NestEgg Investing: 1031 Tenants in Common Exchanges

1031 TIC Exchange Market May Be Showing Signs of Slowing

If you read through all the promotional spin on Inland's earnings call, it appears that demand in the 1031- TIC exchange market may be slowing down.

This year, we anticipate acquiring $100 million of assets for the IREX JV, with potential upside for more depending on the acquisitions market. According to our IREX partner, the slowdown in transactional volume and the credit crunch have had some impact on the tenants in common industry. There are fewer sellers in the marketplace seeking to roll the real estate proceeds into another property. The volume that is out there is going to quality sponsors. Our IREX partner continues to take market share as a result of this flight to quality. IREX is considered one of the best 1031 exchange sponsors in the business.

While some big sponsors are having difficulty in this credit constrained market, IREX is able to leverage the Inland group's established banking relationships to obtain financing for big dealings. In fact, IREX is projecting that 2008 should be another record year for their company in terms of transactional volumes and net income.

How the Credit Crunch Affects the 1031 Tenants in Common Market

How does the credit crunch affect the 1031 tenants in common investor?  Hard to say at this point.  If you break down the components of return on any real estate investment, you can break it down as follows:
1) buy vs. sell cap rate
2) cash flows
3) leverage level

The credit crunch negatively impacts #2 and #3.  If the 1031 TIC sponsor can't raise cheap debt, debt service of its offerings will increase, decreasing cash flows.  Likewise, lenders are becoming conservative, so LTV should also decrease.  All this means, lower cash flow yields. 

#1 is harder to understand.  If you think that the credit crunch allows 1031 sponsors to buy at artificially high cap rates, then you should expect some appreciation over time. However, given the incredible real estate bubble of the past few years and cap rate compression, it's hard to count on any appreciation.

I think this all nets out to pressure on cashflows. 

Because 1031 sponsors market their securities on cash flow yields, I think this makes it even more imperative that investors really do research on the sponsors and the underlying buildings.  There are a ton of ways to game the proforma projected cash flows, and given the pressure from higher cost debt, many more dubious sponsors are going to play some dangerous games. 

Again, make sure you spend time on www.1031reviews.com and really understand what you're getting into.

Excerpt from the Wall St. Journal 2/8/08
In January, no commercial mortgage-backed securities -- pools of commercial real-estate loans -- were issued. That's the first time that's happened since October 1990, says Commercial Mortgage Alert, a newsletter.

Since the start of the year, the cost of protection against default on a basket of CMBS originated in 2005 and early 2006 has more than tripled, according to Markit Group's CMBX index.

Goldman Sachs says the turning credit cycle could drive losses in commercial real-estate loans up to $183 billion, compared with $211 billion on subprime loans, and commercial real-estate prices could fall as much as 26%. While banks have recognized 91% of subprime losses, Goldman says they've come clean on only 17% of expected commercial real-estate losses.

This causes troubling feedback for the economy. Nonresidential building last year added a little less than half a percentage point to economic growth, and cushioned the decline in construction employment. If commercial construction stumbles, that cushion is gone.

1031 TIC Exchange and REITs: SEC Commissioner's Remarks

Excerpts from SEC Commissioner's Remarks Before the NASD Spring Securities Conference
Hollywood, Florida
May 18, 2006

IV. TICs and REITs
The last two products that I would like to discuss this morning relate to real estate, which has been a very hot topic for some time now. Even as I speak, I can already see the question cards being passed down from panicked audience members that read "Do you believe that there has been a housing bubble?" and "Will you please ask your friends at the Fed to lay off the pedal on interest rates?" Well, before you begin writing on those note cards, I should tell you that I must disappoint by instead focusing on the no less interesting topics of "TICs" and "REITs."

TICs, of course, are tenants in common interests in real estate. The sale of real estate may result in the seller being responsible for capital gains taxes on any appreciation. Section 1031 of the tax code, however, permits investors in income producing or rental real estate to exchange the investment for an interest in real estate of equal or greater value in order to defer the payment of taxes on capital gains. TICs permit the investors to pool their assets with other investors in order to invest in larger real estate offerings. Thus, an investor could exchange his or her rights in a rental property for the interests in a pool of assets of a larger property offering owned by several other investors.

