Tenancy-In-Common Turmoil
With bankruptcies and mistreatment of client funds, the last few years have seen fallout in the tenancy-in-common industry.
Ricky B. Novak and James W. Freeman

As real estate investors, developers, and professional advisors look back on 2009 and the years that preceded it, each now recognizes numerous deficiencies that existed in the industry. These deficiencies include questionable underwriting practices within the capital markets, flaws within the valuation system, and a general lack of adherence to fundamental commercial real estate development and investing principals.  Last month, we took a look at issues surrounding 1031 qualified intermediaries.  This month, we focus on similar issues pertaining to tenancy-in-common (TIC) syndicators.

Once Popular, Now Largely Avoided

Over the past several years, TIC transactions have enjoyed substantial popularity due to the ability of smaller real estate investors to invest in larger, more institutional grade properties. Presumably, these larger assets provide an investor the opportunity for stabilized cash flow and significant appreciation potential, while at the same time allowing diversification of the investor’s portfolio both geographically and across core real estate asset types.  These transactions were engineered by TIC syndicators who acquired interests in commercial real estate assets and then sold fractional interests in those assets to multiple tenancy-in-common investors. TIC interests became the investment vehicles of choice for many 1031 exchange investors as both the 1031 and TIC industries gained momentum over the last decade. As taxpayers struggled to identify ideal replacement property for their 1031 exchange, TICs became both a convenient and viable alternative for ensuring the deferral of capital gains taxes and depreciation recapture.

In order to ensure that property qualifies for like-kind 1031 exchange treatment, it is imperative that the TIC transaction not be inadvertently structured as a partnership.  This requires that a tenant-in-common agreement (TIC Agreement), not a partnership agreement, be adopted as the mechanism for managing the TIC’s day-to-day operations and property level decisions, based upon the retention of a property manager or Master Tenant.  These Master Tenant/property managers were typically affiliates of the TIC syndicator and received service fees from the TIC in return for the provision of these services. It has been posited by most tax attorneys that by removing asset management decisions from the TIC level, this master tenant/property manager structure protected the TIC from being characterized as a partnership.

In late 2008, the widely known TIC syndicator, DBSI Inc., as well as dozens of its property specific special purpose entities (referred to above as “Master Tenants”) filed for Chapter 11 bankruptcy protection. This bankruptcy filing impacted hundreds of TIC investors, property tenants, lenders, and other creditors. Like many syndicators, DBSI structured its transactions using a master lease model.  In this model the TIC investors leased the property to the master tenant, which was one of DBSI’s special purpose entities. The master tenant controlled the property and the TIC investors were not involved in either the property leasing or other operational aspects of the property. The master tenant subsequently subleased the property to the sub-tenants that took physical occupancy of the property. The master tenant performed duties typical of the landlord, including the collection of rents, and payment of operating expenses and debt service. The master tenant also paid itself a fee for performing these services; however, since the master tenant was one of DBSI’s special purpose entities, this fee was ultimately remitted to DBSI.

Several TIC syndicators structured transactions much like the DBSI master tenant model, while others used a model whereby a master lease was not implemented, thereby removing the additional layer of tenancy between the actual tenant and the TIC owners. In this more common model, the TIC engaged a property manager affiliated with the TIC syndicator, and this affiliate then sourced the on-site property management to a third-party. The additional layer of property management via the TIC syndicator’s affiliate generated additional fees for that TIC syndicator. In DBSI’s case, the firm was able to use the master tenant structure to guarantee monthly payments to its investors. Investors believed they would receive those payments regardless of the credit strength or financial viability of the actual property tenants. Unfortunately, many of these investors did not consider the worst-case scenario of DBSI’s income not covering its debt obligations.

DBSI had at least two separate companies that marketed and sold TIC investments. One company, Spectrus, sold TIC interests as real estate, while the other company, DBSI Securities, sold the TICs as securities. It has been unclear for some time as to whether TIC interests should be treated as a security or as a real estate interest --— a fact that led DBSI to structure its business in this manner. The distinction between real estate and securities investments is best summarized as follows: assets sold under a real estate platform carry a “buyer beware” element while assets sold under a securities platform carry a “seller beware” element. The difference between the two platforms stems from the strict Securities and Exchange Commission (“SEC”) disclosure requirements that are applied to securities, but not to real estate. One important fact for investors to understand is that regardless of whether the asset was structured and underwritten through the securities platform or the real estate platform, the TIC syndicator’s due diligence should not be mistaken for a guarantee that the property was indeed a sound investment.

