Guaranteed Returns, Commingled Funds & Related Company Transactions

In 2002, an Internal Revenue Service ruling (Procedure 2002-22) set forth guidelines for purposes of determining where undivided fractional ownership interests in real estate could be treated as ownership of real estate. Under the ruling, if "essential elements" of the TIC arrangement are followed, TICs qualify for 1031 exchange deferral of taxes. The structure of a TIC can be beneficial to many investors tired of active daily real estate management. There are many solid TIC sponsors in the market today. However, this is the story of one that wasn't.

By 2005, TICs were a hot commodity. At one time, Boise, ID-based DBSI, which operated under names such as Spectrus Real Estate and For 1031 LLC, was riding near the top of the heap. The 29 year old company became one of the nation's biggest sponsors of Tenant In Common (TIC) ownership interests in commercial properties across the United States. By providing smaller investors with access to the institutional properties markets and, in some cases, a guarantee of investment returns (from 6.5% to 12% returns annually -- whether or not the property performed well), DBSI became one of the most well-known TIC sponsors in a rapidly growing industry. Guaranteed returns, regardless of performance....really?

But as the commercial market began slowing in 2007 and 2008, DBSI began reporting problems. By September 2008, the house of cards quickly began to crumble. In a letter to investors, DBSI indicated it was "temporarily" reducing or eliminating payments. Within six weeks, DBSI had declared Chapter 11 bankruptcy. With the bankruptcy, day-to-day management of its properties broke down.

In October 2008, bankruptcy court-appointed examiner Joshua R. Hochberg, former chief of the Justice Department's fraud section, began investigating claims of fraud. He was directed to investigate allegations that DBSI defrauded investors out of $500 million. DBSI founder and president Douglas Swenson was alleged to have taken somewhere in the neighborhood of $160 million ( (Swenson's counsel denies he did anything wrong).

Hochberg’s (preliminary report, released in June, indicates a tangled web of closely related companies primarily controlled by Swenson. Transactions within the company - including transfers among DBSI related companies, Swenson, and four other minority owners - were more numerous that previously believed. Instead of investing the money as promised, Hochberg declared that the company was "an elaborate shell game." Hotchberg's report seems to indicate that as the market cratered, and new cash infusions dramatically slowed, DBSI and its affiliates used new investor proceeds to continue their daily operations and pay off existing debts. His report also claims that Swenson, DBSI and several other executives exerted control over dozens of DBSI affiliates and essentially ran them as a unified business with commingled funds (where have we also heard this other major problem before?).

Hotchberg continues to investigate the demise of DBSI. A more complete, final report should be out soon. What will the report conclude? Based on the the initial report indicating commingled funds, closely-related transactions and guarantees of returns - three major flags in previous schemes - I'd say it, unfortunately doesn't look good for investors.

All-Cash TIC Advantage for 1031 investments

Some time back, I saw an interesting article by Robert Johnson - president of St. Paul-based AEI Capital Corporation - discussing the advantages of an all-cash tenant-in-common investment. I asked, and received, his permission to re-publish some of the important issues he describes in the article. The full article appeared in the January 2009 National Real Estate Investor. The article contains solid information for 1031 investors that lack debt in their relinquished property and are looking for suitable replacement property investments.

Access to affordable capital has rapidly become a difference maker in the tenant-in-common industry. TIC sponsors that able to use an all-cash acquisition and offering strategy are getting a leg up on their leverage-dependent competition. Moreover, a lack of acceptable financing is forcing some leveraged TIC sponsors to delay bringing. or to pull altogther, deals to the market.

Sales volume in the Tenant-In-Common industry has been reduced due to a decline in U.S. real estate sales and the corresponding decrease in demand for 1031 exchange properties which enable investors to defer capital gains taxes. Despite the drop in sales volume, the TIC property ownership structure remains sound for suitable 1031 exchange buyers.

Benefits of an all-cash TIC transaction include no foreclosure risk, no interest rate refinance risk, and less risk of capital calls. Added benefits include avoiding the bank application process, easier resale, and flexible 1031 exchange closing schedules.

All-cash TIC properties usually generate a slightly lower rate of return. On the other hand, the front-end fees associated with all-cash transactions will normally be less than those of TICs using debt. Ultimately, the all-cash model provides an added layer of protection that is attractive in a market where investors are increasingly averse to risk.

