Although the co-ownership structure associated with tenant-in common properties remains in high demand, the industry is discovering that it is not immune to mounting pressures from the frenzied commercial real estate sales market. The end result is that TIC players are fighting to survive an onslaught of hurdles that include lower returns, a longer lag time to close deals and industry consolidation.
“The real estate market has become overheated. The compression of cap rates and the price of real estate has gotten to a level that makes it more and more difficult to acquire property and present a reasonable investment to TIC investors,” says Charles “Duke” Runnels, president and CEO of FORT Properties Inc. The Los Angeles-based sponsor completed about $150 million in TIC offerings in 2006.
A case in point: FORT Properties recently closed on a $31.4 million TIC offering of Whitehall Tech Center I & II in Charlotte, N.C. The two office/flex buildings encompass 204,800 sq. ft. and are expected to deliver an immediate cash return of 7% per year — 50 to 75 basis points lower than the return the same property would have generated a year ago.
At the end of 2006, average cash-on-cash returns among the securities-based TICs fell to 6.8%, down from 7.2% in 2005, according to Salt Lake City-based Omni Brokerage Inc., a company that specializes in TIC investment for 1031 exchanges. In fact, some TIC offerings on the market have even dipped below 5.5%. “What we are seeing in the marketplace is that it is almost impossible to buy stabilized institutional real estate that produces the yields TIC investors are looking for,” says Manuel Nogales, director of business development at Omni.
So far, the pricing crunch is not stemming the wave of TIC investment. TICs enable investors to acquire a fractional interest in a property, which opens up a wider menu of acquisition options in larger, higher-quality properties such as shopping centers, office buildings and apartment complexes.
TIC transaction volume has been on a fast track since 2002 when the Internal Revenue Service 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 the sale of an investment property when those proceeds are reinvested in the purchase of another investment property.
The tax savings, coupled with other perks such as steady dividend checks and the ability to purchase larger, quality properties have made TICs a hit with investors, particularly aging baby boomers looking to shed the management responsibilities of sole ownership. In 2006, those TICs sold as securities alone were responsible for raising $4 billion in equity — a 26% increase over the $3.2 billion raised in 2005, according to Omni.
Although that pace is down from the 100% growth rate the industry has experienced in recent years, many experts believe investors will adjust expectations and help the industry sustain a steady expansion. “Right now, the TIC marketplace is still very strong. But we won’t see growth doubling as we’ve seen in the last five years,” says Tim Snodgrass, president of Argus Realty Investors, a TIC sponsor based in San Clemente, Calif.
Adjusting to lower returns
Compounding the problem of yield compression is that investors may not be able to count on appreciation to boost returns as they have in the past. Some TIC properties that have gone full cycle and sold have generated phenomenal returns because they took advantage of peak market pricing.
For example, Argus sold its Heritage Corporate Center in Santa Fe Springs, Calif. last year for $84 million — a 45% jump in value compared with the $57.8 million the TIC paid for the 720,000 sq. ft. office building in 2003. Yet investors need to realize that such home runs may be hard to duplicate in the current investment climate. Given the already dramatic run-up in prices, most industry experts believe that achieving such high appreciation levels in just a few years will be difficult.
“With the trending upward pressure in interest rates, combined with the improved returns being generated by the stock and bond markets, cap rates should begin to move upward,” says William M. Swayne II, CEO of Seattle-based WMS Financial Planners Inc. “If that occurs, existing property owners will not experience the same price appreciation they have come to expect. In fact, properties may go down in value unless we see a better than average increase in NOI (net operating income) growth.”
The decline in yields coupled with a proliferation of TIC deals on the market is not deterring investors. But it is prompting buyers to be more selective in the deals they are willing to make. Currently, the average TIC property is on the market for 120 days compared with 18 months ago when TICs were fully committed in 30 to 40 days, according to Omni.
Cathy Scullin is one investor who is continuing to identify TIC opportunities despite the fact that she has seen cash-on-cash returns fall to between 6.5% and 8% — a drop of about 100 basis points since her first TIC buy in December 2004. “If I find a good investment I like, I’m equating it to other investment options,” says Scullin, a senior vice president with NAI Capital in Encino, Calif. “From my experience, I have found that it is a better alternative in many ways than stocks and bonds,” she adds. Scullin owns 12 TIC positions in retail, multifamily and student housing properties across the southern U.S.
Yet investors do have their limits. For example, Scullin reluctantly will settle for a 6% return on a TIC that is part of a 1031 exchange, but as of now is unwilling to go lower. Her threshold on returns for new investment is 7.5%, but she prefers higher yields, such as a current investment property she is vetting that projects a nearly 9% return. “Those higher returns are harder to find, but they are there if you look for the right properties,” Scullin says.
Another concern in the current investment climate is that the lower returns do not adequately compensate investors for the risks they are taking. Risks are inherent to all real estate investment, and TICs are no exception. Some would argue that risks may be even greater among TIC investments because it is still a relatively young industry that doesn’t have a lengthy track record.
