Thursday, February 04, 2010

Consolidate Now
Yesterday's Wall Street Journal had an article on a failed TIC deal.  It is an interesting read.  I read the article as a blanket indictment of the TIC and CMBS structure.  In the mid-2000s CMBS was pretty much the only game in town as the major banks competed to finance every real estate transaction, and most loans were underwritten to fit into a CMBS.  The competition between lenders and the availability of easy money spurred the TIC business and pretty much all real estate transactions of any meaningful size. 

TIC investors were sold a packaged product where a sponsor acquired the property and arranged the financing (almost always debt headed for inclusion in a CMBS).  TIC deals are a direct real estate investment for tax purposes, but are in all actuality a security.  TIC investors have no say in the management of the underlying property, even though they are owners. 

The article strikes to the heart of the TIC problem. Many TIC investors were small investors who had sold properties and then invested the sale proceeds into a TIC transaction to defer capital gains taxes.  The deals were not structured to have significant reserves for unknown leasing events.  The article highlights a property had only one tenant, which has now vacated the building, and the lender will only extend the loan if investors contribute an additional $2 million.  I would guess that most TIC deals don't have enough investors, in aggregate, that can contribute this level of cash.  It is likely that the property will be returned to the lender.

TIC deals need to be consolidated into real estate investment trusts (REITs).  This is the only way to stave off a long process where properties are returned to lenders one at a time.  The REIT structure, via a 721 exchange, will allow investors to keep their tax deferral.  It will also allow their investment to be spread over a larger number of properties.  The REIT can access additional capital for improvements and leasing expenses.  A REIT would also have the collective leverage to renegotiate CMBS debt, rather than a series of stand alone negotiations that quickly hit dead ends.

In a consolidation and 721 exchange, while investors maintain their tax deferral, they lose their ability to exchange to another property.  In essence, the REIT (via ownership in an operating partnership), is the final real estate exchange.  I do not see this a major impediment, because realistically, how many TIC investors were ever going to acquire another property.  It is my opinion that the TIC investment was the last stop for most investors, so why not consolidate into a larger fund to provide diversification and, possibly, a more reliable stream of income.  It is my opinion that consolidation into a REIT would be better for most TIC investors for several reasons:
  • Investors have a diversified investment rather than one property
  • The REIT has easier access to capital for leasing and improvements
  • The REIT has an ability to acquire additional properties at today's valuations
  • Ability to use the size of the REIT to get better financing terms
  • For estate planning purposes, it is much easier to liquidate shares in a diversified REIT than a fractional interest in one building
There are more reasons while a consolidation makes sense. The logistics are tough, and obstacles would include valuations for the exchange and reluctance of just a handful of investors, and on some deals even one investor, could stop a particular transaction.  It is my opinion, that after a few more events like those surrounding the property in the Wall Street Journal article, TIC sponsors and investors will be looking for ways to preempt problems.

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