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The fledgling tenant-in-common (TIC) industry is gearing up for a wave of property sales as owners take advantage of premium pricing. The popularity of the TIC structure has contributed to a commercial real estate buying binge in recent years. The burgeoning sales activity is focusing new attention on reinvestment opportunities. TICs are used almost exclusively as a 1031 exchange vehicle, and the vast majority of investors want to defer those capital gains taxes yet again by rolling sale proceeds into another TIC. The downside of the growth is that some sponsors may lack knowledge and experience, and in effect weaken the credibility of the entire industry. TICs, like other forms of real estate ownership, have benefited from significant real estate appreciation in recent years. One of the biggest criticisms TICs face is lack of liquidity, if an investor should need to sell a fractional ownership prior to a property sale.

The fledgling tenant-in-common (TIC) industry is gearing up for a wave of property sales as owners take advantage of premium pricing. The popularity of the TIC structure has contributed to a commercial real estate buying binge in recent years. A TIC allows up to 35 investors to jointly own an institutional-grade property such as a shopping mall, office building or apartment complex while deferring capital gains taxes.

In 2005, the volume of TIC equity invested totaled about $3.3 billion - nearly double the $1.8 billion that was invested in 2004, according to Salt Lake City-based Omni Brokerage Inc. In contrast, TIC sales have barely registered a blip on the radar screen. But that is set to change as a growing number of TICs move to cash in on soaring property values.

Despite strong incentives to sell, the scenario also sets up a quandary for TIC investors. How do they reinvest those proceeds and continue to defer capital gains taxes in an incredibly competitive buyers market? TIC investors have two exit options: cash out and pay the capital gains tax, or roll the proceeds into a 1031 tax-deferred exchange ( section 1031 of the Internal Revenue Code), either through the purchase of another TIC or through the acquisition of a wholly owned property.

Certainly, one of the largest TIC transactions to date is the recent sale of the 1.2 million sq. ft. Puente Hills Mall in the City of Industry, Calif. Passco Cos. purchased the regional mall on behalf of TIC investors in early 2003 for $148 million and sold it to Glimcher Realty Trust in January for $170.1 million. The sellers opted to capitalize on significant appreciation due to both capital improvements and strong buyer demand.

The property, which sold for a cap rate of 7%, delivered a 20% annual internal rate of return (IRR) to investors. "We don't think the cap-rate compression will continue with interest rates rising, so we think it is a good time to sell to realize peak values," says Bill Winn, president of Irvine, Calif.-based Passco. Passco is currently marketing another five properties for sale on behalf of investors.

Since putting together its first TIC offering in 2002, Los Angeles-based SCI Real Estate Investments has purchased about $1 billion in retail and apartment TIC properties. Although SCI has yet to sell one of its TICs, the firm does expect five of its properties to hit the market in 2006 for a combined price tag of about $200 million. "We expect to have some very nice success stories in 2006," says SCI president and founder Marc Paul.

Maturing hold periods

The negligible sales activity up until this point is a reminder that the TIC industry is still incredibly young. By acquiring a fractional interest in a property, buyers gain access to larger, higher-quality real estate than what they could afford on their own.

TIC transaction volume has been gaining momentum since 2002 when the IRS issued guidance that qualified TICs as like-kind properties eligible for use in 1031 tax-deferred exchanges. Under a 1031 exchange, a real estate owner can defer capital gains tax from a sale when those proceeds are reinvested in the purchase of another like-kind property.

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Qualifying TICs as one of those likekind properties has given the industry a huge boost. The $3.3 billion in equity that was placed in TIC deals in 2005 is nearly 10 times the $356 million in equity that was placed in 2002, according to Omni.

The vast majority of TICs have adopted a five- to seven-year hold strategy. As a result, many of the properties that were bought in 2002 are just beginning to near their projected sell period. And record pricing is pushing many TIC investors to consider selling properties earlier than anticipated in order to capture a fat return before market prices dip.

Technically, TIC co-owners must vote unanimously to agree to a major decision such as a sale. However, most TICs are structured so that a 70% to 80% majority agreement is sufficient to move forward. The majority can buy out the dissenting minority owners, and then implement the plan to sell.

Recycling capital

The burgeoning sales activity is focusing new attention on reinvestment opportunities. TICs are used almost exclusively as a 1031 exchange vehicle, and the vast majority of investors want to defer those capital gains taxes yet again by rolling sale proceeds into another TIC.