Underperforming properties are one of the risks when talking about any real estate investment. “First and foremost, TICs are real estate. If due diligence or projections are not done correctly, you will see deals go bad,” says Pete Johnson, vice president of marketing at Spectrus Real Estate Group, a Boise, Idaho-based real estate investment firm and TIC sponsor. Although Johnson says that all of the TICs that Spectrus has completed meet expectations, some TICs have surfaced in the broader industry that are falling short of expectations.
One risk is that a property delivers lower cash-on-cash returns than projected. That could be the case if a building does not meet leasing goals in terms of anticipated occupancies and rent increases, or unexpectedly loses a tenant. Another risk is that a building does not generate any return, or even operates at a loss. For example, suppose a 100,000 sq. ft. building loses its only occupant to bankruptcy. Not only is there no income stream, but the property also requires a capital call, or additional funds, to pay for marketing and leasing the space, as well as improvements to accommodate a new tenant.
“Due to the high volume of properties being sold in recent years, capital calls may be on the increase because many buyers rely on third-party due diligence reports,” Johnson says. “Some of those reports only scratch the surface,” he adds. Spectrus avoids those potential pitfalls by sending out its own engineer to thoroughly analyze every property the firm intends to purchase. That added scrutiny has uncovered a number of issues, such as roof repair or other structural issues, that are then factored into deal pricing. Sponsors vie for top deals
Clearly, TIC investors are already becoming more selective in their investment choices with deals taking longer to sell out. “This is a direct function of lower yields and an increased supply as the number of TIC sponsor companies has increased,” Swayne says. Currently, there are about 75 active securitized sponsors.
The plethora of TIC sponsors coupled with the scarcity of quality, well-priced properties will force industry consolidation. In fact, that consolidation has already started with about 10 sponsors dropping out in the past year and another eight or nine likely to exit the industry in 2007. “There is only a finite amount of real estate out there, and it is very competitive,” Snodgrass says.
The intense competition is putting pressure on sponsors to come up with new strategies to deliver quality, well-priced deals. One option is simply working harder to uncover solid properties that deliver favorable returns — including tapping smaller secondary and emerging markets such as Nashville and Charlotte, as well as expanding the size and type of target properties.
Competition for real estate is opening up opportunities in alternative property types such as hotels, assisted living housing and oil and gas interests that often deliver higher returns. For example, Spectrus is putting together land TICs that appeal to a more aggressive buyer who is willing to take a bigger risk to capitalize on rising land prices. “We are doing quite a few land deals now where it is more of an appreciation play,” Johnson says. Spectrus recently purchased nearly 14 acres of undeveloped land in Frisco, Texas, which is about 18 miles north of Dallas.
Sponsors such as Triple Net Properties have widened investment parameters in order to find attractive deals. The sponsor that once focused solely on office properties with trophy buys such as 123 North Wacker in Chicago is now exploring opportunities in the retail and multifamily sectors. Triple Net also is considering deals on the smaller end of the spectrum with equity commitments of about $14 million, which is significantly lower than the $48 million it raised for 123 North Wacker. “I think the marketplace has recognized that it needs to be much more flexible and mobile in the current competitive climate,” Nogales says.
It has not been easy for investors to adapt to lower returns, but they are making the adjustment. “The education process that goes on with TIC investors is that their level of expectation needs to be in line with what the market can deliver,” Runnels says.
Investors who expect to realize an immediate cash-on-cash return of 7.5% to 8% may find that to be unrealistic, especially given the fact that commercial real estate properties are trading at cap rates averaging 6.5% to 7%. The added front-end fees associated with TICs, which can range between 5% and 10% of the property value, often drop cash-on-cash returns another 50 to 100 basis points.
“I think investors understand the cap-rate compression, but at the same time it is kind of an education,” Snodgrass says. Most investors have already adjusted expectations. “Last year when we brought out a 6% and 5% deal, they thought we were crazy,” Snodgrass says of TIC buyers. But it is a matter of educating investors that if they want a quality asset in this heated market, that is the return they can expect, he adds.
One question is whether lower returns on TICs, and real estate in general, will prompt investors to move their money into other types of investments such as stocks and bonds. Certainly, many of those investors who are not investing in TICs as part of a 1031 exchange, will search for higher returns elsewhere. However, for 1031 investors, TICs continue to represent a very attractive option, because they can move quickly to close a deal and they are willing to take lower returns if that means saving 20% to 25% of their capital gains by deferring taxes.
The reality is that alternative investments are somewhat limited. If an investor opts to sell a property and then shift that money into an investment other than real estate, he or she faces paying the capital gains tax. “Not to say that investors are backed into a corner and the only option to them is TICs. That is not the case at all,” says Swayne of WMS Financial Planners. But TICs are earning a reputation as an increasingly viable option that offers a relatively secure real estate investment, generates steady cash flow and is not management intensive.
Adds Swayne, “The fact that not only are more and more private investors buying TICs for the first time, but that more than 90% of investors who are selling TICs are reinvesting in them again, would demonstrate that the concept continues to gain acceptance.”
—Beth Teig is a Minneapolis-based writer.