The $148 million Puente Hills Mall in City Of Industry, Calif., looked like an ideal investment for a pension fund or REIT. But when the owner decided to sell, 32 individual real estate investors pooled $56 million in a tenant-in-common (TIC) structure and snapped the mall up before anyone else knew it was on the market.

To date, the Puente Hills purchase ranks as the largest acquisition ever made by a TIC group. Participants call the deal a model that will foster the growth of TIC investing and enable individual investors to compete for major pieces of commercial real estate.

“This transaction dealt with ground-breaking issues and created a model that can be replicated,” says Richard Walter, president of Faris Lee Investments, the Irvine, Calif., broker that initiated the deal.

In the past, TIC transactions have ranged from $10 million to $40 million and included fewer than 10 investors, according to Sterling McGregor, senior vice president of acquisitions and finance for Passco Real Estate Enterprises Inc., the company that syndicated the Puente Hills TIC.

As the first TIC mega-transaction, Puente Hills proved that small real estate investors could combine their equity, qualify for a large commercial mortgage-backed securities (CMBS) loan, and purchase an institutional-quality property.

To buy Puente Hills, 31 individual investors — mostly 1031 exchangers — put up an average of $1.5 million each. The balance of the equity, about $10 million, was supplied by a limited liability corporation (LLC). The capital formation was managed under a TIC structure syndicated by Passco Real Estate Enterprises Inc. of Santa Ana, Calif. RBS Greenwich Capital supplied a $92 million CMBS loan for the transaction.

Putting Passco and Puente Hills Together

In 1998, the San Francisco-based Krausz Cos. bought the 1.2 million sq. ft. Puente Hills Mall. The property had fallen into disrepair and lost about 70% of its tenants. Over the next few years, Krausz improved the occupancy to 90%. Two vacant anchor spaces were filled with an AMC 20 theater and a power center wing. Temporary tenants filled the in-line vacancies, and a kiosk program expanded the space available for lease.

Early this year, Krausz altered its investment strategy to eliminate holdings that require third-party property management and focus instead on triple-net leased properties. The decision led the company to put 750,000 sq. ft. of Puente Hills Mall up for sale with Faris Lee. Robinsons-May and Sears, the two department store anchors, and several out-parcels accounted for about 450,000 sq. ft. The department store retailers owned their parcels. Krausz wanted to retain the out-parcels, which were triple-net-leased to credit tenants and required no management.

Walter of Faris Lee pursued an innovative marketing idea for Puente Hills. Instead of calling on the usual institutional prospects, Walter thought it best to avoid excessive price wrangling by taking the mall to Passco, a pioneer in TIC syndications. TICs attract section 1031 tax exchange investors — real estate investors who exchange one property for another, thereby deferring capital gains taxes. Because 1031 exchangers are primarily interested in preserving capital, they tend to focus less on price and more on returns.

In a TIC, individual equity investors combine to purchase a property larger than what they could buy on their own. Larger properties tend to produce greater returns. While TIC investors own a property in common, just as a husband and wife own all the money in their joint checking account, returns from the acquired property are paid in proportion to individual investments, enabling relatively small investors to benefit from the economies of scale related to a large property investment.

Walter also believed that Passco would bring extensive retail, property and financial management expertise to the transaction. Passco Real Estate Enterprises holds a portfolio of 1.6 million sq. feet of retail and office properties.

An affiliated company, Passco Property Management Inc., provides property management services for more than 3 million sq. ft. Another affiliate, Passco Capital Inc., serves as a registered broker-dealer and placement agent for Passco-sponsored securities, such as tenant-in-common offerings. In short, Passco had a proven track record of raising money in the 1031 exchange market and managing a retail property effectively.

And Passco wanted the mall. Since the early 1990s, Passco-sponsored TICs had assembled a portfolio of nearly two dozen grocery-anchored shopping centers, each valued between $10 million and $30 million. Last year, however, Passco began selling neighborhood centers, believing the category had peaked. “We changed our strategy and began to look at malls,” says McGregor.

Company executives viewed Puente Hills as an evolving center in a good location: the 10-mile trade area has a population of 1.6 million people with an average household income of $72,440. About 9 million people visit the mall every year. Still, no TIC had ever bought a property as large as Puente Hills.

Organizing the TIC

Hurdles appeared right away. In March of last year, the Internal Revenue Service (IRS) issued Revenue Procedure 2002-22, which defines the tax differences between partnerships and TICs. Partnerships cannot accept or make 1031 exchanges, while TICs are allowed to make the exchanges. According to the IRS, TICs managed like partnerships would likely be declared partnerships for tax purposes. In response, Passco revised the way it manages TICs to safeguard its investors' tax status.

In a TIC, each investor owns property in common with all other investors. IRS rules demand unanimity among TIC owners for all major property decisions. To get around the bottlenecks created by the unanimous decision requirement, TICs used to lease the entire property to the sponsor under a master lease. This conferred the responsibility for most property management decisions on the sponsoring company, which might farm out the property management or keep the job for itself.

Under this arrangement, the sponsor/property manager made decisions, collected rents, deducted fees and passed the income along to the TIC. When the property matured and was sold, the sponsor typically took a share of the profits — about 25% — as an asset management fee.