Although TIC offerings requiring leverage are still offered, they are considerably more difficult to organize in today's relatively illiquid market. As financing has become more expensive, and difficult to obtain, the advantages of an all-cash strategy become more meaningful for 1031 investors.

As Mr. Johnson points out, all-cash TIC offerings tend to focus on properties priced under $10 million and may not be suitable for all 1031 exchange investors looking to reduce risk (larger, institutional-grade properties are typically perceived by investment professionals to contain less overall risk). TIC offerings should be reviewed with full due diligence and a complete understanding of the investment risks. If you are considering an investment in a tenant-in-common property, you should discuss the offering details with your legal and tax professionals. For futher details on the ideas expressed here, contact Robert Johnson at 800-328-3519 or at aei1031@aeifunds.com.

Luna-TIC Fringe

Michael Franklin, author of this entry, is an Executive Vice President of Los Angeles-based FORT Properties Inc. He has graciously allowed us to borrow his thoughts about the recent economic crisis as it relates to the Tenant in Common (TIC) industry.

The past year has undoubtedly been the most challenging in recent memory for those involved in commercial real estate. Tenant-in-common (TIC) sponsors have felt the pressures and, in some high profile cases, have succumbed to the rapid changes in our economy. As in all areas of the commercial real estate sector, however, there are TIC sponsors that are reacting proactively to the challenges and there are those that won't survive the downturn. What are the major issues facing TIC sponsors in 2009? and who will live to see another deal?

A Business Model Issue, Not an Industry Issue

The past year was a few high profile TIC sponsors fail completely or take to the sidelines. While it may be expedient to view this as an indictment of the entire industry, those familiar with these firms recognize the reality - the stresses on this sector have magnified the fault lines of companies whose business models work only in the best of times.

Transparency and 'skin in the game' provide the incentive for sponsors to act with integrity. Each TIC investment must stand on its own merits. Those who invest in the asset inherently invest more comprehensive due diligence and are more realistic about the property's prospects - after all, this sponsor is willing to own the asset.

Refinancing - The Elephant in the Room

The majority of TIC investments were financed through Commercial Mortgage-Backed Securities (CMBS) vehicles. With an estimated $40 billion in CMBS loans for the TIC industry alone coming due in the next three years, the choices available may be difficult. Lenders have shown a skeptical willingness to extend existing term and the ability to extend the term may cost dearly.

Borrowers can also turn to more traditional sources of lending to refinance a property though they face the same challenges as all commercial real estate borrowers in addition to the burden of educating traditional lending sources about TICs. One challenge inherent in the TIC structure continues to prove difficult for all lenders - creating a comfort level in dealing with the multiple owners of a TIC asset.

Commercial real estate transactions have been paralyzed by the unwillingness (or inability) to lend. Supply cannot be manufactured without debt and fears within the market have made debt difficult to obtain. TICs are particularly susceptible to this environment as investors hoping to utilize a 1031 exchange find it increasingly difficult to find a buyer who can obtain financing.

There is Good News

While the evolution of the industry will result in far fewer TIC sponsors, those that remain will have done so because their business model is investor focused and realistic. These same sponsors will certainly have a history of strategic acquisitions and exceptional asset management or they would have been unable to obtain financing during these turbulent times.

TIC investments remain an outstanding strategy for certain investors. Well capitalized, strong sponsors will ensure that this option remains viable and attractive long after the economic crisis has passed.

For more information on thoughts addressed in this article contact Michael Franklin at 213-572-0222. If you have questions about 1031 exchanges and Tenant-in-Common Interests, please visit our website or give us a call at 888-367-1031.

1031 Exchange Partnership Issues

Investment real estate is commonly owned by multiple owners in a partnership or by multiple owners as tenants in common to an undivided interest in the underlying real property. An exchange of a tenant-in-common interest in real estate poses no problems and is eligible for 1031 Exchange treatment. However, an exchange of an interest in a partnership is not permitted under the Code and Regulations. Careful forward planning is required to ensure a successful 1031 exchange where partnership issues are involved.

If a partnership owns property and desires to sell and exchange it, the partnership is the entity or party to the like kind exchange. Since the partnership will take title to the replacement property, no issues are apparent during the exchange period. However, if the partners wish to split up immediately after the exchange, the "held for" requirement may not be met on the replacement property. The partnership would need to retain ownership of the new property for an unspecified period of time (one year is commonly thought to be sufficient) to meet this qualification. Once sufficient time has passed, the partnership can then dissolve and distribute the property - through deed to individual properties or tenant-in-common ownership - to the former partners.

