Many users of the popular tenant-in-common (TIC) investment vehicle in commercial real estate are hoping they have the stamina to withstand a double blow — more expensive debt financing and a pullback in buyer demand. Turmoil in the debt markets has slammed the brakes on what had been a booming business.
The implosion of the subprime lending market in residential real estate first began to emerge in February, throwing the debt markets into a tizzy globally. Months later that downturn spilled into the commercial mortgage-backed securities (CMBS) market as bond buyers grew ever more skittish.
The much wider spreads that began surfacing in the CMBS market in July have thrown TIC sponsors for a loop as they scramble to line up alternative financing sources and reprice deals.
Still, the first-half figures for deal volume mask the market turbulence. During the first six months of 2007, the TIC market was rolling along at a healthy clip with only a slight dip in equity pouring into the market. Securitized TIC sponsors — those that sell TICs as securities in accordance with the Securities and Exchange Commission regulations — raised $760 million in the first quarter and $875 million in the second quarter, reports Omni Consulting and Research in Salt Lake City, Utah.
Although still a sizable chunk of change, the $875 million of equity raised in this year’s second quarter was down from peak levels reached in the latter half of 2005 and early 2006 — including three consecutive quarters that surpassed the $1 billion mark.
“Until we had the subprime market go haywire on us, we were on track to have another increase in the third quarter,” says Manual Nogales, vice president at Omni Consulting.
Driving forces behind TICs
The TIC structure enables an investor to own an undivided fractional interest in a property in one of two ways: TIC interests can either be sold as securities by registered representatives, or TICs can be structured as real estate deals that are not bound by SEC rules.
Many small real estate investors prefer TICs because they provide an opportunity to purchase a stake in higher-quality properties than what they could afford on their own. Investors also like the prospects of a predictable income stream and minimal management responsibilities.
This investment vehicle is fueled predominately by investors who are pursuing TIC properties as part of a 1031 exchange in order to defer capital gains taxes from the sale of another property. The vast majority of TIC investors are selling residential properties such as rental homes, duplexes and small apartment buildings.
Ripple effects of subprime
A slowdown in the residential sector has had an immediate effect on the TIC industry. In recent months, equity pouring into TICs has fallen off as the volume of existing home sales — which dropped 8.5% in 2006 — is forecast to drop another 6.8% in 2007, according to the National Association of Realtors.
“There absolutely has been a slowdown in exchange buyers in the last 24 months,” says Bernie Haddigan, a managing director at brokerage Marcus & Millichap Real Estate Investment Services in Atlanta. Although data on the national volume of 1031 activity is scarce, Haddigan estimates that the number of 1031 transactions is down 25% to 40% compared with 2005.
That slowdown has been most noticeable in California and Florida. Soaring residential property values that fueled significant sales activity in the Golden State have flattened in the past two years, subsequently cooling the white-hot 1031 market. At the same time, rising insurance premiums and the softening condo market have contributed to slower 1031 activity in Florida, Haddigan notes.
Despite the cracks beginning to appear on the demand side, some of the biggest TIC sponsors say they have yet to experience a decline in business activity. How could that be?
Top sponsors such as Argus Realty Investors LP of San Clemente, Calif., have benefited from a significant decline in active TIC sponsors. Currently, there are about 40 to 50 active sponsors in the securitized TIC market compared with about 70 a year ago — a drop of more than 40%, according to Omni.
“On a broad scale, the TIC industry has been ticking right along,” explains Tim Snodgrass, president of Argus. “This year, we’ve closed on four properties, and business has been robust.”
For example, Argus purchased the $160 million Wachovia Center in downtown Raleigh, N.C., in March, raising $42 million in TIC equity in just 30 days. Although activity at Argus is on par with the level of activity in 2006, most securitized TIC sponsors have averaged only one to two deals year to date.
Survival of the fittest
The higher cost of borrowing is expected to narrow the field of sponsors even further in the coming months. CMBS lenders that are still quoting deals have increased spreads from 105 to 120 basis points over the 10-year Treasury yield to about 200 basis points over the past few months. For example, a loan that was priced at 6% several weeks ago is now priced at about 6.8%.
Sponsors tend to favor CMBS money because its trademark tight spreads make it one of the cheapest sources of debt. The higher-priced capital is a death knell to acquisitions that were already offering slim returns due to intense competition in the commercial real estate arena.
“The bull’s-eye of hitting cash-on-cash returns is so narrow that even the slightest shift in the cost of debt financing will make that property no longer viable for the TIC marketplace,” says Nogales of Omni Consulting.
Although there are already deals in the pipeline that have locked in debt financing, the impact of those lending hurdles will begin to emerge at the end of the third quarter. “We will see deals tabled while the lending situation is resolved and sponsors wait for the marketplace to level out,” he says.