Rev-Proc 2002-22 notes that the courts have characterized entities operating with master leases and profit sharing as partnerships for federal tax purposes. That interpretation has led TIC sponsors to change their ways.

Passco, for example, re-engineered its management approach for the Puente Hills TIC by establishing itself as the property manager and the asset manager working directly for the TIC owners. As property manager, Passco will earn fees by performing day-to-day tasks such as maintenance and lease management. As asset manager, Passco will earn a percentage of increases in cash flow generated from property improvements that attract higher-profile tenants willing to pay higher rents.

Borrowing Money

While revising its TIC management approach, Passco also discussed the deal with CMBS lenders, only one of which opted to pursue the deal — Greenwich Capital.

Greenwich saw Puente Hills as an opportunity to test new lending guidelines in Rev-Proc 2002-22. The new guidelines make it easier for lenders to protect TIC properties — owned in common by all — from bankruptcy problems related to the property or a single TIC owner. With bankruptcy concerns reduced, CMBS lenders can consider larger TIC loans.

“The Rev-Proc changed the landscape for TIC investing by helping the financing world accept the TIC structure,” says Alexander Ovalle, senior vice president with Greenwich, who committed a $92 million, five-year CMBS loan at 5.3% interest.

Ovalle also had to deal with securitization issues. The $92 million loan would rank as the largest loan in the CMBS securitization pool Greenwich was assembling. In analyzing CMBS issues, rating agencies scrutinize the 10 largest loans in a pool. So does the special servicer.

Fearing that the unusually large TIC loan might fare poorly and be “kicked” from the pool, Ovalle discussed Puente Hills at length with the rating agencies and GMAC Commercial Mortgage Corp., the special-servicer for the issue. Had problems arisen, Ovalle would have split the loan in two and sold one of the notes outside of the securitized pool at a higher interest rate.

The technique would have reduced the leverage of the securitized portion of the loan and ensured acceptability. While this procedure is not uncommon, it would have reduced Greenwich's profit, since the loan would have sold outside of the securitized pool at a higher interest rate. Ultimately, the rating agencies and GMAC accepted the full loan for the pool.

Raising Equity

While all of this was unfolding, Passco Capital developed a private placement memorandum (PPM) that explained the investment to TIC investors. According to the PPM, the Puente Hills purchase price of $148 million would yield an annual income, or capitalization rate, of about 9.5%. Less property and asset management fees, the investment would actually return about 8.25% annually. Depreciation would shelter 50% of the first year's cash flows. The PPM also specified a three- to five-year holding period after which the property would be sold. The total annualized return is projected to be 22%.

Passco markets TICs through a network of two dozen or so broker-dealers — financial advisors licensed to buy and sell securities. The Puente Hills TIC offering asked for a minimum investment of about $1.6 million.

But that number was flexible. When one investor put in $6 million, for example, the minimum request dropped. “Most investments were between $1 million and $1.6 million,” says Thomas Jahncke, president of Passco Capital.

The offering attracted 1031 exchangers swapping multifamily and retail properties. Three investors bought their shares with cash, viewing the TIC as a way to get into the 1031 exchange market. When the investment turns over, they will exchange into another property.

After studying the PPM, Joral Schmalle exchanged his family's seven-unit San Francisco apartment building for a TIC interest. Schmalle particularly liked Passco's plan to sell the mall in three to five years. “I would rather be in a five-year business plan than a 30-year business plan,” he says. “If I exchange appreciating property every five years or so and re-leverage each time, my returns will be much greater than if I hold one property for 30 years. That's my plan for building wealth.”

In the end, Passco raised $56 million and turned away $12 million from 1031 investors clamoring to get into the deal. And it happened quickly. So many 1031 exchangers are now looking for properties that all the commitments and most of the money arrived within 10 weeks of the appearance of the Puente Hills PPM. McGregor says winning the deal is all about speed. “That's how we compete with institutional buyers.”

Michael Fickes is a Baltimore-based writer.

Puente Hills Mall: TIC Investment Returns

Investment Cash Flow Projections: $1 Million Ownership for TIC
2003 (10 months) 2004 2005 2006 2007 Total
Investor Cash-on Cash Return 8.25% 8.5% 9.0% 9.5% 10.0%
Cash Distribution $68,750 $85,000 $90,000 $95,000 $100,000 $438,750
Projected Profit @ 9.25% Cap Rate $617,178
Return of Capital $1,000,000
Total $2,055,928
Total Annualized Return Projected 22%
Source: Passco Real Estate Enterprises Inc.


Puente Hills: Area Demographics

2002 1 Mile 3 Miles 5 Miles
Population 12,322 146,381 368,819
Avg. Household Size 3.31 3.81 3.57
Household Income 1 Mile 3 Miles 5 Miles
$0-$24,999 15.1% 15.7% 14.5%
$25,000-$49,000 21.5% 20.8% 20.5%
$50,000-$74,999 21.5% 20.5% 21.0%
$75,000-$99,999 15.1% 15.4% 16.1%
$100,000+ 26.7% 27.5% 28.0%
Avg. Household Income $92,602 $78,874 $78,874
Source: Passco Real Estate Enterprises Inc.