owners crafting 1031 exchanges, named for a section of the federal tax code that allows sellers of income-producing real estate to defer capital-gains taxes if they roll over their sales proceeds into other income property within six months.
In the early years, property sizes and asset classes ranged from $20 million shopping centers to trophy office towers priced upwards of $180 million. The TIC concept permitted investors with as little as $500,000 to $1 million of equity to invest and purchase a percentage of ownership into a series of substantial buildings previously reserved for pension plans, insurance companies, and real estate investment trusts.
At the end of 2002, the total equity raised from these dozen or so sponsor firms was approximately $360 million. As the commercial real estate industry heated up, TIC investments became more publicized, especially on the West Coast. Equity was raised at unprecedented figures as properties literally were fully subscribed within hours. The equity stimulating this market nearly doubled on an annual basis every year from 2002 until 2007, according to Omni Research and Consulting.
In today's market, TICs certainly are experiencing the same pain as the rest of commercial real estate. In August 2007, when the credit crunch struck the U.S., the cheap interest rates and creative financing structures that fueled the debt components of just about every major TIC transaction suddenly were gone.
Due to the lack of liquidity in the market, several lenders halted financing altogether, while others were forced to charge spreads upwards of 500 basis points over the 10-year treasury on commercial mortgage-backed securities loans. Also gone were the days of 70 percent to 90 percent loan-to value and interest-only financing. Lenders were forced to tighten their underwriting standards, and with the CMBS market no longer an option, the more prominent sponsors were forced to seek out alternative financing through insurance companies, government agencies, and bank lenders.
For some TICs, the problem has been aggravated by the way the deals were structured, and by weakness among the sponsors that organized the TICs. That has led to some high-profile failures that have wiped out investors. Because the law allows a tenant-in-common arrangement to include up to 35 investors -- all of whom usually are strangers to one another -- it can be difficult to organize them to avert failure when markets sour, and to make matters even more difficult, the IRS also requires that, for investor decisions to be implemented, they must be unanimous.
Another issue currently confronting TICs is its limited distribution channels. While some large broker-dealers have begun to take a look at TICs, most TIC deals have been conducted through the independent broker-dealer community. Therefore, in terms of present growth, clients of broker-dealers and registered reps currently engaged in the TIC business are the main sources of equity being placed.
Many TIC sponsors have been permanently sidelined or forced out of the industry because they underestimated the longevity and commitment of continued investor-client relations. Others have merged, consolidated, or been acquired by other sponsors with more funding to weather the storm. As the real-estate market contracted, sponsors were no longer selling new deals, couldn't increase income and couldn't keep paying on master leases where the property tenant's rent didn't meet the master lease.
Most of the high-profile TIC blow-ups have involved sponsors using the master-lease structure rather than the more common management-agreement structure. Under a management-agreement structure, the sponsor is paid a fixed fee to manage a property, with TIC investors enjoying the upside in gains in rents and property values.
But under a master-lease arrangement, each TIC investor is a master lessor, or landlord, who leases the property to the master lessee, the sponsor. The sponsor then subleases the property to individual tenants. The TIC members get a fixed rent and the sponsor enjoys any increase in rent paid by the tenants above the rent the sponsor must pay the TICs. However, the sponsor makes up any shortfall if the rent from the tenants can't cover the master-lease rent. On the sale of the property, the TIC members get any appreciation in property value, while the sponsor typically receives a disposition fee of 3% to 5%.
The master-lease format was employed by DBSI, a sponsor of mostly retail and office properties in 30 states, which according to press reports had a value of $2.4 billion, based on acquisition prices. Near the end of 2008, DBSI, which was based in Boise, Idaho, and had at least 8,500 TIC investors nationwide, filed for Chapter 11 bankruptcy protection. Under a master lease, if the sponsor gets into financial trouble, it affects the individual investments. As a result, every one of DBSI's transactions ended up in bankruptcy court.
For TIC investors, the credit crunch has slowed the pipeline as properties are taking much longer to sell due to the increased inventory on the market and the current financing woes. This turmoil has had a substantial effect on the amount of equity available to the TIC market, reports The Insurance Journal.
Benefits of Tenant in Common Investments
- Little to no-management responsibility.
- Long term leases with multiple credit tenants can reduce risk.
- Ease of diversification to reduce risk.
- Each Tenant in Common owner has the same rights as an individual owner.
- Fee-simple deed at closing.
- Pre packaged real estate with debt frequently in place.
- Pre packaged due diligence to facilitate the selection process.
- Pro-rata share of all net monthly income, tax benefits, and appreciation/depreciation.
- Potential deferred current and future capital gains taxes.
- Investment can be scaled to fit 1031 exchange requirements.
- Property and asset management reports to each owner.
- Income typically distributed monthly with periodic operating reports.
Weaknesses of Tenant in Common Investments
- Many previous deals had excessive sponsorship fees/load and were bought at the top of the real estate market
- Because the IRS requires unanimous consent on major decisions, one TIC investor can hold up major decisions
- No secondary market - little liquidity