A 2003 NASD notice to members reminds broker dealers of their suitability obligations in selling "non conventional investments," which includes TICs. The notice explained that broker dealers engaged in the sale of non conventional investments must ensure that the products are offered and sold in a manner consistent with the member's general sales conduct obligations. Thus, broker dealers would be required to perform both reasonable basis and customer-specific suitability analyses.

Transactions in TICs present a number of suitability issues. For example, a customer may wish to exchange the total proceeds from a sale of real estate for a TIC interest. Although perhaps not a problem inherently, this exchange may result in a significant concentration of the investor's overall portfolio in real estate. Further, there isn't a secondary market for these interests, so TICs are illiquid. Also, there are fees associated with TIC exchanges that reduce or may outweigh the value of the tax benefits provided by the exchange. Last year, NASD issued a notice to members specifically highlighting these and related concerns. Broker-dealers should consider each of these issues before recommending a TIC exchange.

Also, the sponsors of TIC exchanges routinely obtain legal opinions regarding whether a particular exchange structure would qualify as a like kind exchange of real property under Section 1031. As tax considerations drive these exchanges, broker dealers should obtain a "clean" legal opinion or perform sufficient due diligence into the tax risks of the exchanges and ensure that they are disclosed to the investor.

REITs, or real estate investment trusts, are an investment that has increased in popularity among retail investors during the past few years. REITs are entities that invest in different kinds of real estate or real estate related assets, including shopping centers, office buildings, hotels, and mortgages secured by real estate. Interest in these investments has been positively correlated with the strong returns on real estate investments in recent years.

REITs that are not traded on a national securities exchange or the over the counter market present particular suitability issues. For example, because they are not traded on an exchange an investor may not be able to redeem them for years. As a result, these types of securities present liquidity issues. Investors should be informed of the difficulty that they may have in selling their investments and broker dealers should ensure that the customer will not need the money within a short time period. Also, on occasion, REITs have been marketed to customers as a conservative investment. The reality is that unlisted REITs may involve a high degree of risk. Also, they may have high costs that motivate a representative to make an unsuitable recommendation so they present particular supervisory challenges

How do you know a 1031 TIC Exchange Firm is Honest?

I got the following questions emailed to me:

are the main questions we should ask of the RSP or real estate provider?

how do we know they  are honest?

how do we know the property is really going to yield 6-7 %?

1) All the questions that I list on how to choose the right 1031 exchange firm (link) are questions you should ask the real estate firm, other investors and folks like your CPA, CFA.  For your CFA, ask if they have any biases, commissions,etc. Often the CFA is recieving a 5% commission to introduce you to a firm

2) How do you know they are honest?  This is a tough one.  Asking prior investors is the best way to tell.  Also, take a look at their fee structure.  If their fee structure is egregious (ie greater than 15% of equity rolled in) it's a sure sign that the firm is trying to make a quick buck.  You can also ask a a lawyer or friend who is a lawyer to take a quick look to see if the ceo of the organization or the organization itself has ever been sued

3) How do you know you will get the promised yield?  Most offerings have a triplenet lease which is a contract guaranteeing the return.  To make sure that the firm lives up to the guarantee, ask if there has ever been a capital call.  Also, look to see how aggressive the loan agreement is.  If it's a variable, interest only loan, you might ask how the firm is going to continue its cash yield commitments when interest rates rise and principal needs to paid back.

To better serve you, we're looking to launch a feedback project on 1031 service providers (find out more link) .  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com

Researching a 1031 TIC Exchange Firm Part 3

Continued from previous post (link)

7) Has the firm ever been sued? 

8) Has the firm ever had to make a capital call?  If the firm has had to make a capital call, that means the firm used too much leverage, did not manage the property well enough, or made a similiar mistake.

