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Feature Article, January 2008
1031 Market Sees Interesting Times
Impacted by the credit crunch, the 1031 and TIC industries are seeing a flight to quality.
Karen Stone, CCIM
Whether you call it a crunch, a slow-down, a stall, a blip, a crisis, a meltdown, a correction, or an adjustment, the contraction of the housing market that occurred in the summer of 2007, followed by the mortgage and credit industry upheaval, has radically impacted the 1031 market. By the end of 2007, it had put the brakes on a year that started off strong. Shopping Center Business recently spoke with a number of executives in the 1031, tenant-in-common (TIC) and triple-net field to see how changing dynamics are affecting the sectors.
A One-Two Punch
“The first 6 months of 2007 were stronger than 2006,” says Bill Exeter, president and CEO of Exeter 1031 Exchange Services LLC. “The last 6 months have been significantly weaker. As the market was trying to navigate through the changes to the housing market, we got a second punch with the mortgage and credit industry crisis. That took the wind out of the sails of the exchange market almost completely.”
Jonathan Hipp, president and CEO of Calkain Companies, Inc., headquartered in northern Virginia, agrees. “The phone isn’t ringing as much,” he notes. “Although there are still buyers in the 1031 market, there are not as many transactions happening.”
For Pamela Michaels, vice president of Asset Preservation, Inc., a nationwide qualified 1031 intermediary, 2007 was busy, with the exception of one month during the fall 2007 blip. “The real estate market stalled and deals that were scheduled to move forward did not,” says Michaels. “Even though the 1031 market is not really debt dependent from the seller’s side of the transaction, buyers were impacted because they were not able to get the financing they had anticipated on the replacement property side of the equation. For the most part, that market has returned, maybe with slightly different deal terms.”
Bill Winn, president of Passco Companies and president-elect of the Tenant in Common Association (TICA), notes, “Buyers and sellers were unable to close due to stricter financing. Banks — especially local banks — reacted to the sub-prime situation by tightening their underwriting and credit requirements on both the real estate itself and the borrower.”
Hipp notes that 2007 had started to slow down already because lenders began pricing risk again. “During the first part of the year it was hard to tell the difference between a B credit and an A credit and investment grade and non-investment grade began to blend together.” The CMBS market turnover in August 2007 put the nail in the coffin, risk jumped to the top of the analysis list and transactions came to a halt.
Darryl Steinhause, partner with Luce, Forward, Hamilton & Scripps, says, “We do feel the slowdown and we are seeing some impact on the commercial market, but not near the level where people should panic.”
Jay Bastian, senior vice president with National Retail Properties, notes there was lessening demand throughout the year. “We track the number of keyword inquiries for our industry, such as ‘1031 exchange’ and ‘net lease properties,’ and we have seen a gradual decline in the number of keyword searches. We have also noticed a fall off in the number of responses to offerings on our website and distributed via email blast.”
How Far Down Is Down?
Bernie Haddigan, managing director of Marcus & Millichap, estimates that 1031 exchanges for 2007 are down approximately 30 to 35 percent compared to 2006. “Although the capital markets began to re-price themselves somewhat in July, that slow down has been in the last two quarters,” he notes.
“When you look at the 1031 industry on a more global level,” says Bill Dwyer, managing director of Net Lease Capital Advisors, “there has been a significant drop off in the number of transactions — especially smaller transactions. Since our firm tends to focus on the larger transactions with an average of $50 million, we have observed that larger transactions are continuing to get done. Because borrowers coming into larger transactions are more ‘financable’ and lenders get good economies of scale in larger deals and the credit of the tenants is better, lenders are willing to do things like trim their spreads to make the larger deals happen.”
Exeter agrees with Dwyer on the trend favoring larger deals. “Average equity per 1031 exchange has increased from the $400,000 to $600,000 range to between $1.2 and $1.4 million. Part of this trend is due to the credit crisis that is really hitting the residential market, which includes the single family/condo/duplex investment market. Many investors that hold these types of properties are out of the market right now. Investors that have properties in the $1 million to $5 million range are repositioning their portfolios right now. In general, it is a difficult market for individuals to get into now, unless they want to get involved in TICs.”