The heated investment sales market is pushing investors back into a competitive buying market in search of another 1031 exchange. "Investors recognize that it's a great time to sell, but they also are asking, 'Where am I going to put the money?'" says Duane Lund, CEO of The Geneva Organization, a securitized TIC sponsor based in Minneapolis. "There is certainly the possibility that investors could end up reinvesting at a lower cap rate than they're receiving on a sale," Lund adds.

Although 1031 investors certainly have the option of purchasing a wholly owned property, Passco's Winn expects nearly all of the 29 investors from the Puente Hills Mall sale to buy a fractional ownership in another TIC. The average investor is coming out of the sale with $2.5 million in equity', and for those looking for a simple cash transaction, there are not many properties to accommodate them, Winn notes.

The good news is that the industry's explosive growth has spawned a myriad of choices, which was not the case even a few years ago. In 2001, for example, the industry was home to less than half a dozen TIC sponsors. Today, investors can choose from deals offered by more than 65 securitized and non-securitized sponsors. securitized TIC sponsors are regulated by the securities and Exchange Commission (sec) and National Association of securities Dealers (NASD), while non-securitized real estate sponsors are regulated at the state level.

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"In a short period of time, you can look at a lot of different TIC options and find one that suits you" says Joral Schmalle, a TIC investor and licensed broker with 1031 Exchange Options in Walnut Creek, Calif. Schmalle, one of the Puente Hills Mall investors, studied 20 to 30 different TIC properties before selecting five new TICs for a 1031 reinvestment that included both office and apartment properties.

The key to reinvesting is getting an early start to identify like-kind properties within the 45-day window allowed under 1RS guidelines. As soon as Schmalle knew Puente Hills was going forward with a sale, he started checking out reinvestment opportunities. Not only did he have all of his 1031 exchange TICs identified within the allotted 45-day period, but he also closed on four out of five of the properties in the first month.

The downside of that growth is that some sponsors may lack knowledge and experience, and in effect weaken the credibility of the entire industry. "While we want to give our retail investors the widest possible choice of replacement property, there are some new sponsors out there that are not adequately capitalized, nor do they have a deep bench when it comes to a management team," says clay Womack, CEO of Direct Capital securities Inc., a licensed TIC broker/dealer based in Santa Monica, Calif.

The biggest risk is getting stuck with a bad investment. Another risk for investors is choosing a sponsor that is unable to close a deal, and in the process blow an investor's chance of successfully completing a 1031 exchange.

Client retention is no small task

The challenge facing sponsors is retaining clients after a sale. Despite delivering an attractive 20% annual IRR, Passco expects to retain only 50% to 60% of its Puente Hills Mall investors. Because the price tag on the mall sale was so large, Passco has been scrambling to find suitable properties to buy in what remains an incredibly competitive investment market. "We are having difficulty in accommodating all of those investors," Winn acknowledges. "Given the amount of capital that needs to be placed, the buying market is very difficult right now."

And that problem may only get worse as the year progresses. Passco is currently marketing five additional properties for sale, including the 90,369 sq. ft. Chapman Heights Shopping Center, a neighborhood retail center in Yucaipa, Calif, that is listed for $12.6 million. "Obviously, we would like to retain these clients as best we can," Winn says. For example, Passco is offering its new TIC investments to existing clients first before marketing to new investors.

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San Clemente, Calif.-based Argus Realty Investors LP sold two TIC properties in 2004. All of the investors have reinvested in new TIC deals, but only half stayed with Argus. "I don't mind if investors move on to a different type of property or different company," says Argus President Tim Snodgrass. "I want them to make a choice that's right for them. The more choices they have, the healthier the industry is." Argus, which is a securitized sponsor, currently has seven TIC groups that are considering property sales.

Part of that shift is natural as investors move to diversify portfolios by property type and geographic mix. Another factor that may encourage investors to shop elsewhere is stiffer investment requirements. For example, the minimum buyin for some of the deals Argus is currently offering is $1.4 million. So some of those existing investors may not be able to stay with Argus even if they wanted, Snodgrass notes.

Other sponsors are more optimistic about client retention. Geneva, for example, has retained 100% of the investors from two TIC properties it has sold, and the firm is hoping to retain the majority of investors that sell properties in the coming year. Geneva has four TICs that are currently contemplating a sale.