The fact that some of DBSI’s TIC investments were sold through a real estate platform, which has less stringent disclosure requirements than those that were sold through the company’s securities platform, compounded the DBSI issue. Whether or not these TIC interests should have been sold as securities, rather than real estate, is a matter that must be addressed by the SEC. For years there has been significant debate as to whether TIC interests that are sold as real estate instead of securities violate SEC regulations. In DBSI’s case, there have been lawsuits against the company whereby investors claimed that DBSI did not give investors who purchased their TIC interests through the real estate platform vital information, such as the property purchase price and appraisal information. DBSI was also charged with securities fraud by both the state of Idaho and by an arm of the U.S. Justice Department. Further, in October 2009 a court-appointed examiner’s report for the U.S. Bankruptcy Court for the District of Delaware alleged that the company and its officers created a misleading financial picture of the company by inflating the values of assets, hiding the nature of inter-company payments, concealing mounting debt obligations, engaging in year-end cash manipulations, changing bookkeeping entries after the fact and pooling money that should have been kept separate.

Since DBSI’s cash reserves were pooled into one fund that was established to service both performing and non-performing assets, the company was in need of cash and working capital when the commercial real estate market dramatically slowed, property vacancies increased and TIC sales all but ceased. As a result, DBSI’s TIC investors began experiencing problems receiving their “guaranteed” monthly payments. It is believed that thousands of investors either received delayed payments or no payments at all, with all payments being subject to DBSI’s eventual bankruptcy.

Another example of TIC failure was Sunwest Management. At the height of the market, Sunwest was one of the largest assisted-living facility owner-operators with over 275 properties and an estimated annual revenue of $500 million. By January 2009, over 100 of its TIC properties had been placed into foreclosure, receivership, or bankruptcy. Sunwest structured its TICs through a real estate platform until July 2006, when it began selling them via a securities platform. In March 2009, the SEC filed securities fraud charges against Sunwest, its former President and CEO Jon Harder, and several related entities for allegedly misleading investors. These allegations were based on SEC findings that while Southwest claimed 10 percent annual returns on its TIC investments, in reality as many as half of its properties lost money. The SEC argued that Sunwest concealed this from investors by commingling funds and paying returns from both pooled funds, as well as proceeds from debt refinancings. On December 9, 2009, the U.S. District Court for the District of Oregon sided with the SEC in a motion for summary judgment against Harder and other individuals and entities connected to Sunwest. It remains to be seen how many other TIC syndicators will be forced into bankruptcy or litigation based on the affects of the current commercial real estate downturn.

The Clock is TICking

In many instances, the purchase price of the TIC assets reflected a market premium as they were purchased during the height of the commercial real estate frenzy. Further, because the TIC syndicator had significant due diligence and operational expenses associated with creating each individual TIC, and also needed to ensure revenue was generated for its benefit, a front-end load of between 8 to 12 percent was also common. When considering the asset purchase price paid by the TIC syndicator and the load associated with the asset, it becomes clear that many of these investors (although certainly not all TIC investors) paid a 15 to 20 percent premium to invest in the TIC asset. While there are benefits for incurring this additional expense, such as the ability to invest in a more institution grade asset that the investor otherwise could not have been able to purchase, and the peace of mind associated with having the asset professionally managed, the premium certainly meant that it would take at least a few years before appreciation brought the value of the asset in-line with what the investor paid for it.

When looking at many TIC investments in today’s commercial real estate market, it becomes clear that trouble may truly be on the horizon. As vacancies continue to rise, the negative impact on a property’s cash flow has resulted in an erosion of the TIC investors return on investment. This reduction in cash-flow, coupled with the valuation reset of an asset which was most likely over-priced when acquired, results in a drastic reduction in the TIC asset’s value.