Deborah Vanelli, CCIM, director of net lease sales for Minneapolis-based Upland Real Estate Group, Inc., describes the 2007 market as a little more realistic. “Overall cap rates appeared to increase by 25 basis points for non-credit deals,” Vanelli says. “Investment grade credit picked up for a short period of time while the capital markets stopped lending. It then came back down as the ten year T-bill came down.”
Barry Silver, principal with The Silver Group, agrees. “Cap rates have begun to shift slightly, mostly for property priced above $2.5 million. The movement has not been dramatic, “ he says, “but sellers are raising caps by about 25 basis points.”
Keith Sturm, CCIM, principal with Upland Real Estate Group, Inc. feels the credit crunch has created pent up demand. “Because exchangers have limited time to close their 1031 deals, they were on the sidelines for a limited period of time, and then they came back.”
But some of them may not be as happy as they would have been if they had exchanged during the first half of 2007. “It is almost impossible to get a conduit loan priced anywhere near where it may have been 5 or 6 months ago,” says Haddigan. “For all practical purposes, the lending community at the moment is largely comprised of banks and insurance companies and they look at the world differently.”
“We are in not just in debt uneasiness,” says Steinhause, “ we are in debt turmoil. As a result, interest rate spreads have gone from 100 basis points a year ago to 300 basis points today.”
The Cycle Takes A Turn — With A Twist
According to Don Meredith, director of west coast operations for Concorde Exchange Group/Professional Asset Management, the challenges in the current 1031 market are unique in that they are mainly credit and cap rate related.
Paul Domb, asset manager for Miami-based United Trust Fund, agrees. “This cycle is unique because 1031 money is the driving force that is fueling and fanning the flames of the real estate market. Tax savings is actually catalyzing transactions more than the smart side of investing in real estate. It is definitely the tail wagging the dog.”
Winn notes that in past cycles the fundamentals of the economy have not been as strong as they are today. “Metrics like unemployment, inflation and interest rates are really pretty good right now,” he explains, “ and this usually doesn’t occur when the market is declining or perceived to be headed into recession. Overall, performance of commercial properties is good and occupancy is very high in all the main food groups. Rather it is the housing market that is having the impact. This is a new phenomenon because in the past we didn’t have pools of debt that were sold on Wall Street for housing loans.”
Exeter mentions another unexpected and significant influence: the actions of two qualified intermediaries that misappropriated funds during the year. “Not only did this affect activity, it could essentially start a trend where we are subject to more supervision and regulatory oversight,” he says.
Sean O’Shea, managing director of the net lease group of BRC Advisors, calls the net lease market “frothy,” and agrees it is fueled by 1031 taxpayers who wished to defer their substantial capital gains, apparently at almost any cost. “Before the crunch,” says O’Shea, “buyers could afford to pay a premium for replacement properties since debt was so easily accessible and offered in such a range of debt vehicles and sources. Now, the days of the $600 per square foot Walgreen’s are over. The dramatic shift in available credit combined with more stringent underwriting parameters is conspiring to force the investor market, both buyers and sellers, to recalibrate their expectations for return on invested equity giving rise to new equity requirements and the attendant risk re-evaluation.”
“Essentially, valuation has been thrown to the wind,” says Domb. “There are many people sitting on property because they don’t want to pay the taxes and because of the tremendous appreciation of real estate over the past 10 to 20 years, this money has to find a home.”
Property Sectors
“We are seeing a huge push for A-plus locations and stricter underwriting on the deal points,” says Vanelli. Hipp agrees, and adds, “Overall, there has been a flight to quality.”
“According to statistics from OMNI Consulting, retail is returning strong in the TIC world, representing 24 percent of equity closed during the third quarter 2007. This indicates pricing has adjusted,” says Hipp.
