It is easier than ever for small investors to acquire an interest in high-quality commercial real estate, thanks to an investment vehicle that has rapidly gained in popularity over the last four years, known as a tenant-in-common, or TIC. This trend has raised the stakes for CPAs with clients who are wondering whether a TIC investment is right for them, and if so, which one to select. By keeping a few guidelines in mind, you can significantly increase the chances of success.
Tenant-in-commons have surged in popularity, thanks to a ruling issued in 2002 by the IRS. Known as Revenue Procedure 2002-22, it set guidelines that govern the formation of investment vehicles and most importantly, established that the fractional shares constitute real property and therefore qualify for deferred tax treatment of capital gains.
Investors, of course, could gain the tax advantages of investing in real estate by shopping for a piece of commercial property on their own. But the advantage of a TIC is that the prospectuses are pre-packaged, including all of the required due diligence paperwork; such as title insurance, environmental, tax opinion and study lease documents. This work, completed on the investors’ behalf by the sponsor, mitigates the up-front costs that the investor would incur if they sought out the investment independently and eliminates any of the conventional landlord’s headaches.
Through a tenant-in-common, an investor with as little as $100,000, or even less, can acquire a fractional share of a prime piece of commercial property. Investors in a TIC also benefit from economies of scale by pooling their money with that of groups of up to 35 investors, to purchase better, higher-grade pieces of property than they could afford individually. In many cases, TICs can increase cash flow and overall returns, and provide investors with valuable tax write-offs greater than direct purchases.
These innovative investment vehicles are clearly catching on with many investors. Since 2002, over $20 billion has been acquired through real estate investments and approximately 80 companies have moved into the niche and are now sponsoring tenant-in-commons. Over the last four years, as real estate values in general have soared, it has been difficult not to make money, at least at the back end on the appreciation of the underlying asset. But with interest rates on the rise, the days of easy money in real estate are probably over, at least for the foreseeable future. And with the proliferation of TIC sponsors, some are offering deals that are shakier than others.
What CPAs Should Consider
One of the first decisions that an investment advisor will face is whether to recommend a securitized tenant-in-common or one that is structured as a non-securitized investment. The vast majority of sponsors offer the securitized variety, which are subject to regulation by the Securities and Exchange Commission (SEC) and National Association of Securities Dealers (NASD), and may only be sold by registered securities dealers. Two prominent sponsors specialize in non-securitized TICs. Structured as straight real estate investments, they are not governed by the SEC or NASD and may be sold, just like any other piece of property, by a real estate agent. But the SEC has yet to weigh in on the legality of non-securitized TICs.
Securitized tenant-in-commons will almost always be a better choice for investors for reasons beyond the fact that there is no uncertainty about their legal status. To begin with, securities dealers have a fiduciary duty to act in their clients’ best interest and therefore are obligated to undertake due diligence to assure that an investment is reasonably sound and that it meets the particular client’s needs. The regulators also require the dealer to issue a private placement memorandum providing the prospective investor with full disclosure about the sponsor, details of the property offered for sale, third-party opinions about the deal and a run-down on risks associated with the investment. Investors considering the purchase of a share in a non-securitized TIC should be prepared to do much of their own due diligence and look out for their own interests.
There are a number of other criteria that should guide CPAs and their clients in searching for a solid investment in a tenant-in-common such as:
- Structure: Since the TIC structure itself is just four years old, you won’t find any sponsors with an extensive track record in that particular niche. But you certainly can find, and should look for, sponsors with longevity and well-established reputations in the field of real estate acquisition and asset management pre-dating the advent of TICs.
- Sponsor: You should consider how many real estate deals, including tenant-in-common sponsorships, they have done and above all, how those projects are performing. In today’s cooling property market, it is more important than ever to consider whether the investment, based on conservative underwriting parameters, is likely to be profitable on a day-to-day basis.
- Due Diligence: An investor and his or her CPA should look carefully at the depth of the due diligence that the brokerage offering the tenant-in-common has performed on the underlying piece of real estate. Ideally, they have carefully scoured the market for the best opportunity, often from resources not available to the normal investor, and have found an exceptional property in an “off” market that is being selected based on a variety of critical parameters. And, since the sponsor will have an ongoing role in overseeing the project, you should make sure they have a solid record as asset managers and are adequately capitalized. It is also prudent to find a sponsor with alternative sources of income. If the market for TICs dries up, they should have revenue from other sources to assure that they will stay in business and continue to manage the property.
- Pitfalls: In searching for a suitable tenant-in-common investment, it is important to consider possible pitfalls and how to avoid them. One risk is that sponsors may put together a package around a weak property based on overlying aggressive projections or one purchased at too high a price, perhaps thinking investors looking to buy a fractional share of a packaged deal may not be as discriminating as if they were buying real estate on their own. That risk underscores the importance of finding a sponsor with extensive experience in buying and selling commercial real estate in the particular market and a proven knack for finding good bargains. Additionally, the value of a broker/dealer is tremendous, as they provide thorough due diligence along with a registered rep that already understands the product and is able to pass along the advantages of investment strategies.
- Fees: Avoid a tenant-in-common that is overloaded with fees. One advantage of an investment vehicle is that all of the fees that go along with purchasing real estate are included in the cost of a pre-packaged tenant-in-common. But some sponsors may fold in excessive or unnecessary fees with those that are inevitable when acquiring property. In the TIC world, loan fees for appraisals, legal opinions and the like, can amount to up to 30% or more over the property value, however, quality deals may range anywhere from 4 percent to 10 percent over market value. The lower end of the scale is consistent with the all- inclusive costs of buying direct and ideally, investors would like to find a TIC with fees that total as little as possible.
Tenant-in-common offerings, especially securitized, are an option that a CPA should consider for real estate investors. This is particularly pertinent for clients with funds sitting in a 1031 exchange and facing an all-too-short 45-day period to transfer into another real estate investment in time to avoid the capital gains tax. TICs are great alternatives to other real estate investments because of their similar costs, opportunity to increase cash flow, better appreciation, and they produce lower risk and less involvement. A TIC can be an ideal investment choice if a direct real estate deal doesn’t work out.
For that reason, CPAs can best fulfill the needs of their clients by considering a tenant-in-common offering from the minute the client begins to look for a real estate investment. Since the sponsor will already have completed due diligence and put all other aspects of the property deal in place, an investor can much more quickly and with greater confidence assess the project and make a decision in a matter of days.
Written by Daniel Oschin, Executive Vice President and Director of Real Estate Services with AFA Financial Group, LLC. The website is www.goafa.com