One additional element that warrants further insight is leverage. In determining the long-term viability of the syndicated TIC market, it is beneficial to understand the critical role played by the commercial mortgage backed securities (CMBS) market. A vast majority of TIC products were structured using CMBS lending. These non-recourse loans were typically structured as a 7- or 10-year balloon note with between 50 percent to 70 percent leverage. As a majority of TIC properties were syndicated between 2003 to 2007 using the aforementioned CMBS balloon products, investors are now faced with a wave of refinance deadlines that begin next year, and last for the next several years. The timing of these billions of dollars in loan maturities could not be worse. First, there continues to be a glaring void of available refinance capital in the commercial real estate capital markets, including the continued limitation of available CMBS lending. Even if a refinance commitment can be secured, it will most likely be a recourse loan instead of the investor-preferred non-recourse loan that fueled the TIC industry growth. Secondly, there has been a shift in the lending environment whereby loan to value ratios and debt to equity requirements have dramatically changed. As asset values have plummeted, most investors have found that most, if not all of their equity has eroded. Therefore, if the TIC investor can find refinance capital, the lender will require less leverage against an asset that has depreciated in value.

The above scenario potentially results in a majority of TIC investors facing the prospects of hefty capital calls during a period of time when liquidity is a precious commodity and the ability to borrow additional capital is challenging. Even properties that were purchased with lower leverage may face troubles, depending on the asset’s current cash-flow. Many TIC owners facing these challenges may seek to sell their individual fractional interest. However, this will prove difficult without a functioning secondary market. Unless lenders are willing to extend the note term until the capital markets fully recover (a practice affectionately referred to by many as the “Pretend and Extend” strategy), many TIC assets may face the prospects of default, and could ultimately be forced into bankruptcy. While bankruptcy may prove a difficult challenge for any property investor and lender, bankruptcy for a TIC asset is substantially more complex due to the fact that as many as 35 TIC investors can be invested in each property. Banks and receivership firms would therefore find themselves coordinating with the numerous investors within in these failed TIC entities. As TIC investors look to exit the property and avoid bankruptcy, this scenario may provide opportunities for investors with access to cash and debt capital to purchase core assets at a substantial discount.

While the worst-case scenario for many TIC assets and investors could prove an administrative nightmare, not all TIC assets will fail. The value of a TIC interest as a viable investment alternative should not be summarily dismissed. Quality performing assets that were properly underwritten, purchased at a true “fair market value” with a reasonable debt equity ratio, subject to a minimal front-end load, and leased to strong credit tenants should have a legitimate opportunity to find refinance dollars. As the commercial real estate market slowly navigates through the recovery process, non-recourse financing via CMBS, or similar alternatives, may return to the industry. Once this occurs, TIC activity, and commercial real estate activity in general, should increase. Investors that consider TIC assets will need to carefully review underwriting analysis for the property, which might include less-sophisticated investors hiring third-party commercial real estate experts to assist them in performing due diligence on these assets. Investors may wish to underwrite the TIC syndicator as well, focusing on the historic performance of previous TIC offerings. Regardless of current challenges, if structured and underwritten properly, TIC assets can prove to be a valuable part of a real estate investor’s portfolio.

Where Do We Go From Here?

This year will likely prove to be another challenging one for the TIC industry.  The industry is directly tied to cycles in the commercial real estate market.  The majority of real estate transactions and those which employ a 1031 exchange element in 2010, much like 2009, will most likely contain either an all-cash or seller-financing characteristic due to the constrained capital markets.  As these markets begin to loosen throughout 2010, transactional volume should increase. However, since many investors may not experience substantial capital gains from disposition, or may have loss carry-forwards to offset any capital gains, investors that would normally perform a 1031 may instead consider foregoing an exchange.  This will in turn provide investors with ample time to fully vet future investments. Additionally, as commercial real estate values bottom-out, investors in U.S. real estate should witness a significant transfer of real estate wealth. Commercial real estate investors that purchase assets in 2010 will be prime 1031 exchange candidates in the years following, as substantial gains are realized during portfolio repositioning and subsequently deferred through reinvestment.  The return of real estate development should also positively affect exchange volume.  As 1031 exchanges and transactional real estate volume increase, more TIC syndications and sales will likely occur, but on a more prudent level with increased due diligence.

Ricky B. Novak is president and James W. Freeman is CFO of Atlanta-based Strategic 1031 Exchange Advisors. Freeman is a licensed CPA in multiple states, while Novak is a licensed attorney in the state of Georgia. Freeman can be reached at jwfreeman@sea1031.com, and Novak can be reached at rbnovak@sea1031.com.

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