Silver notes the inventory of available property in 2007 was similar to that of 2006, with drugstores, auto related, discount stores, financial institutions and restaurants leading the way. “The wide variety of retailers we saw in the early 1990s has been greatly reduced while companies focus on improving operations instead of growth,” he adds.
Dwyer has observed that retail and office remain very vibrant sectors that are favored for exchanges, with industrial/distribution slightly trailing those two sectors.
According to Exeter, retail has had a really good run in performance, especially for the last 3 or 4 years. “In fact, retail has done so well for so long, these properties have capped out of their ability to increase rents at an acceptable rate. We expect near term appreciation percentages will be lower.”
“Within retail itself, a staple of the triple net retail focus has been drugstores, and we are continuing to see this,” says Dwyer. “Buyers know they can exchange into them because they are very commoditized and they know that if they prefer a short-term hold, there is a very fluid exit with minimal frictional costs.” for these types of properties.
During 2007, Exeter also began to see investors coming out of retail and commercial office and trending toward a demand for multifamily. “I see that trend continuing in 2008 because we will see more renters in the market.”
Hipp notes another new niche that is developing as people start to look at alternative investments. “Combination office and residential condo projects in downtown urban areas are starting to become a preferred asset class. We are actually starting to see some of this interest move to the suburbs, as well, and we think we will see more of this in 2008.”
Michaels believes this demographic of 1031 investors is also looking for passive investments. “Even northeastern based investors, who are generally conservative, are willing to consider TIC interests as an option. We feel this is due to increased education and information in the marketplace and the TIC track record.”
Steinhause believes people will continue to look at quality properties because they don’t want to lose their principal and that a move toward multifamily and hotel investments will continue because they are currently yielding a higher overall cash flow return.
“As a result of the 2007 crunch,” says Sturm, “people are returning to buying properties for the right reasons and overall this is a good thing.”
2008 Outlook
Buyers and sellers are looking for stability and security in the midst of uncertainty in the market.
“People have been in a wait and see mode to see how we finished 2007,” says Hipp, “and we believe they will bring their product to market in the first quarter of 2008 because interest rates are where they are. People who feel like they missed the window the last time will want to make sure they don’t miss it this time.”
Dwyer anticipates volumes will pick up again once sellers realize that the cap rates they were seeing a year ago are no longer as pertinent because of the capital markets. O’Shea believes that sellers are becoming more realistic as 2008 takes the stage. “You will no longer find 8.5 caps unless someone’s computer has broken,” O’Shea notes. “Sellers have been drunk on the wine of cheap money. They may have just realized that they have gotten to the bottom of the bottle, and the hangover is just beginning to settle in.”
“People are semi-optimistic,” says Steinhause, “and as cap rates go up and the interest rates come down, we will find that happy medium again sometime soon.” According to Steinhause, most people see the debt market stabilizing the end of the first quarter of 2008.
“We are just now starting to see the very front edge of a pull back in demand on the 1031 side based on the crisis in the credit market, the housing slump and all those things we hear about every day,” says Rob Hannah, president of TSG Real Estate, a TIC sponsor. “I feel that in 2008 you will see a significant reduction in the overall exchange market, particularly in that of individuals doing exchanges — and of that group I think you’ll see a primary impact in the southern California markets where people were able to buy single family homes and sell them for a 40 percent to 60 percent gain. Because of the housing slump, you will not see that anymore and that will slow down the exchange market.”
Hannah is a little bit bearish on 1031 demand going into 2008. “But, if we look at the numbers, 1031 demand got up to in excess of $250 billion a year ago, so that even transaction volume goes down to $180 billion, it is still a huge market.”
Meredith believes an excessive volume of negative news has put some buyers and sellers on hold and has put things into slow motion. “But we live in a huge economy and it doesn’t take long for pent up demand to work its way through the system. There is money out there and there is still property moving,” he says.