9) How do I get out?  A life event may force you to have liquidate your ownership share earlier than you intended.  You should get in writing the process for selling down your ownership. In highly leverage buildings (70% debt), often the loan document must be amended and the new buyer approved by the bank.  This will incur significant fees in addition to the decrease in selling price do to your distressed situation.  Some firms won't let you get out at all.  More generally, have a firm layout in black and white exactly the restrictions (both legal and practical) you will face if you need to sell

10) Talk to prior investors: If you do anything at all, talk to private investors about their experience.  If you can find someone not referred by the 1031 firm, all the better.  It will give you confidence that the firm you are working with is legitimate. Please also help others in this regard. If you have performed a 1031 exchange of any kind (traditional, TIC, etc.) and have feedback--good, bad, or indifferent-- on any the firms that you've worked with, please email us with feedback: nesteggemail@gmail.com

Continued at Researching a 1031 Firm Part 4 (link)

Researching a 1031 TIC Exchange Firm Part 2

Continued from previous post (link)

4) Fee Structure:  Have a 1031 syndicator layout on paper their entire fee structure.  Many times they will list the fees as a percentage of assets rather than a percentage of equity.  For example, a large firm quoted us fees of 10% of the asset purchased which sounded reasonable.  However, when you consider that the building was being purchased with 50% debt, the fees equated to 20% of equity exchanged which is higher than the national capital gains tax.

5) Underwriting Leverage:  From what we've seen, 1031 syndicators underwrite their purchases from 0% debt all the way up to 80% debt.  Obviously, the lower the debt, the less risky.  We generally think that around 50% debt makes sense.  With higher debt levels, there's greater chance that firm will not be able to cover debt service and deliver their guaranteed return.  Even worse, they are not able to cover debts service and will make a capital call which requires you to put more money in.

Finally, the greater the debt, the more restrictions the banks will have on the investors.  Thus, they may have restrictive covenants that prevent you to sell down your portion, etc.

Also pay attention to how this debt is structured.  Many firms will use interest only debt in the early years.  They do this to increase their yield to investors at the cost of big principle payments and lower returns (and potentially capital calls) in the future.

6) Debt Available to You:  When you do a 1031 exchange you need to rollover both your equity and your debt.  Most firms will provide loans for you.  This is helpful, as raising debt on your own can be difficult for a fractional ownership of a building.  Be careful about how these loans are secured. Many firms will over non-recourse loans which are secured by ownership in the building itself rather than your personal assets.

Diligence List Continued (Link)

1031 TIC Exchange Firm Due Diligence List

The 1031 industry is in some ways brand new.  As a result, it's pretty difficult to determine which firm you can trust.  To help sort through the wheat from chaff, we've put together a "due diligence list" below to help you more rigorously research firms to work with.  As always, consult your tax and financial advisors.

To better serve you, we're looking to launch a feedback project on 1031 service providers (find out more link) .  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com

1) Firm background: Find out how long your 1031 syndicator has been in business, how many transactions they have performed, and how credible the leadership of the firm looks.  Many firms have grown out or are subsidiaries of title or brokerage companies.  So be careful about differentiation between the track record of the 1031 company and the parent company.

2) Offering:  First take a look at what type of offering (Tenants in Common, Tenants in Common Triplenet Leases, UpREIT). Generally, we feel that the UPREIT still has not been approved by the IRS and is thus more risky.  Second, look at the properties themselves:  research the geography, the tenants, and the general quality of the assets.  Finally, how big is their property portfolio.  The bigger usually will indicate a larger and more established firm.  Also, when you go to exchange it's more likely that they will have a property available.

3) Promised Return:  Be careful about exactly what return the firm is promising.  Some firms advertise "cash on cash yields"  which are really returns to your equity.  Others advertise capitalization rates which are returns to equity and debt. 

Diligence List Continued (Link)

Choosing the Right 1031 TIC Syndicator or Exchange Firm

Six months into our research, we do think that the new options available under the loosened 1031 law can very powerful vehicles for personal investors.  We've talked about this in the prior posts, but these new 1031 options allow investors to diversify geographically, to eliminate management (through exchanging into triple net leases), to increase yields (particularly if you are exchanging away from the low cap rate geographies like the Bay Area), and to reduce principal and tenant risk (if you are exchanging into institutional properties). 

That's great in theory, but how does play out where the rubber hits the road?  We're beginning to research actual firms that provide 1031 exchange options and our advice is be careful and really do your homework.  This is a new industry, and while there are some reputable firms, we've certainly found plenty of fly-night operations. 

To help you do your homework, we've created (and will update as we continue to do our research) a diligence list of good questions to answer before working with a 1031 syndicator.  As always, consult your financial and tax advisor.

Firm Due Diligence Checklist Link

Please also help us with this effort.  We're looking to launch a feedback project (find out more link) on 1031 service providers.  If you think this would be valuable, please post  comment or email us at nesteggemail@gmail.com. 

