Investors shopping for tenant-in-common (TIC) properties are reveling in a sudden shift to a buyer's market. “There has been a huge influx of TIC properties on the market,” says Manuel Nogales, director of business development at Salt Lake City-based Omni Brokerage Inc. “For the first time, there are more properties than there are interested investors.”
In 2005, the number of available TIC deals on the market in any given week was typically 10 to 15 properties seeking between $120 million and $170 million in investor equity. As of March 10, Omni-tracked deal volume had nearly tripled with 43 deals on the market seeking $334 million in investor equity.
The proliferation in TIC offerings represents explosive growth in this fledgling industry. TICs allow investors to acquire a fractional interest in a property, which allows buyers to pool their capital and acquire larger, higher-quality assets. TICs also require little hands-on management and pay out steady annual dividends. According to Omni, equity placed in securitized TIC deals reached $3.2 billion in 2005 — nearly 10 times the $356.6 million of 2002.
TIC transaction volume has been gaining momentum since 2002 when the IRS issued guidance that qualified TICs as “like kind” properties eligible for use in 1031 tax-deferred exchanges. Under a 1031 exchange, a real estate owner can defer capital gains taxes from a sale when those proceeds are reinvested in the purchase of another like-kind property.
Longer shelf life
The flood of TIC deals is giving investors more time to shop the market. Six months ago, hot TICs were selling out in days, while even average deals were off the market in two to three weeks. Although the most desirable TIC deals are still selling relatively quickly, within a week or two, Omni reports that the average shelf life on TIC properties is 69 days.
The added time actually comes as a relief to many in the TIC industry, because it allows brokers and investors to conduct thorough due diligence, weigh different options and avoid hasty decisions. “Overall, it's a good thing. It gives investors and brokers a breather, because there are more choices available,” says Clay Womack, CEO of Direct Capital Securities Inc., a managing TIC dealer based in Santa Monica, Calif.
In mid-2004, SCI was selling out its TICs in as little as 24 hours. Now deals are closing in 30 to 90 days. “I think that is a healthier market for investors,” says Marc Paul, SCI president and founder. “The industry has more of a balance where there are enough TIC properties on the market. So investors have some options, and have time to make good decisions and go to quality sponsors.”
Yet investors still need to stay on their toes and act quickly for attractive TICs. For example, Oak Brook, Ill.-based Inland Real Estate Exchange recently completed an offering for the Kroger-anchored Innsbrook Town Square in Murfreesboro, Tenn., that sold out in a single day. Inland purchased the 88,257-square-foot center for $14.5 million, and the projected cash-on-cash return during the first year is approximately 6 percent.
Cause for caution
TICs, like any type of real estate investment, can be loaded with risk. One concern is that 1031 investors have been jumping into TICs too quickly — focusing on the benefit of deferring capital gains taxes without fully considering the ramifications of making a bad real estate investment.
The biggest pitfall associated with a TIC investment relates to the exit strategy. The property needs to be sold or refinanced at the end of the holding period, which is typically between five and seven years. Ideally, owners are hoping for a gain, but the challenge for some may be preventing a loss.
Just to break even, a TIC property needs to be sold for the original purchase price plus the up-front fees associated with TICs. Those fees can be costly, ranging between 8 percent and 12 percent of the original sale price depending on the sponsor. “The risk, particularly if cap rates move up, is that the exit price is not achieved,” says Keith Braddish, a senior director at New York-based CBRE/Melody. The firm provides mortgage debt and bridge equity for TIC sponsors.
The other option for pulling equity out of a property is to refinance. However, that also could be difficult in the future, particularly for properties that are paying interest only and have not made a dent in the loan value. Many of the recent and current TIC deals have been able to secure record-low rates between 5 percent and 6 percent, Braddish notes, and and it's anyone's guess as to where interest rates will be in a few years.
In addition, TICs have been widely criticized for their lack of liquidity. There is no established secondary market for the resale of TIC ownership. TICs are usually set up with right of first refusal, which allow existing owners to buy out another investor who might choose to sell his or her stake prior to the sale of a property, Braddish notes.
So far, incidents where owners have wanted to sell early have been rare, and those that have sold have found eager buyers within their own group. Nevertheless, the fear is that if a TIC property is not performing up to expectations, an owner may have to sell for a discount or be stuck with his or her ownership in the property.
Another challenge of TIC investments is that IRS guidelines allow for up to 35 different investors in a single TIC. “There is always a risk when you have multiple owners, because the owners may not be in agreement on strategies related to managing, leasing and taking care of the property,” Braddish says.
Demand for retail
TIC investors are traditionally looking for safe, reliable, cash flowing real estate investments. “Retail is perfect for that, because it is able to get a substantial amount of credit tenants on triple net leases,” Paul says.
Yet office properties represent the dominant property type, accounting for 36 percent of all TIC transactions, followed by multi-family at 23 percent, retail at 11 percent and industrial at 9 percent, according to Omni. Although retail represents a relatively small slice of the overall TIC market, it is one of the most requested property types along with multi-family. “It is kind of surprising that retail isn't bigger, because the demand is there,” says Direct Capital's Womack.
One of the reasons retail has not captured a bigger chunk of the TIC market is because of the competitive investment market and high sale prices. Cap rates on retail properties have dropped from an average of 8.3 percent as of fourth quarter 2003 to 7.1 percent in fourth quarter 2005, according to New York-based Real Capital Analytics. “It is much harder for sponsors to bring out retail offerings with credit tenants, and still be able to provide the cash-on-cash returns that investors are looking for,” Nogales says.
Compressed cap rates and lower yields on retail properties have prompted sponsors such as Irvine, Calif.-based Passco Cos. to scale back their retail acquisitions. Prior to 2005, Passco had focused exclusively on retail properties. In 2005, only about 38 percent of its $400 million in acquisitions included retail properties. The firm purchased $150 million in retail properties and $250 million in apartments. Given the competitive retail investment market, it is hard to meet investors' yield expectations, says Passco's president, Bill Winn. Retail yields that had dipped to the mid- to high-6-percent range a few months ago, have since dropped to the low-6-percent level with some deals even falling below 6 percent, he adds.
Good retail properties may be difficult to find in the current market, but they do exist. Direct Capital was the managing broker on the recent TIC acquisition of Dellview Marketplace in San Antonio. The 122,000-square-foot center, which is located next to a Wal-Mart, includes tenants such as Marshalls and Shoe Carnival. The property, which was purchased last August by Covington Realty Partners for $21.8 million, is expected to generate a 7.75 percent return during the first year. “I actually think we will see an increase in retail transactions in the next year,” Womack says. Capital flowing into retail properties is slowing down a bit, which should ease competition.
The boom in TIC offerings is due in large part to a surge in TIC sponsors — those firms that structure TIC deals, acquire the properties and market TIC ownership to potential investors. Currently, there are about 70 securitized sponsors, up significantly from 46 at the end of 2004 and 20 at the end of 2003, according to Omni.
Contributing to the surplus of TICs is the fact that many existing sponsors have significantly increased their deal output. For example, Inland acquired $228 million in TIC properties in 2005, and the company expects to nearly double that deal volume in 2006 with $450 million in acquisitions.
As competition heats up, it is going to create growing pains for some of the smaller sponsors that do not have the financial strength or stability to survive. The oversupply of deals on the market is expected to lead to consolidation among sponsors. Yet a shakeout could be good news for the industry if that means weeding out some of the weaker players.