Only the Strong Survive

Capital constraints and sluggish commercial real estate sales have taken a big bite out of the tenant-in-common (TIC) marketplace. The volume of TIC equity raised has dropped significantly in the past year. Securities-based TIC sponsors raised $792 million during the first half of 2008, plummeting about 50% from the $1.6 billion raised during the same period a year ago, according to Omni Research & Consulting.

The sharp decline in deal flow has created a growing divide between TIC sponsors. On one side, the challenging investment market has forced consolidation among some sponsors, while others have suspended their TIC activity as they wait for the market to turn. On the other side sit those sponsors who are reaping the benefits of a less competitive market.

Oak Brook, Ill.-based Inland Real Estate Exchange Corp. is one of the most prolific TIC sponsors in the industry. The firm expects to post a record year for both equity raised and properties purchased in 2008. “Our pipeline of properties is the deepest that it has ever been,” says Patricia DelRosso, president of Inland Real Estate Exchange and president of the Tenant-In-Common Association (TICA).

This year, Inland plans to raise between $200 million and $250 million in equity compared with $180 million raised in 2007. Inland expects to deploy that capital by purchasing $500 million in properties for TIC investors this year.

Sponsor shakeout continues

There have been about 20 active securities-based TIC sponsors so far this year compared with 57 in 2007, according to Omni Research. “There is no question that the choices are fewer, but demand also has been reduced. Therefore, what we're finding is a relative level of equilibrium between supply and demand,” says James Shaw, president and CEO of Cap Harbor Real Estate Exchange Solutions in Beverly Hills, Calif.

But the concern is that the volume of sponsors will continue to shrink unless the financing picture improves. “If the debt markets don't change, I would guess that by the middle of 2009 there may be only 10 legitimate TIC sponsors still functioning,” says Daniel Oschin, president of SCI Capital Group and managing director of Los Angeles-based SCI Real Estate.

If the debt market remains constrained until the end of 2009, Oschin speculates that the number of sponsors could fall to five or six. “There are only a handful of TIC sponsors that are getting debt, and the rest of them can't survive,” he says.

“Most of them are not diversified companies, and diversification is the key,” emphasizes Oschin. Sponsors that are able to draw from a broader base of real estate investment management activity will be better equipped to weather the ups and downs in the TIC industry.

That diversification will be even more important to sponsors in light of continued uncertainty in financial markets in the wake of Lehman Brothers' bankruptcy filing and Bank of America's acquisition of investment bank Merrill Lynch.

Overcoming financing challenges

The biggest hurdle sponsors face is securing debt financing. “There are very few people in the industry, TIC or not TIC, who can get financing right now,” says Oschin. Sponsors need to have long-term relationships with lenders, deep pockets, a strong track record in the industry, and a diversified base of operations. “There aren't many companies who fit that profile. So it is very hard to get debt, and it's killing deals,” he says.

In the past, TICs have relied heavily on the low-cost capital supplied by the commercial mortgage-backed securities (CMBS) sector. Since that capital source has dried up in the wake of the capital crunch, TIC sponsors have had to pursue new relationships with banks and life insurance companies.

One challenge for sponsors is that the capital provided by banks and life insurers is more expensive than the incredibly low spreads that CMBS lenders were offering just 18 months ago.

A higher cost of capital can be a deal breaker for TICs by making it more difficult to generate returns that warrant the risk. The net cost of capital has increased at least 125 to 150 basis points for most sponsors since mid-2007.

Cash-on-cash returns have dropped slightly as financing has become more costly. Although higher capital costs have been offset by a slight rise in cap rates, initial cash-on-cash returns ranging from 6% to 6.5% are common today compared with 6.75% to 7.25% a year ago.

Another obstacle for sponsors is that some banks and life companies are reluctant to finance TICs. The chief stumbling block is the TIC structure, which allows for a maximum of 35 individual investors or co-owners. Conservative lenders tend to view that larger ownership pool as a high-risk factor.

Some lenders have solved that problem by offering only recourse loans, while others have agreed to provide financing only if a TIC limits investors to a smaller number, such as 10 to 20 individuals.

