THE RISE OF TIC SYNDICATIONS
Is this investor exuberance a repeat of the 1980s?
Rance Gregory
What would the pricing of real estate look like today without Section 1031 of the Tax Code? These days, most real estate professionals complain about too much capital chasing too few deals. Obviously, many factors are at play in this heated market, but could one of the most significant be the real estate tax break?
Every election cycle or so, Congress decides to retool the tax code to favor investments in certain industries. Inevitably, this tinkering tends to distort natural market forces. During the 1970s and 1980s, these industries included oil and gas exploration, construction, horse breeding, and movie production. Real estate was featured as one of the most prominent tax shelters of the 1980s. Soon, every salesman and developer who could fog a mirror wanted to be the general partner of a syndicate. The fees were huge, the upside enormous and the downside limited. Or so everyone thought.
Real estate fundamentals and economics went out the window, and real estate started to trade like art — it was nice to look at and one hoped it would go up in value. Buyers became more aggressive about buying a commodity not for its intrinsic value or income stream, but for its unique Congress-given advantage — the tax break.
As the tax code became more complex and some of its intricacies made less sense than originally intended, the 1986 Tax Act came along, stripping real estate of the ability to offset paper (passive) losses against active income.
By the end of the late 1980s, aggressive overpaying, over-lending and overbuilding began to take their toll on the real estate industry, and a nasty, long real estate recession set in. Savings and loan institutions failed and the Resolution Trust Corporation (RTC) was formed to restructure and liquidate problem, bank-owned real estate assets. Thankfully, the RTC succeeded in quickly ripping off the Band-Aid by aggressively selling loans and REO to aggressive Wall Street capital, which came to the table in the early 1990s to restructure and/or sell the enormous quantity of distressed assets. The economy was then able to make a sharp recovery, which lasted until 2001.
Throughout the 1990s, real estate was systematically undervalued as investors shied away from what was still considered a wildcatter asset class and reallocated these dollars to the equities (stocks) and fixed-income markets (bonds). Next arrived the venture equity-infused technology/dot-com feeding frenzy and collapse. Suddenly, the stock market tanked, interest rates fell to historic lows and investors found themselves again saying, “Hmm…this real estate sector doesn’t seem so bad after all.”
And they’re right. Real estate, used properly, is a tremendous addition to any individual or institutional portfolio. In general, it can provide intrinsic value, income, upside potential, a hedge against inflation and — guess what? — left-over tax benefits. For those of us who make our living buying and selling real estate assets, the many advantages of owning real estate are well understood. We should also be careful to separate those advantages that are endemic to the business from those that are granted by the tax code. The former are more dependable and sustainable than the latter.
Today, in place of the 1980s tax shelters, we are now witnessing an explosive phenomenon known as the tenant-in-common (TIC) syndication. Real estate has long been exchangeable on a one-off basis, in which an owner sells one property and buys another without a tax payment due under Section 1031 of the code covering “like-kind” exchanges. But the TIC industry really took off in 2002 when the IRS issued guidance confirming that TICs qualified as like-kind properties eligible under Section 1031. Essentially TIC syndications allow investors to pool their capital with others to leverage their buying power.
In early 2002, there were but a handful of TIC sponsors. Today, there are more than 75. In 2002, less than $500 million of TIC syndications were completed. Omni Brokerage of Utah estimates the 2006 total could exceed $5.5 billion. The growth is easy to spot in prices being paid for real estate, particularly in certain markets where TIC sponsors are most active.
There are several advantages to the TIC syndication approach:
1) smaller investors can acquire larger, more institutional quality real estate by teaming up with other like-minded investors
2) 1031 tax deferral
3) passive ownership (lack of management)
And there are some disadvantages:
1) complicated legal structure makes dispute resolutions difficult
2) lack of liquidity
3) lack of alignment with the sponsor. The sponsor is actually prohibited under the tax rules from retaining an interest in the profits. Therefore, they take their cut up front, usually ranging from 10 percent to 30 percent of the amount invested. This is in stark contrast to institutional fund managers who charge a back-end fee (typically 20 percent) based on performance above an IRR hurdle.
4) Due to the lack of alignment, some syndicators don’t really care what price they pay for the property. They get their fees out and it’s the investors’ money remaining at risk.
Keep in mind that disadvantages 1 and 2 above apply to all TIC syndications. Numbers 3 and 4 only apply to the wrong syndicators. Certainly, there are many firms doing a professional job for their investor clients and providing tax benefits at the same time. But like any other industry experiencing this type of growth, there are many inexperienced opportunists who are entering and distorting the market with aggressive practices.
Nevertheless, even in the hands of a qualified TIC sponsor, the tax-deferred exchange rules require rigid transaction timing deadlines. With today’s scarcity of good product, these deadlines put a gun to the head of otherwise rational investors who may find themselves overpaying for a property to avoid paying capital gains tax. Say an investor decides to sell a property worth $100 based on a 6 percent cap rate ($6 of net income). Let’s assume he would pay a combined federal and state tax rate of 25 percent. The investor would net $75 assuming zero basis in the property. Remember, this is only tax deferral, not tax avoidance. Alternatively, the investor could exchange this property into a new $100 asset valued at 6 percent cap rate. The investor saves $25 in taxes. But if the investor chooses a TIC sponsor that pays a 6 percent cap rate (or less) for a comparable replacement property and charges 25 percent in upfront fees, he has exposed himself to an immediate diminution in value. In other words, they paid the tax all right, just not to the government.
We are witnessing an epidemic of irrational decisions based on avoiding taxes and the realities of product scarcity. Tax-motivated investors are overpaying for real estate and paying large upfront fees, almost guaranteeing an eventual loss. The tax code should be designed to motivate rational decisions. One aspect of lofty real estate pricing today relates to the desperation of investors trying to cash out at high prices and move into TICs or other similar vehicles. In other words, the tax code is distorting market forces.
To understand the potential impact on today’s pricing, ask yourself these questions: What if we lost the depreciation deduction? What if capital gains tax rates go up? What if interest rates continue to increase? What if the IRS were to change its guidance on the like-kind nature of TICs? The answers help distinguish the fundamentals from the frenzy.
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