Debt financing constraints are already affecting the pipeline of TIC offerings. “Those sponsors that didn’t lock loans aren’t going to do those deals,” says Snodgrass of Argus. Even those sponsors that have rates locked on pending loans are concerned that financing may fall through due to lack of liquidity in the CMBS market.
Argus, for example, has four TIC deals in the pipeline valued at about $350 million. “Even if you have a locked loan, that doesn’t mean it will be easy to get it closed,” Snodgrass says.
So far it appears that those loans are going forward, but ultimately financing will be subject to activity in the broader capital markets. “Some of our deals might not make it. If there is another glitch in the market, it doesn’t matter how much you rate lock,” Snodgrass says.
Although TICs are still working hard to uncover potential deals that make economic sense, the reality is that the higher capital costs have sidelined many sponsors. In a market where returns are already extremely tight, it is difficult to find deals that are economically feasible.
Many sponsors are sitting back and waiting for the dust to settle in the shape of a stabilized CMBS market or a drop in property pricing — whichever comes first. “What I hope is going to happen is that sellers are going to realize that the 6.5% cap rate that was there a few months ago is now a 7.5% cap rate,” Snodgrass says. “The only way that will happen is if they test the waters and there are no buyers.” (The cap rate is the buyer’s return in the first year of ownership based on the property’s net operating income and the purchase price.)
Size really does matter
Challenges on both the equity and debt side will create an even greater divide between the larger, sophisticated sponsors and the smaller firms that don’t have the resources to sustain volatility in the market.
“At SCI, we are raising more equity than we ever have in the history of the company,” says Marc Paul, president and co-founder of SCI Real Estate Investments, a real estate investment firm and TIC sponsor based in Los Angeles. In 2006, SCI purchased nearly $500 million in real estate.
Although Paul concedes that hitting its original $800 million acquisition target for 2007 will be difficult due to debt constraints, demand remains strong. TIC investors continued to show a voracious appetite for SCI’s Class-A properties — despite cap rates dipping below 6%.
In fact, Paul expects SCI to benefit from the debt crunch in the short term as demand heightens for the limited inventory of available TIC properties. SCI had locked loans on the acquisition of five new properties in early July. Even though lenders went back and repriced those deals at a higher rate — about 30 basis points higher, the end rates were still much cheaper than debt that is available today, Paul notes.
For example, SCI is marketing Austin City Lights, a 352-unit Class-A luxury apartment complex in Austin, Texas, that it acquired for $40 million. SCI is raising $20.1 million in equity, with minimum investments of $250,000. The property was purchased at a 6.13% cap rate, and expects to deliver a 5.56% cash-on-cash yield in year one.
Those sponsors that have offerings on the market are going to benefit from the existing demand because they have lower-cost financing in place. “There is a good amount of equity out there that is going to look for a home — especially in the short term over the next 30 to 90 days,” says Aaron Cook, executive vice president and national sales manager at CORE Realty Holdings, a securitized sponsor based in Newport Beach, Calif.
CORE currently has two TIC deals on the market, one of which is an offering for a $26 million retail property on the West Coast. Cook expects the property to fully commit the equity portion relatively quickly, in large part because the deal features an interest-only loan for seven years — financing that is impossible to find in the current market.
The sponsor has four additional deals in its pipeline that are still feasible today, even with higher financing rates. CORE tends to include ample capital for property expenditures in its underwriting, so there was a cushion already in place to absorb this financing hit, Cook notes. CORE also is exploring financing options other than the currently pricey CMBS lenders, including life insurance companies, banks and other balance-sheet lenders.
There is no doubt that the TIC industry faces a number of daunting hurdles in the coming months. Although Omni was originally predicting that securitized sponsors would raise $4.5 billion in equity in 2007, Nogales estimates that volume will likely be lower — between $3.2 billion and $3.8 billion due to current market constraints.
It is difficult to predict how much equity the industry will raise in 2008. “The longer it takes the capital markets to settle down, the bigger the hit we will see on the equity side in the coming year,” Cook says. “And I don’t think it will be a short-term fix in the capital markets. It will likely be the first quarter of 2008 before the capital markets calm down and become less volatile with greater liquidity.”
Those sponsors that can weather the storm will be in a strong position once the market stabilizes. Some industry observers point out that a growing investor pool will help to offset the hit the TIC industry is taking from the slowing residential market. Another factor that will help fuel investment dollars to the TIC industry is a growing distribution network.
“The TIC marketplace is becoming more established and recognized by traditional advisors,” says Omni’s Nogales. “So even though the interest from 1031s has slowed down, the number of investors and advisors who are aware of this product is growing proportionately.”