Yet shrinking the investor group puts more pressure on the sponsor to raise the minimum investment requirements. The sweet spot for TIC funds is a minimum investment in the $350,000 to $500,000 range. Once a TIC exceeds that $500,000 mark for a minimum buy-in, the syndication time almost doubles.

The big get bigger

Those sponsors that are able to secure financing have been successful in boosting market share. During the first quarter, the top five sponsors accounted for 55% of the TIC offerings compared with 38% in 2007 and 34% in 2006, according to Omni Research.

Oschin admits that SCI benefited significantly when its main rival, Spectrus Real Estate, decided to suspend its TIC activity due to the more challenging financial climate.

“2008 has been a struggle, but it has gotten better,” Oschin says. “As we trended into the third quarter and now into the fourth, we have seen an increase in equity, better deals available, more realistic sellers with more flexibility, and our access to debt is making the deals more attractive.”

SCI reports a 40% drop in its business, but that decline is not as severe as the slowdown in the broader commercial real estate industry where sales have plummeted by about 50%. SCI expects to raise between $125 million and $150 million in equity in 2008, which would enable the TIC sponsor to purchase about $300 to $350 million in properties.

In addition, SCI expects to see business pick up in 2009 with projections for raising between $225 million and $250 million to be used for $600 million to $700 million in real estate acquisitions. “Our advantage is growing every day, and as that happens, it is better and better for us,” says an optimistic Oschin.

SCI also has been taking advantage of its ability to buy quality assets by bidding on properties with all cash — eliminating the financing contingency on which most buyers rely. SCI will put debt on the property after the company closes the sale. After the debt is in place, SCI will package the property as a TIC. “We often are the fifteenth in line in terms of price when we bid, and we are the bid that gets picked because the seller knows that we are going to close,” Oschin says.

Earlier this summer, SCI purchased Campus Park in Stillwater, Okla. The student apartment community sits on 19 acres, about six blocks from Oklahoma State University. The project features 138 units in 10 apartment buildings with a clubhouse, pool and other amenities.

Investor demand slows

The slump in property sales across the commercial real estate industry also has stymied a key supply of equity flowing into the TIC market. Commercial and multifamily property sales during the first two quarters of 2008 totaled $86.7 billion — about half the $175.9 billion in properties that traded hands during the same period in 2007, according to Real Capital Analytics. The research firm tracks deals in excess of $5 million.

Clearly, demand for TICs is slowing as activity drops among the core clientele — 1031 exchange investors. Historically, more than 95% of the equity flowing into TICs comes from investors pursuing tax-deferred exchanges.

Still, industry experts say that the same demographic factors that helped drive explosive growth in the TIC industry in recent years are still in place, and continue to push demand for TICs — albeit at a more subdued pace.

TIC investors such as Gary Scott of Danville, Calif., say they are still TIC proponents, even though they have been sidelined by property sales of commercial real estate. Scott owns stakes in 12 separate TIC properties across the country, ranging from an office building in Minneapolis to apartments in Salt Lake City.

“Right now I'm standing pat to see how the real estate market is going to filter out before I go diving into anything else,” Scott says. He is hopeful that commercial real estate sales will start to revive in January.

Ironically, today's capital constraints are making TICs look even more attractive to investors who are having a difficult time securing financing on their own. “Buyers are finding that financing for residential property with one to four units is close to impossible right now,” Shaw says. The fact that TICs have the leverage to put deals together, obtain the financing and close on deals is still attractive to potential investors, he adds.

Reason for optimism

Once liquidity returns to the market, some of the sponsors that are sitting on the sidelines will likely return to the marketplace. “The key to the TIC industry is that there is no less demand from investors,” DelRosso says.

TIC sponsors have long touted the demographic shift in the U.S. as one of the key drivers to industry growth. Aging baby boomers are trading out of properties that require hands-on management in favor of TIC properties that are of institutional quality. Buyers moving into retirement mode like TICs because of their reputation for delivering steady cash returns without the management headaches of a sole ownership.

Aging baby boomers continue to enter into TICs as part of a tax-deferred exchange. So the dynamics that have been fueling the growth in the TIC industry in recent years are still in play. “The investors are there,” DelRosso says. “I think you will see expansion and contraction in the TIC industry based on what happens with the capital markets.”

Beth Mattson is a Minneapolis-based writer.

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