If a partnership wishes to exchange property but one or more of the partners want to "cash-out" or go their separate way(s), it is common for the partnership to split out the ownership before the sale. The partnership distributes tenancy-in-common title to the individual partners who wish to proceed in separate directions. The partnership (and its remaining partners) would then proceed with an exchange of the remaining ownership in the name of the partnership.

Frequently, individual partners desire to end the partnership relationship when the owned property sells. They would prefer to take their share of the partnership sale proceeds and buy qualifying 1031 replacement property in their own names. Far too frequently, the partnership gives each individual their undivided tenant-in-common interest in the old property just days or hours before closing. The plan is for each partner to take ownership in his or her name and individually complete a 1031 exchange. This lack of planning presents problems. The entire exchange could fail since the partnership could be seen as the selling entity that did not take title to qualifying replacement property. The individual owners have not met the "held for" requirement as they only owned the property in their individual names for a short period of time.

If partners wish to discontinue the partnership, sell the property and go their separate ways - with either the cash or a 1031 Exchange - it is necessary for the individual partners to receive deed to the property from the partnership in advance of the sale of the property. This is done through a distribution of property from the partnership to its individual partners. The partners are then generally required to hold the property as tenants in common for an unspecified period of time (decent interval of time) in order to comply with the "held-for" requirement of a 1031 Exchange that requires a taxpayer to have "held" qualifying property for business or investment purposes prior to the exchange.

The services of a tax professional are essential for tax planning purposes. An experienced Qualified Intermediary is also needed to ensure a successful exchange structure where partnership and co-ownership real estate interests are involved. To view more on partnership issues or other issues related to 1031 exchanges, take a look at this 1031 Exchange Manual or give us a call at 888-367-1031.

Tired of Being a Landlord Yet You Don’t Want a Big Tax Bill?

Anyone who has owned investment real estate, whether a student rental, a small apartment building, an office building or a strip retail center, knows that two of the most demanding aspects of being a landlord is dealing with tenants and maintaining property. For many, being a real estate investor appears a Catch-22: you want out, but to get out you must give away all or most of what you have worked for. One of the best strategies for freeing yourself of landlord hassles while deferring taxes is 1031 Exchanging into an Absolute-Net-Leased property in which the tenant maintains the building.

1031 Exchange. The IRS Code allows you to exchange one real estate investment asset for another while deferring the gain and depreciation recapture on the sale of the first property. With 15% federal capital gains tax, state taxes and the recapture of depreciation, the potential for deferring taxes is huge...particularly if you have held the property for many years. On the sale of an investment property that has been held long enough to generate significant appreciation while a significant amount of depreciation has been taken, it is not unusual for 30% to 40% of the proceeds from the sale to be paid in taxes if the seller does not 1031 exchange into another property.

The IRS Code says properties eligible for a tax-deferred exchange must be like-kind. For real estate held for investment, that gives you a lot of latitude. An apartment building you own in California can be exchanged for an office building in Colorado. Raw land can be exchanged for a fully-developed building. Your 100% ownership in the building you are selling can be divided into two or three properties to create diversification. As long as the exchange is done properly the options for tax-deferred investments are limitless.

Replacement Property. Locating and securing your 1031 replacement property must be done swiftly, skillfully and knowledgeably. The replacement property must be identified in writing within 45 days of the sale of your relinquished property. Then, the closing on the purchase of the second property must occur within 180 days of the sale of the relinquished property. The process of selecting your replacement property should begin as soon as you know you have a solid buyer for your replacement property. You do not want to wait until day 44 to begin looking, or you are likely to come up empty handed.

If you are looking to let go of the hassles associated with being a landlord, then you should focus search on Absolute Net-Leased properties. Such properties can be purchased as fractional interests (also known as Tenant-In-Common, or TIC, interests) or as ‘whole’ properties. TIC interests are available in large retail centers, multi-family housing, luxury private student housing and office buildings. Generally, you will need a minimum of $150,000 in cash and meet certain accreditation requirements in order to buy into a TIC.

