Real estate investors looking to cash out of an appreciated property face a hefty tax bill. Or do they? One way to defer taxes while still participating in the boom in commercial real estate is to take those profits and immediately plough them into a tenant-in-common investment.
In a TIC transaction, a “sponsor” acquires a large income-producing property – such as an office building, shopping centre or apartment complex – arranges the debt financing and sells fractional interests to up to 35 accredited investors. These interests are particularly attractive to real estate investors who are in search of properties that qualify for a “1031” tax-deferred exchange.
With a TIC, the investor owns a share of a professionally managed, institutional-grade property and enjoys stable cash flow but escapes the management headaches associated with rental properties.
“For TIC investors, cash flow is king,” says Arnold Harrison, a partner at Jenner & Block and chair of the law firm’s real estate securities group.
TICs became popular in 2002 when the Internal Revenue Service said they qualified for 1031 tax-deferred exchanges. This refers to the part of the federal tax code that allows owners of an investment property to defer capital gains taxes if they reinvest the proceeds in a “like-kind” replacement property (a non-investment property, such as a personal residence, does not qualify for a 1031 exchange). The rules say a replacement asset must be chosen within 45 days and closed on within 180.
“Taking advantage of the tax rules is a crucial part of investing in real estate, probably more so than in any other business,” says Phil Rosen, a corporate partner at Weil, Gotshal & Manges and co-head of the firm’s real estate transactions and finance practice.
Marc Paul, president of Los Angeles-based SCI Real Estate Investments, one of the largest TIC sponsors, says sophisticated real estate owners know that leverage can maximise wealth, and deferring taxes is a form of leverage.
In other words, investors can use the “savings” from the deferred capital gains tax and depreciation recapture on the sale of a prior property to acquire a larger property. This is an appealing prospect for many baby-boomers who invested in real estate years ago. Though they can now make a tidy profit by selling, they would rather spend their golden years enjoying cash flow from a passive investment than worrying about tenants, maintenance and so forth.
“The older people get, the less concerned they are with the growth of equity,” says Lou Weller, principal and national director of real estate transaction planning for Deloitte Tax. It is “the preservation of equity” they are concerned with.
“There are large groups of boomers reaching retirement age who have amassed unprecedented amounts of wealth, a lot in real estate, who are now looking to cash out of their investments and do it in a tax-efficient way but want to avoid responsibility for operating the assets,” he says.
But, Mr Weller adds: “TICs are not designed to make people rich. They are like the bonds of real estate.”
The returns on a TIC investment are commensurate with its risk profile. TICs generate an annual yield of about 6 to 7 per cent compared with, say, a 10-year Treasury bill, which pays 4.76 per cent.
Investors have been flocking to TICs in recent years. In 2002, $356m of equity went into securitised TIC investments, according to Omni Brokerage, a securities broker-dealer specialising in TICs. Last year that figure soared to $3.7bn from $3.2bn the year before.
Brady Flamm, director of research, says the average securitised TIC transaction for 2006 was just under $400,000, while the average investor age was 58, which has come down every year since 2002, when it was 65.
While most TICs are sold as unregistered securities, SCI sells fractional interests through licensed real estate agents. It has a real estate portfolio of about $1.6bn. Industry leader Triple Net Properties has $4.6bn of commercial real estate under management.
Mr Paul says the attraction of TICs is that they give smaller real estate investors an opportunity to own a share in a larger, institutional quality building, “with better quality tenants and a much higher-quality manager”. The average age of SCI’s investors is 64.
“The population is ageing and as they age they look for easily understandable investments that produce income for their retirement that are relatively stable and have some protection against inflation built into them, that is the definition of commercial real estate as, over time, rents tend to increase.”
That does not mean TICs are risk-free or suited to all investors. Like any investment, there are downsides. “You are buying real estate, not a government bond, so the returns are not guaranteed. You can’t assume guaranteed retirement income,” Mr Paul says.
“Real estate prices are at historical highs right now, if interest rates rose and prices became softer, values could go down. You have exposure to general real estate risk. Value and cash flow can go up and down in cycles.”
Mr Weller says prospective investors should consider the “load”, or fees and commissions, associated with these transactions and how these costs are computed. In a TIC structured as a securities offering, the load can be 20 to 25 per cent of the equity portion of the deal. But the load on real estate TICs can be 10 per cent of the total value of the property, he says. (SCI charges a 5 per cent commission for putting together a deal.)
“TICs are generally not going to be profitable as real estate investments in the short run because of the loads,” Mr Weller says. “[Investors] have to rely on appreciation to get back their capital.”
There is always the risk that the building will sell for less than the mortgage and wipe out the equity. For now, however, the commercial real estate market appears solid.
“Commercial real estate is extremely strong,” Mr Paul says. “People may get confused with the residential market being a bit soft or subprime falling apart. This has nothing to do with high-quality commercial real estate.”
In her book, Effortless Cash Flow: The ABC’s of TICs, Kathy Heshelow points out that TICs, like all real estate, are not liquid investments. “All TIC investors should think of the investment as long term, whether that means a three-year hold, a 10-year hold or even longer,” she writes. “Investors should go into an investment with the plan to stay until the property sells.”
Getting out before the property sells is not easy, however, as there is no developed secondary market. And there are other potential downsides that should be considered, including management risk, the risk of a capital call and group risk.