The tenant-in-common industry is in the throes of an identity crisis that is forcing investors to choose sides on a complex — and often contentious — issue. Is TIC ownership real estate, or is it a security?
The answer, at least for now, is both. TICs are packaged, marketed and sold as securities by more than 70 securitized sponsors. At the same time, the concept of fractional ownership as a means to hold real estate title has been around since the turn of the 19th century. Dozens of real estate firms around the country have been offering such co-ownership opportunities for decades.
Both the real estate and securities industries are licensed and regulated, and both have opposing views on how transactions involving their asset class should be represented and marketed. “The challenge of meeting the expectations and requirements of both these industries may be one of the biggest challenges the TIC industry faces over the next five to 10 years,” says William M. Swayne II, CEO of Seattle-based WMS Financial Planners Inc.
Investors are typically introduced to real estate and/or securities TICs by a financial planner or real estate broker as an option in a 1031 tax-deferred exchange. The vast majority of all TICs — an estimated 95% — are conducted as part of a 1031 exchange. By definition, investors who are selling real estate as part of a 1031 exchange must purchase “like-kind” real estate. An owner can’t sell an investment property and purchase stock or other property for personal use.
“It can be confusing to the public and to some of the tax authorities, because if you’re doing a 1031 exchange into a TIC and buying a security, by definition that is not permitted,” says Marc Paul, president and founder of SCI Real Estate Investments, a real estate-based TIC sponsor in Los Angeles.
Yet the current assessment by various tax, government and regulatory authorities is that TICs can be both real estate and a security. That assessment has been reinforced by a number of rulings. The most significant ruling is IRS Revenue Procedure 2002-22, which recognized the TIC structure as real estate and qualified TICs for use in 1031 exchanges. Prior to 2002, the IRS had viewed TICs as interests in a partnership, which do not qualify as like-kind real property.
Parsing the differences
Real estate and securities-based TICs possess a number of similarities. Both sides offer investors a fractional interest in a property with all the same rights and benefits of real estate ownership. Most TICs are structured as a limited liability company where income is paid monthly and owners are not active in day-to-day management decisions. Both sides also rely on sponsors to find, acquire and package properties for sale to investors. “People want to paint all TIC structures with the same broad brush, but there are broad differences,” Paul says.
The biggest distinction is that securities-based TICs must follow Regulation D of the 1933 Securities Act. In order to comply with Reg D, securitized sponsors are required to sell TICs through licensed securities brokers and registered representatives. Also as part of Reg D, securitized TICs are prohibited from general solicitation, essentially barring them from mainstream marketing and advertising.
Real estate TICs face no such restrictions. Licensed real estate brokers play a key role in assisting clients in TIC decisions, and TIC sponsors can take advantage of a variety of marketing tools ranging from e-mail blasts to newspaper ads.
Reg D also requires securitized sponsors to provide extensive disclosures relating to the property details and risk factors. The result is a Private Placement Memorandum (PPM) that offers detailed property and due diligence information on everything from cash reserve requirements and net operating income to environmental reports and lease summaries. Although real estate TICs are not bound by the same requirements, many leading real estate firms offer an equally rigorous level of review, analysis and disclosure.
The SEC reporting requirements are often viewed as one of the biggest selling points for securitized TICs. “Investors prefer to invest in assets through a securities channel due to the fact that the nature of disclosure in order to comply with Reg D is more extensive,” says Kevin Shields, president of Griffin Capital, a securities-based TIC sponsor based in Los Angeles.
The reporting requirements and higher broker commissions result in higher costs on the securities side. Although the expense of securitized TIC offerings are declining due to competition, fees are still averaging about 9% of the purchase price compared with fees on the real estate side averaging between 5% and 6%.
Another significant difference between real estate and securities-based TICs is the management structure. Securitized sponsors continue to have some ongoing role in the management of its TIC properties as asset manager, and in some cases both asset manager and property manager.
On the real estate side, once co-owners come into title, they select a third-party management firm and a third-party asset manager who supervises the property manager. “Unlike the securitized sponsors, the investor is not looking to the sponsor for guidance. That is the main difference in our structure,” Paul says.
Controversial distribution model
The biggest point of contention in the real estate vs. securities debate focuses on the distribution model. TICs packaged as real estate can be sold by licensed real estate professionals. Once something is packaged as a security, it can only be sold by a licensed broker/dealer. “We feel that is a really important distinction,” Paul says. “The crux of my position is that who is better able to assist and protect the public in determining what is the appropriate real estate for them to buy other than trained commercial real estate brokers?”
Essentially, real estate professionals are being shut out of the securities side of the TIC industry, which raised $4 billion in equity in 2006. The restriction is a big issue to groups such as the National Association of Realtors, which has some 1.3 million active members. “NAR believes that the interest of the public is best served by being able to have a real estate professional involved in reviewing the real estate aspects of a tenant-in-common offering,” says Blaine Walker, a licensed real estate broker in Utah and chair of the National Association of Realtors’ TIC task force.
NAR is working toward obtaining a No-Action Letter from the SEC that would provide an exemption for licensed real estate professionals related to some of the Reg D requirements. NAR is hoping for a favorable decision that would allow real estate brokers, at the request of the investor, to offer advice on the real estate aspects of a securitized TIC offering and receive compensation for that advice.
Such a move by the SEC would solve the compensation debate at a federal level, allowing individual states to set their own standards in terms of who is responsible for regulating TIC transactions — real estate departments and/or securities departments. Walker is hopeful that the SEC will announce its response this spring and that it will be a favorable response for real estate professionals.
Even though there are distinct differences between the two platforms, both sides agree that it is essential for investors to scrutinize both the property and the sponsor. “As in any business, the quality of sponsors on the securities side runs the gamut from the good, the bad and the ugly,” says Shields. “The same is true on the real estate side.”