Haddigan believes it will be late summer before people get an idea of where the economy is going and Wall Street will be more aggressive about how it will put money back into the market. “Acquisition people for large commercial property owners are sitting on their hands right now, at least on the retail side of the business. They don’t want to make big bets when they don’t know where the market is going. It could get worse before it gets better.”
What About Deal Volume?
Deal volume is a prediction that varies among the executives SCB talked to.
“Transaction volume will not recover to its previous levels because even though there might be some liquidity in the credit markets in the future, the underwriting standards are changed for the long term to be more conservative,” says Passco’s Winn. “This means buyers will not be able to get as much debt and rates may not be quite as attractive — therefore we will not see the volume we had prior to the recent credit crunch.
“2008 will cautiously start off more active in the first quarter,” predicts Calkain’s Hipp. “Things will lighten up again in the summer months. Also, there will not be as many brokers in the market chasing as many transactions because when there is a shake up in the market, the market starts to ‘clean up’ and the older, more seasoned brokers with good reputations will use this as an opportunity to increase their platform and their base.”
Vanelli believes that the supply in retail may fall as retailers pull back on their expansion plans.
“We have definitely seen a slow down in the number of stores retailers have scheduled to open for expansion in 2008,” says Sturm. “We think this may lead to a supply decline in retail.”
Will Demand Be Up?
Our panelists had a lot to say about the demand for TIC, 1031 and triple-net leased properties in 2008. Some believe demand will increase:
“There will continue to be an insatiable appetite for all real estate asset classes, particularly net leases,” says Domb. “We expect to see strong continuing demand into 2008. Although credit of tenants is trending down, fundamentals of the real estate will take a back seat to the desire to defer taxes, and buyers will be willing to take a hit on income streams to accomplish this. Smart money — the institutions and the people that have been in this business a long time — will sit it out for a while, even though it is a seller’s market.”
“Real estate investors will mirror the stock market effect,” says Hannah. “When there was a major pull back in the stock market, investors no longer had any faith that buying any stock would result in a profit. Therefore, they became more conservative.”
Hannah believes this may lead to an increase in the TIC market in 2008. “There will be people who will particularly like TIC options because they see it as an opportunity to get into a better quality of investment and/or one with a greater surety of income,” he says. “While buying an investment house on the coast was attractive a year ago, now it may be more attractive to buy an interest in an office building or a retail property where you know you will get income every month. Security will become a greater attraction.”
Long-time executives like Silver believe that the market will be strong. “2008 will be another great year in the single tenant market,” he says. “High leveraged deals may be gone for now, but the security and reliability of cash flow from single tenant properties will continue to be the reason why I am bullish on the future.”
Vanelli and Sturm agree, “2008 is going to be a wonderful year for real estate investment and opportunities will continue to present themselves throughout the year,” they say. “We believe it is a good time to be in the market and to be an investor and that there are good opportunities for people to take advantage of.”
With the uncertainty in the market, good operators and those who ride out the storms always keep their heads above water.
“I believe change and disruption is good for the market,” says Haddigan. “Shaking things up keeps it interesting. Many savvy investors like to have disruption because less experienced investors may leave the market and create opportunities as they go. This is a market where you really need to have skills in the business because lenders, retailers, developers and brokers are all experiencing caution.”
A NEW TACK FOR TICs?
In late 2005, Louis Rogers, CEO of Spectrum Realty Services, was standing in line at a deli in Laguna Beach, California. Two soccer moms were in front of him and their conversation caught his attention. The first woman commented that she and her husband had just sold a rental house and they were going to invest in a TIC. The second woman replied that she and her husband had also just sold one of their properties and that they were going to invest in another property, flip it and then do a TIC.
“TICs are changing the face of real estate ownership and investing,” says Rogers. “The trend that started on the west coast is spreading outward from California where the TIC first sprouted.”