One incentive for investors to stay with Geneva is that the firm offers lower accounting and legal fees to repeat clients. Clients get a break on legal costs, for example, because some of the key documents are already on file. In addition, Geneva is anticipating upcoming sales, and stepping up efforts to identify properties for new TIC offerings.

Reluctant sellers

TICs, like other forms of real estate ownership, have benefited from significant real estate appreciation in recent years. Average cap rates on commercial and multifamily properties have dropped about 200 basis points in the past three years from 9% to 7%, according to New York-based Real Capital Analytics. Still, attractive pricing is not enough of an incentive for some TICs to sell properties earlier than anticipated.

One reason for that reluctance is that it is a very competitive buyer's market. Even though TIC investors could sell a property at an attractive price, they may not want to turn around and pay an equally hefty price on an acquisition. In addition, TIC investment is not cheap. Sponsors charge between 14% and 30% on investor equity for each deal, which includes both fees and a commission on the property acquisition.

Another limiting factor on TIC sales is simple demographics. "Most of our owners have owned properties for decades. This is not new money that rushed into the market in '04 and now wants to exit," Paul says. "This is a way to hold real estate wealth over long, substantial periods of time." So, most TIC investors are content to let their investments sit and pay out steady annual dividends.

Optimal hold period

Since 2002, Inland Real Estate Exchange Corp. has closed 50 different TIC offerings valued at almost $1 billion. Among those transactions, Inland has sold only one of those TIC properties. "What we hear from investors is that they are looking for a fiveto seven-year time frame, and we haven't hit that," says Patricia DelRosso, president of Inland Real Estate Exchange, a securitized TIC sponsor based in Oak Brook, 111. Inland's earliest TICs will begin maturing in 2008.

The one property that Inland sold on behalf of its TIC investors was The Landings of Sarasota, Fia., a 94,248 sq. ft. retail center anchored by Office Depot. The property, which was purchased in 2002, was sold in July 2005 because of changes that were occurring in the surrounding trade area. In light of increased competition, Inland advised its investors to sell the fully leased property to capture gains before sales started to decline. The owners realized an annual IRR of nearly 30%.

Even if owners are reluctant to sell, sponsors such as Inland are constantly looking for creative ways to take advantage of high property values and make more money for investors. For example, Inland initiated a refinancing of Broadway Commons, a 140,739 sq. ft. power center in Rochester, Minn. on behalf of its TIC investors.

The refinancing of the retail power center generated a cash distribution that amounted to about 20% of an investor's total investment. So an investor with a $500,000 stake received a cash payout of $100,000. At the same time, the refinancing boosted annual cash-on-cash returns from 10.9% to 14%.

Early exit is possible

One of the biggest criticisms TICs face is lack of liquidity, if an investor should need to sell a fractional ownership prior to a property sale. True, a TIC - as with traditional real estate ownership - is not meant to be a liquid investment. "That doesn't mean you are sentenced to life in your TIC deal," notes Paul of SCI.

TIC investors are free to market their ownership stake to another buyer, if they should want to sell their fractional ownership. The reality is that very few owners want an early exit. At SCI, only three investors out of hundreds of clients have sought an early exit. In each instance, investors that did want to cash out of their ownership stake with a pre-sale were able to do so.

Investors in TICs offered by securitized sponsors do need to follow sec guidelines when selling an ownership interest, such as hiring a licensed broker. Non-securitized sponsors such as SCI can play a more active role in marketing a pre-sale to existing clients. "In our deals, we give the other co-owners in the property the right of first offer at fair market value," Paul says. "Typically, that's all it takes, because we have so many investors looking for good quality TICs." Most investors prefer to buy into an existing versus a new TIC because there is already an established track record of specific returns.

Passco has not encountered a single instance where even one investor has sold a fractional ownership prior to the property sale. Although TIC investors certainly can sell if they choose, most want to hang on to their investments for the duration, Winn notes. In addition, most sponsors only work with accredited investors. Passco requires a minimum annual income of $300,000, or a net worth of $1 million for a retired couple. Corporations are required to have a net worth of $5 million.

Those investors that do opt for an early exit are finding a healthy demand for TICs - even as annual dividends have slipped. TIC returns have been declining along with sinking cap rates. Excluding gains from appreciation, average yields have dropped from 8% in 2003 to 7% in 2004 and 6% in 2005. Still, investors exhibit a tremendous appetite for TIC properties. Winn notes that investor demand today is 10 times greater than it was a few years ago - even on the lower yield.

Beth Mattson-Teig is based in Minneapolis