Caldera Asset Management

back to August 2010 issue

What Does the Future Hold for 1031 Exchange Transactions?

By Marc Perusse Principal
RSS Advisors, Denver, CO
mperrusse@rssadvisors.net

Like all the commercial real estate businesses, Tenant-In-Common ("TIC") transaction volume has plummeted from the height of the market in 2006. However, the TIC market faces even broader challenges than the market in general. While there is anecdotal evidence of an increase in TIC transaction volume, a closer look shows that transaction volume is not only well off its peak, but also continuing to decrease.

According to Omni Brokerage, $14.2 billion of TIC equity was raised between 2001 and 2010, including a total of $3.7 billion in 2006 alone. By 2009, it dropped by a stunning 94%, to just $228.7 million. The figures for 2010 are even more dismal, with only $50 million raised to date. The projections seem less than half of 2009’s trickle.

Assuming 70% leverage on total equity, the TIC transaction volume in 2006 was almost $12 billion, amounting to about 4% of the total 2006 transaction volume. Worse, as a percentage of the overall volume, TIC transactions have been dropping even more than the pessimism in the overall market, from approximately 4% of the total market in 2006 to 1.5% today.

With, TIC transaction volume continuing to drop, there are concerns and questions regarding rumors of an increase in volume, and the overall direction of this market. There is no doubt that there will be even fewer TIC sponsors and brokers in about twelve months from now. In fact, the continuing shakeout in the industry may be at least partly responsible for the rumors of an increase in transaction volume today. According to Real Estate Investment Securities Association, the national trade association for TIC’s and real estate securities, membership was 468 individual members at the peak of the market and decreased to approximately 170 today. This means that the smallest volume of the remaining volume is getting funneled through an even smaller number of brokers, and that probably accounts for the anecdotal evidence of an increase in volume.

Where Does The TIC Market Go From Here?

Despite this downward trend, some demand still exists for TIC transactions. With capital gains and taxes potentially on the rise, investors will have more reasons to consider creative ways to shelter capital gains. These tax-motivated investors will help the market recover. But, note that the financial crisis has exposed inherent flaws in the TIC structure, which needs to be addressed before the market can recover fully. Given the significant challenges and conflicts of interests in this market, it may take some time before that becomes a reality.

One of these flaws is related to the unsustainable business models employed by some sponsors. They applied practices such as, employing interest-only loans, drawing from property-level reserves or, taking on additional debt to pay distributions, and even utilized a “master lease” structure to insulate investors from the cyclical ups and downs of real estate investments.

Unfortunately, these practices allowed many sponsors to run properties into the ground before investors could become aware of problems. At that point, it was often too late to save the assets. The master lease structure has also lead to the demise of several large TIC sponsors, as they did not have the balance sheet to support the reduced lease income on a down market.

While the initial implosion of TIC deals was primarily a result of faulty sponsor business models, the second wave of TIC defaults is now on the horizon. The causes of these defaults will mirror the broader problems in the commercial real estate market. Sadly, the cumbersome TIC ownership structure (sometimes characterized as “dysfunctional”) only magnifies the typical issues experienced by real estate partnerships in down markets.

•	Funding Operating Deficits – When net operating income (“NOI”) declines, many owners are unable to contribute additional cash towards funding ongoing capital requirements and servicing debt payments. Once the initial reserves funded by investors are depleted, each individual investor must face the choice of either providing his/her portion of the necessary cash or potentially losing the asset.
•	Lack of Organization – With as many as 35 investors in a single TIC deal, all with varying levels of accreditation and sophistication, it is difficult to maintain coordination between the various investors. The resulting inability to quickly make basic, property-specific decisions has adversely affected the willingness of lenders and advisors to offer viable solutions for distressed assets. Additionally, many TIC investors lack the sophistication and real estate expertise to adequately evaluate viable solutions. We have seen this as the biggest problem of all.
•	Inability to Refinance – In the existing market, it is challenging to obtain financing for an asset held by one owner. This problem is magnified by the TIC structure, which can have up to 35 different owners, all of whom must agree on all the terms and conditions. Furthermore, rescuing underperforming transactions is even more difficult when lenders are faced with negotiations involving up to 35 different counterparties.
•	Variable Tax Consequences – In many instances, investors faced with losing their investment in TIC assets are also faced with capital gains exposure and depreciation recapture. However, not all investors will have the same basis in the asset, and while a few investors may be indifferent to losing the property, others may want to prevent foreclosure at all costs.

Ultimately, Alignment of Interests is what Matters The Most

The passive 1031 investment solution works and demand for these investments still exists. However, the current reluctance among credit providers to lend into the cumbersome TIC ownership structure means that most of the new deals will need to be structured as all-cash transactions, or as a Delaware Statutory Trust, which is primarily limited to a single-tenant, triple-net leased properties, unless it contains a master lease.

Lack of leverage will reduce returns, resulting in more scrutiny on the onerous up-front fees and expenses typically charged by sponsors and brokers. Undoubtedly, this will cause more responsible industry participants to address one of the most troublesome issues facing the 1031 exchange business i.e. the persistently poor alignment of interests between sponsors and investors.

Rev Proc 2002-22 limits the traditional solutions to this issue, but it does not eliminate them. Reputable sponsors can easily comply with Rev Proc 2002-22 by investing alongside their clients on a pari-passu basis in meaningful ways, or by creating a hybrid, master lease structure that offers a base rent guarantee for debt service payments. Far from eliminating the ability to create an effective alignment of interests between sponsors and investors, Rev Proc 2002-22 will help distinguish deal syndicators from true investment managers.

For sponsors, this will make TIC deals less profitable and even harder to close. But for investors, this evolution is much more likely to lead to positive investment returns. A longer-term, investor-oriented focus will create a more sustainable business. The ability to revive the market ultimately depends upon the willingness of sponsors and brokers to structure and promote more investor-friendly TIC structures.

About the Author
Marc Perusse is a the president and co-founder of RSS Advisors. The firm is primarily focused on providing consulting, and restructuring services to Tenant-in-Common investors and broker dealers in all major asset classes, including consulting, workout, investment banking, and due diligence services. . For more about RSS Advisors, please visit www.rssadvisors.net.