Monday, August 28, 2006

Lease Risk Dichotomy
Properties with lease risk are common in TIC offerings. In a TIC offering with a single office property, lease turnover of 100% is not uncommon over a ten-year term. The offering's cash flow could be impacted if the space is not leased for an extended period or if unanticipated tenant improvement costs are required to retain existing tenants or to attract new tenants. Sponsors estimate leasing costs and either borrow these costs initially or reserve cash from operations. But future leasing costs are best-estimates, as a leasing market in five years, for example, is unknown.

The large non-traded REITs avoid properties with significant lease turnover. Sponsors view lease turnover and the potential impact on cash flow as too risky. Long-term leases that generate predictable cash flow are preferred.

The dichotomy, in my opinion, is strange. The TIC offerings need the steady income and do not have the means to pay for unanticipated leasing costs or the reserves to withstand an extended vacancy. Unanticipated leasing costs and extended vacancies in a TIC offering will result in a distribution cut and may impact the long-term outlook for the offering. The non-traded REITs, with their diversified portfolios, can take leasing risk because of their cash reserves and access to capital. A non-traded REIT's all-important distribution should be unaffected by one property's leasing problem.

In the TIC market, leasing risk will result in out performance and under performance, as some offerings will benefit from a strong leasing market while others will suffer in poor leasing markets. Analysis should be centered on a property's lease terms, and the assumptions a sponsor has made. The non-traded REITs will muddle along. They may not have much leasing risk, but they certainly have cap rate risk, but that is a discussion for another post.

(Another issue for a future post is that TIC offerings' cost structures (front-end load) make properties with long-term leases unattractive, as these properties are expensive and a TIC's load structure makes the properties more expensive. Many TIC offerings with single tenants are uneconomical and do not sell despite the long-term lease.)

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