“A whole industry has sprung up around TICs,” notes Bill Exeter, president and CEO of Exeter 1031 Exchange Services LLC. Bill Winn, President, Passco Companies and President-elect of the Tenant in Common Association (TICA) points to the numbers to show the dramatic growth of the TIC industry. “In 1998, TICs represented $500 million in acquired properties. In 2006, that number had risen to $12 billion. Estimates for 2007 are quite a bit lower, at approximately $9 billion, due to the credit crunch.”
“If you look at the 1031 pie,” says Winn, “ the TIC portion of the pie continues to grow and it is spreading geographically from the west where it started to the eastern part of the US.” He expects the market share will continue to grow, even in the face of the current market fluctuations, because a large part of the market is still untapped.
The TIC Debate
SCB talked with Bill Winn, the president-elect of TICA, about the ongoing debate around the question, “Are TICs real estate or securities?”
“The ongoing debate has taken a back seat to another important issue,” he says. On November 17, 2007, the SEC released exemption language that, if approved, would allow TIC sponsors, who are registered broker-dealers, to pay real estate agents an “advisory fee” for referring clients into a securitized TIC structured transaction. Currently TIC broker-dealers cannot by law pay a fee to non-broker dealer licensed professionals. The whole rationale of selling TICs as real estate goes away if the proposed exemption language becomes law because then sponsors will be able to pay both real estate agents and securities brokers in a TIC transaction.
“The period for comment to the proposed exemption language, which was initiated by the National Association of Realtors (NAR), expired December 17, and affected real estate groups have weighed in,” says Winn. It is expected the SEC will release the final revised language during the end of the first quarter of 2008. If passed, the argument about securities versus real estate will become much less important. “We believe that sponsors selling TICs will convert to a securities platform, and this will solve approximately 90 percent of the debated issues.”
Winn notes the exemption language also proposes a minimum experience level for real estate agents to participate in compensation, which would hopefully ensure their ability to advise clients on the investment side. “The language suggests that participating realtors would have to have some kind of commercial certification or level of experience, such as a CCIM or its equivalent, in order to receive a fee,” he explains. Winn does not believe the final language will require a CCIM designation but that some other criteria will be established.
The opinion of other industry experts:
“The TIC industry has been kind of like the Wild Wild West up until the last several years,” says Keith Sturm, principal of Upland Real Estate Group. “Now the market is starting to mature. As real estate professionals, we think the situation going on between the SEC and the NAR, and the proposal to allow real estate people to participate in TIC transactions is a fantastic solution. It allows the people who should be selling real estate to do what they know how to do best. The securities people should also be delighted because they will have real estate professionals ‘on the street’ in the markets, providing them with more qualified buyers for their properties as well as detailed analysis of those properties.”
“When adopted, the exemption will revolutionize the entire TIC industry,” says Rogers. “This solution makes much more sense than dual licensing, by allowing securities brokers and real estate agents to do what they do best. This will open up the TIC transaction ceiling again. If you think about the army of real estate agents that are out there selling properties everyday, the industry will grow dramatically.”
Rob Hannah, president of TSG Real Estate, who presented the first no action letter request to the SEC over 3 years ago, believes the proposed exemption indicates that real estate professionals will get some form of regulatory relief. “The critical issues in 2008 will then become how the exemption will change the marketplace,” he says. “How will companies, whether they are broker dealers or TIC sponsors, modify their business plans? At the end of the day, it represents greater demand for product, which is a good thing.”
“The debate on whether TICs are real estate or securities is dying,” says Steinhause. “Primarily, the industry is acting as if they believe TICs are securities and the last two major players that have treated them as real estate are converting to securities platforms.”
Rob James, managing director of Kimco Exchange Place, believes TICs are a real estate product, no matter how you package them, and should be sold as real estate. “Tenancy in common ownership has been around for a long time and with the tenants-in-common agreements and the TIC roadmap that has been given by the IRS for doing them, I don’t see why we can’t sell them as real estate and pass the savings on to the investors. The securities loads and commissions are quite high and make for a more expensive and less efficient product.”
— Karen Stone |
©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.
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