United States: Real Estate-Based Business Owners: Comparing REIT vs. TIC Proposals

There are many businesses of all sizes that are real estate-based, that is a significant portion of the assets necessary to operate the business is in the form of real estate. The list of such businesses include hotels, hospitals, senior living facilities and golf courses. Because of the ability of the underlying business to generate cash flow, these types of assets have attracted significant interest from real estate investors looking for a higher return than they are able to realize from the typical apartment building or triple net office investments. Conversely, the owners of these businesses for a variety of reasons may want to take their equity out of their real estate assets, or at least get such assets and their accompanying liabilities off of their balance sheets. However, they do not want to give up control of their real estate, and they want to continue to operate their business on it.

This convergence of interests is not new. Businesses of all sizes have done sale-leasebacks for many years with institutional real estate investors. However, in the past these sale-leasebacks were underwritten primarily on the credit-worthiness of the underlying business, and not in any significant way on the value of the real estate.

In recent years the traditional sale-leaseback world has been greatly expanded, primarily by aggressive REITs which are willing to do such transactions with non-institutional borrowers as the REITs understood and were able to value the real estate independently of the business. These REITs have become a very significant source of capital for certain real estate-based business owners, particularly with respect to hotels, hospitals, senior living facilities and golf courses.

While this REIT-based trend was developing, and completely independent of it, the Tenant in Common (TIC) industry was born. Unlike REITs, which typically raise capital through blind-pool public offerings, the TIC industry raises capital on identified properties through private placements, generally to accredited investors who wish to invest the proceeds from real estate they have sold, deferring taxes on any gain through the like-kind exchange that is built into TIC offerings.

As with REITs, during its early years the TIC industry stuck to plain-vanilla real estate, e.g. apartment and triple net office buildings. However, in the last year or two the TIC industry has followed the REIT industry into sale-leasebacks on hotels, senior living facilities, golf courses and even hospitals. This has presented owners of real estate-based businesses who wish to consider a sale-leaseback with a choice: should you sell to a REIT or do a TIC offering? This choice has lead to a great deal of debate over the relative merits of REIT vs. TIC. What follows is a brief outline of some of the critical differences in the two structures from an owner’s perspective.

REIT: REIT issues Letter of Intent and then Purchase Agreement, both of which have many conditions, without any nonrefundable deposits. The REIT is spending money on due diligence but is not otherwise at risk. This makes the transaction highly contingent in nature from the Seller’s perspective, and can result in last minute readjustments of the pricing of the deal to the detriment of the Seller.

TIC: Purchase Agreement between Seller and a Seller affiliate (the "Sponsor") has few conditions and is in any event completely under the control of the Seller. Only closing risk is that the Offering will not sell, which by historical industry standards is extremely unlikely for an appropriately priced deal underwritten by a credible Managing Broker Dealer.

REIT: REIT performs and/or obtains from third parties extensive due diligence, which can be lengthy, expensive and burdensome for management. It is also "institutional" in focus which may lead to identification of "problems" which on a practical level are not material, leading to "remedies" in the form of required capital improvements which Seller/Sponsor must pay for.

TIC: Managing Broker Dealer performs due diligence and obtains a third party due diligence report, which the Buyers (the TIC investors) do not typically see. The due diligence is thorough but does not take as long or require management involvement to the same extent as a REIT’s "institutional" due diligence. There is a significantly lower risk of identification of non-material problems requiring expenditures by the Seller.

REIT: At least 120 days, with little economic incentive for the REIT to move quickly.

TIC: Typically 120 days, but TICs are highly motivated to close to meet their IRS deadlines and the Managing Broker Dealer is also highly motivated to close as they do not get paid until and unless the deal closes.

REIT: REIT needs to build in return expectations for its investors, which may be higher than for TIC investors because REIT investors are not getting the like-kind exchange tax deferral. REIT also needs to build in return for itself. This may put a ceiling on the Purchase Price that is lower than for a TIC Sponsor. In the current market a REIT may pay 10x cash flow while a TIC Sponsor may pay 12x cash flow. REIT is also less likely to be able to identify precisely all closing costs in advance, which although funded initially by the REIT are built into the Acquisition Cost, which is then multiplied by the rental rate, so in effect the Sponsor/Master Lessee pays such costs over time.

TIC: Purchase Price may be higher as return expectations of its investors may be lower due to like-kind exchange tax deferral. Closing costs are modeled in detail by the Managing Broker Dealer, are largely performance-based and are more within the control of the Seller/Sponsor than in the REIT scenario. All costs, including financing fees, capital improvement reserves, master lessee capitalization and legal fees are paid from offering proceeds.

• Term: Typically 20 years.

• Rent: Rate x Acquisition Cost. The rate may be higher than TIC due to higher investor return expectations and need for return to the REIT.

• Percentage Rent: Typically at least 10% of Revenues (i.e. gross, not net) above current base, cumulative. This could be as much as 50% of the increased NOI.

• Capital Improvement: Funded from Capital Replacement Reserve tightly controlled by REIT which must be replenished from property revenue.

• FF&E/Personal Property: Included in Purchase Price and transferred to REIT.

• Security Deposit/Capitalization of Master Lessee: Typically at least one year’s lease payments, in cash, without interest, in an account controlled by REIT.

• Option to Purchase: Master Lessee typically has no option to reacquire property and no control over sale, except perhaps a right of first offer.

• Term: At least 5 years but very flexible and determined by Seller/Sponsor/Master Lessee (all affiliates).

• Rent: Rate x Equity Cost, which may be lower than REIT due to use of lower cost senior debt and lower return expectations of TIC investors.

• Percentage Rent: Typically none, i.e. improved performance of the property is for the Master Lessee’s benefit.

• Capital Improvements: Capital Replacement Reserve funded from equity proceeds is under Master Lessee’s control, subject to requirements of Senior Lender.

• FF&E/Personal Property: FF&E and personal property stay with the Master Lessee and can be used to establish some net worth in the Master Lessee, reducing the capitalization requirements.

• Capitalization of Master Lessee: No security deposit. Capitalization is very flexible, with typically a mixture of cash and non-cash, with lender reserves counted toward any required capitalization. For a project that has sufficient cash to cover debt and equity return, the requirements are very modest. Any required capitalization is under the control of the Master Lessee.

• Option to Purchase: Master Lessee has Fair Market Value option to purchase, typically starting five years out

REIT: Closely controlled by REIT and fully subordinate to Master Lease.

TIC: Terms and fees more flexible as they are established between affiliates (Master Lessee and Property Manager).

REIT: Must comply with all REIT reporting requirements, which can be extensive.

TIC: Must comply with Senior Lender reporting requirements and send regular reports to TIC Investors, neither of which typically require REIT level reporting.

This comparison suggests that the TIC offering alternative deserves serious analysis by the owner of any real estate-based business before making the decision to sign up with a REIT. Although the TIC offering structure may seem more complex, the REIT closing process has its own complexities, and the loss of independence and greater reserves inherent in the REIT structure may well justify choosing a TIC offering.

This brief study merely scratches the surface of the complex issues in any such comparison. Real estate-based business owners considering a sale-leaseback should consult professional advisers, particularly legal counsel, who have significant experience with both structures.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.