The ABCs Of TICs
The TIC structure is becoming a more popular way for non-traditional retail investors to enter the sector.
Scott L. Shafer

TIC ownership has become a popular topic with 1031 investors as a means of acquiring undivided fractional interests as co-venturers in an entire investment property while participating proportionately in net income, tax shelters, growth and profit upon sale. This co-ownership structure is typically favored by a property owner who has sold property and is looking to reinvest the proceeds in a replacement property for his/her IRC section 1031 tax deferred exchange.

Specifically, a TIC sponsor sells fractionalized interests in a prepackaged investment property to 1031 investors who will enjoy the same bundle of rights and privileges as a single fee simple owner while deferring capital gains taxes. These rights and privileges inure to smaller investors with a few hundred thousand dollars and who are commonly limited to only a few alternatives to invest in a fee simple property as well as wealthier investors who have access to a greater amount of equity.

The benefits to an investor derived from a TIC investment are substantial. The investor will have access to large multi-tenant investment grade properties with financially secure credit worthy tenants under long term leases with minimum equity requirements. As a result, the investor may realize more secure cash flow and a greater appreciation potential due to the quality of the investment. There are no management obligations since the TIC sponsor or its affiliated company is responsible for day-to-day operations and property management. By acquiring fractional interests in several TIC investments simultaneously, a 1031 investor will ultimately develop portfolio diversification much like a real estate stock mutual fund

Generally speaking, TIC sponsors who offer a wider range of investment opportunities essentially facilitate the purchase of a fractional interest by 1031 investors, such as multi-tenant retail, multi-tenant office, industrial and multifamily property types, than is conventionally available when limited to purchasing a smaller, single (fee simple) ownership interest in a property. Regardless of the property type, a TIC sponsor provides an investor with the benefits of ownership with a separate deed and title insurance without the burdens commonly associated with fee simple ownership.

Typically, a TIC sponsor offers superior efficiencies in identifying and acquiring a property after completing a comprehensive due diligence review and analysis while providing long term financing and management services of the particular asset. In this way, an investor does not have to go through these same arduous tasks in deciding whether to invest his/her equity in one property or another, but is able to review each property through a sponsor's investment package with ease and comfort given the strict time restrictions. Essentially, every TIC sponsor provides a one-stop shopping experience for prospective 1031 investors.

Clearly, it is understandable why TICs have become so popular to 1031 investors seeking an upgrade in the quality of his/her investments while seeking replacement properties. Likewise, it is also understandable why there is also an increasing number of TIC sponsors who are interested in securing their fair share of the available investment pool dollars among 1031 investors. According to Utah-based Omni Brokerage, there has been a steady increase in the number of TIC sponsors over recent years. Clearly, TIC sponsors play a particularly important role as a source of replacement properties for 1031 trade buyers. Correspondingly, there are significant fees associated with these pre-packaged investments that will be absorbed proportionately among the co-venturers and may eventually impact their return.

1031 investors will ultimately pay a premium for his/her investment arising out of the conversion process from a single fee ownership to fractional interests. Most TIC sponsors treat the sale of their fractional interests for a particular property to be governed by securities laws. A minority of TIC sponsors view the sale of their units as a real estate transaction. Consequently, the costs associated with the sale of fractional units deemed as securities have a greater cost impact than those TIC properties that are considered a real estate investment.

The fees that are earned along the way as a single ownership property is acquired and subsequently converted into a TIC property can become quite significant. There is no industry standard whereby the fees or fee structures are the same from one sponsor to another or even for one particular property type. Initially, a TIC sponsor acquires an investment property as a fee simple interest at some negotiated price. The fee simple interest is converted into a TIC property through various legal documents that each co-venturer is required to execute at the time his/her fractional interests are actually purchased for the subject property.

The resulting fractional interests are then sold to investors collectively at a higher price than the original purchase price paid by the sponsor. For those TIC properties that are sold as securities, investors purchase these fractional interests through a network of broker-dealers, i.e., licensed financial advisors, who collect a fee from the sponsors upon the sale of every fractional interest by an investor.

Typically, a TIC sponsor, who considers the sale of its units to be restricted by securities laws, may be compensated by collecting a fee, similar to a sales commission, that equals 3 percent of the original purchase price, initially upon the sponsor's purchase of the property from a seller. In the event the seller does not pay a commission to the sponsor or the sponsor has to share the commission with the seller's broker, the TIC structure will ultimately pay this commission either in its entirety or partially, respectively.

The sponsor will earn a commission after the conversion on the resale of the property to the TIC investors. The 1031 investor, who is represented by his/her real estate broker, will also be required to pay a commission, perhaps equal to 2 percent of the sales price of the TIC purchase price, to the broker. This commission is added onto the sponsor's fee. Additionally, the sponsor may collect a loan fee for originating the permanent financing or placing the first trust deed as part of the transaction when the co-venturers acquire the TIC property. This fee is usually calculated as 1 percent of the loan amount.