‘Whole’ Absolute Net-Leased properties are often the separately-owned pad sites of larger retail centers. It could be the real estate for a Jack-in-the-Box, a Big-O Tire Store, Blockbuster Video or a Starbucks. One of the classic Absolute-Net-Leased properties for the larger buyer is the real estate for a Walgreens Pharmacy. In general, you will need $500,000 or more in cash to purchase a quality ‘whole’ Absolute-Net-Leased property.

Where to find Expertise. The 1031 Exchange is the ideal tool to move from a management-intensive property into an Absolute Net-Leased property. While you do not personally need to have all the answers, you need to know where to find them. Two essential members of your team are: (1) an investment real estate broker who can provide you with and help you evaluate various TIC and ‘whole’ replacement property options, and (2) a top-notch Exchange Qualified Intermediary, QI for short. With the right expertise, you can preserve your hard-earned equity, establish a predictable and reliable cash flow, and free yourself from getting the call when the toilet is not working.

The above article was graciously provided by Mark Casey. Mark is president of Casey Partners, Ltd. a real estate brokerage and consulting firm headquartered in Boulder. Mark holds a Master of Business Administration (MBA) from the University of Virginia. and is a member of Commercial Brokers of Boulder and the Denver Metro Commercial Association of Realtors (DMCAR). Casey Partners can be reached by calling 303-665-6000 or email info@caseypartners.com.

One dollar is worth fifteen

The following except was provided in a recent newsletter from John Temple, President of 1031 Property Watch. I felt the content was important and wanted to include it in our blog. He graciously agreed to allow us to repost it. John writes,

I just returned from a strategic planning meeting with the Tenant-in-Common Association (TICA) Board of Directors. It should come as no real surprise that the effects of the credit crisis that started in the second quarter of 2006 are being felt throughout the industry. Arguably, this real estate correction will take some time to work itself out. In the past 60 days prices have softened to the point where the average cap rate has risen 60 basis points, from 6.20% to 6.80%. This is good news for real estate buyers; however finding value will still require a sharp pencil and an experienced eye as prices continue to correct.

The market is also getting back to real estate basics. Properties are no longer being valued based upon speculative assumptions, but rather through predictable increases in net operating income (NOI). Solid increases in NOI will keep real estate performing over the next few years. I believe it will not only bridge this market correction, but is how a disciplined investor should invest over the long term.

Let me give you an example of how increasing the NOI can add value over time. Let’s say that a given property has an annual rent increase of 2%, for a total of 20% over ten years. Given a cap rate of 6.67%, a $1 dollar increase in net operating income will increase the value of the property by approximately $15. So if your property has an NOI of $100,000 and a rent increase of 2%, in ten years the value of your property would raise from $1.5 million to $1.8 million. In this example, a $20,000 increase in NOI moves the price up $300,000 dollars. This explains why experienced investors look for properties that can sustain long-term occupancy and support small steady increases in net operating income.

NOI / Cap Rate = Sales Price

If you would like a more detailed article on how NOI growth works or if you want more information on how this could affect your property, please give John a call at 877-337-1031. He can also be reached at john@1031propertywatch.com.

Commercial Real Estate Broker exemption considered

On November 9th, the National Association of Realtors (NAR) submitted a request to the Securities and Exchange Commission (SEC) on the organization’s exemption from securities broker/dealer registration. Under the requested exemption, a licensed real estate agent or broker that is predominantly engaged in, and has substantial experience in, commercial real estate to provide real estate services and receive compensation from buyers purchasing Tenant-In-Common (TIC) fractional ownership.

Under NAR’s request, a Real Estate Advisory Fee could be paid by the purchaser. It also allows the fee to paid on behalf of the purchaser by a sponsor or issuer of a TIC security that would reduce the commmission or compensation received by a registered broker-dealer involved with the TIC security transaction.

The requested exemption would allow for a potential purchaser of a TIC Security to benefit from the real estate expertise of a commercial real estate professional, while still receiving necessary protections afforded by security laws. It would also limit the role of the commercial real estate professional and real estate firm involved in the transaction. NAR believes this would be consistent with the SEC's mission to protect investors while allowing the public to benefit from a licensed broker's knowledge and experience.

The requested exemption will enter the Federal Register at the end of November. The public then has thirty days to review and comment on the request. After the close of the comment period, the SEC will review the request as well as the public comments and determine the outcome.

This ruling could have a significant impact on the Tenant-In-Common industry. If commercial real estate professionals are not allowed to provide real estate services to, and receive commission from, investors, the exposure to undivided partial ownership interests in real property might be limited.