1031 TIC Exchange Triple Net Leases, The Management Free Option

An increasingly popular 1031 exchange option is the triple net lease  (ie. "NNN").  A triple net lease is a long term lease where the tenant pays for all maintenance, taxes, insurance, and utilities.  Usually, these NNN leases are with well know franchises or chain stores such as Walmart, Walgreens, Pizza Hut, and Starbucks. 

The advantages of exchanging your investment property (either individually or through a tenants in common) into a NNN property are:

1) Zero maintenance

2) Zero occupancy risk- high credit tenants sign long term leases

3) Lower principal risk (because of #2)

4) If you purchase through a tenants in common structure, you can buy a larger, and thus higher yielding property

The attached article provides a good overview: article link

1031 Tenants in Common Options

This is a good article re: the benefits of new the tenants in common 1031 options (see Link to 1031 overview for more).  Based on our research, the general points are correct.  However, be a somewhat skeptical reader in that Omni brokerage is a syndicator whose primary business is TIC products.

If you do find yourself more interested in 1031 TICs, we've put together a list of questions to ask 1031 TIC Syndicators. We've seen a real mixed bag out there and it pays to do your homework:  Choosing the right 1031 firm (link)

TIC 1031 Exchange Properties – The High Yield Solution

February 7, 2005

A popular choice among real estate investors seeking a 1031 replacement

property is Tenant-in-Common (TIC) ownership, or fractional interest. As a TIC owner, you have an undivided fractional interest in an entire property and share in your portion of the net income, tax shelters, and appreciation.

(PRWEB) February 7, 2005 -- While many savvy investment property owners recognize this as an opportune time to dispose of their property, they are also discouraged to find that it is an unpleasant market to locate a

suitable exchange property.

Each TIC owner receives a separate property deed and title insurance for

their portion in the property investment. This gives you the same rights of

ownership that a single owner would enjoy. Because TIC offerings are often “packaged” with management and financing in place, TICs simplify the 1031 process for the passive real estate investor.

TIC investments provide simplicity by eliminating active management

headaches. Individuals who are ready to relinquish the day-to-day burdens of being a landlord, or who own land and would like an income-producing property, will benefit from TIC investments. TIC programs provide a "mailbox management" investment that can save you time and money.

Furthermore, TIC ownership allows you the ability to diversify your 1031 exchange into more than one property, and to own potentially larger,

institutional-quality properties.

Cash flow is generally paid monthly and is tax-sheltered via depreciation

pass-through and interest deductions (in many cases a portion of your net

income is tax sheltered.) You may also experience appreciation over the time that you hold your property.

According to OMNI Brokerage, the average cash-on-cash return of TIC

interests was 7.0%-7.5% in the previous quarter. Compare this with Single Tenant Net Leased Properties such as a Walgreens that are currently selling for an average cap rate of 6.50% (according to Loopnet for a new 25 year lease with no increases). Assuming an interest rate of 6.3% fixed (180 basis points over the 10 year U.S. Treasury which was 4.50% at the time of this writing) and a 25 year amortization period, annual debt payments equate to 7.92% of the amount borrowed. Assuming 40% down, an investor’s cash on cash return is a measly 4.37%.

Based on the aforementioned scenarios, the TIC Investment yields 60-72% more cash flow than the investment in the Net Leased Walgreen’s Property. However, investors should take note that TIC investments may pose additional risk depending on additional factors such as lease length and the individual tenant’s credit rating.

With all of the added benefits of TICs, including the elimination of management headaches, diversification, and monthly cash flow, it is easy to understand why the TIC market is attracting so much attention.

The Q1 2005 Edition of OMNI News offers a glimpse of where this market is heading: the securitized TIC marketplace has grown from placing close to $167 million TIC equity in 2001 to placing $1.73 billion in 2004, and it is estimated that over $4.27 billion TIC dollars will be placed this year. This is why seasoned investors, “baby boomers” seeking to build extra retirement income, and others are turning to TICs to meet their 1031 exchange requirements. Further details on the industry are available at www.1031street.com.

About the author - Brian W. Topley, CCIM holds a securities license and

offers TIC replacement properties through OMNI Brokerage, Inc. and is a real estate investment advisor with Arroyo & Coates, Inc.