All equity raised by the network of broker-dealers will earn an equity formation fee usually equal to 4 percent of the equity raised from 1031 investors through the purchase of his/her fractional interests. This fee is based on the broker-dealer contacting a 1031 investor or is introduced by the investor's real estate broker, who ultimately acquires fractional interests as a replacement property for exchange purposes. For example, if the TIC sponsor is required to raise 30 percent of the purchase of the property as equity for the down payment in the transaction, then the fee for each broker-dealer will be based on the sale amount of the interests acquired by the 1031 investors.

A sponsor, or its affiliated company operating as a property management company, usually earns a monthly management fee equal to 3 percent to 5 percent of the gross receipts revenue of the property unless the lease is a NNN property and then, in this case, the tenants pay the fee directly as an increase to their base rent. So, whether the tenant pays a higher rent, which includes the management fee, or the fee is collected by the sponsor as a management fee on a smaller rent that does not include the fee, the same fee, regardless of its classification, is still collected by the sponsor.

The success of the operations for a multi-tenant property is directly related to the sponsor and its management skills and/or the selected management group and its staff. The vicissitudes of the market place play a compelling role as market trends impact the lease-up of the property during the holding period. The creditworthiness or strength of the tenants ultimately impacts the cash flow from operations, especially in turbulent economic times.

For multi-tenant retail or office properties, the sponsor or its affiliated company will receive a leasing commission equal to 6 percent of the value of the lease entered into during the term of the management agreement and 3 percent for renewals. The basis of the fee is limited to the length of the lease term and will not include option periods. A construction management fee can also be earned for supervising any construction or repair project on a sliding scale that is capped at 3 percent of the amount of the work.

The sponsor receives a non-accountable marketing and due diligence allowance in the amount of 1.5 percent of the gross proceeds from private placement of the units sold to investors. The TIC sponsor also receives a non-accountable marketing and due diligence expense allowance for serving as the managing broker dealer of approximately 1 percent of the gross proceeds.

A sponsor or its affiliated company will receive a sales commission up to 5 percent of the gross sales price of the TIC property, provided the terms of the sale are approved by the TIC investors, upon the close of escrow.

Sponsors will collect an administrative fee of approximately 1 percent on all rents collected, which pays for the investor's financial reports, either quarterly or annually.

The sponsor or its affiliated company will also participate in the net cash flow from operations on a sliding scale from 15 percent to 25 percent after the distributions are made to the TIC investors.

A sale fee is also charged to the TIC investors in the event the sponsor sells the entire property equal to perhaps as high as 20 percent of the net profit gained in the sale. The equity that has been built up over the holding period is also considered net profit by the sponsors and is subject to the same 20 percent sale fee.

It should also be pointed out that the 1031 investor will also pay his/her attorney for the representation in reviewing the disclosure documents prior to purchasing the fractionalized units. The formation costs for the preparation of these same documents will also be paid by the investors as a reimbursement to the sponsors as part of the initial costs to acquire his/her interest in the property.

In addition to these fees, the TIC investors will also pay (at the time of the purchase of their interests in the property) legal fees for lender and borrower representation, title and escrow fees, third party reports and the LLC formation costs (a reimbursement to the sponsor as a marketing and due diligence allowance). The sponsors will be reimbursed for organizational costs and marketing expenses incurred in selling the fractional interests. Other than the reimbursable costs and expenses, the balance of these fees are usually considered as reasonable based on an investor's purchase of a 100 percent fee simple property.

It should be observed that the sponsor will arrange for the resale of fractional units as the situation may arise on a case by case basis after the initial purchase of the TIC property by the approved co-venturers. Typically, the request to resell these units occurs prior to the expiration of the scheduled holding period.

The significant drawback to the purchase of a fractional interest is the lack of liquidity. Although it is relatively easy to get into a co-venture ownership property, it is even more difficult to get out of it as well, especially prior to the scheduled holding period for all co-venture interests.

Again, this is another service provided by a sponsor for TIC investors. The TIC investor must be able to match his/her 1031 investment with the same financial parameters of a replacement investor in order to sell the interest prior to the pre-determined sale date of all the co-venture units. Clearly, this matching process requires time and the selling investor will incur some expenses in order to complete this sale.

As is the case, the increase in investor awareness of co-tenancy ownership through the purchase of fractional interests has been met with a significant increase in the number of TIC sponsors as well.

Looking at the totality of a sponsor's effort, TIC investors receive a material benefit for the services. Fees earned by a sponsor for these services rendered may be justifiable, but nonetheless impact the return on a co-venturer's return on the equity invested in the venture.

The total amount of “fees” paid by the TIC structure to the sponsor and its affiliated company are substantial. The TIC investor pays going in and going out as well as along the way. It is clear about one thing in these co-venture structured relationships: the TIC investor pays and the sponsor collects.

Scott L. Shafer is president and CEO of 1031 Trade Solutions, a TIC sponsor based in Los Angeles. He can be reached at sshafer@1031ts.com.