Looking forward into the coming year for the tenant-in-common (TIC) industry always requires fortitude. This year, making predictions is particularly risky. Over the last six months, we have witnessed the most fundamental restructuring of the financial services industry most of us are likely to see in our lifetimes. What does it all mean? How will it affect our industry? Here are some thoughts:
- Contraction. The number of transactions and the total equity raised in 2008 is tracking to finish at less than half of 2006. It is easy to blame that fall on the debt markets, which are certainly a factor. However, a more fundamental problem is the significant decline in the number of people selling highly appreciated real estate, particularly in California. If real estate owners are not selling, then they also are not in the market to do an exchange. If there are fewer investors, sponsors will do fewer offerings, and some will leave the industry entirely, as will some broker-dealers and registered representatives. This "hunker down" mode will continue in 2009, particularly during the first half of the year. Efforts will continue to bring to the market non-TIC-specific products like funds, note offerings, and land and other development deals, but the depth of demand for such products sold through the TIC channel is unclear.
- Broaden Distribution. One way of dealing with the lack of exchange investors is to reach beyond the traditional TIC distribution channel. The simple truth is that most sellers of appreciated real estate have never heard of TIC investments as an alternative for their like-kind exchanges. There are larger broker-dealers not currently active in the TIC industry, who the sponsors may seek to reach out to in their search for investors. Will these broker-dealers be willing to make the investment necessary to enter the market? If they have access to a sustainable pipeline of saleable deals and eligible exchange investors, the answer is probably yes.
- Less Risk. In 2006 and 2007, we expressed concern about investors and their representatives "chasing yield" and not looking critically at the relationship between risk and reward. This is one area where, thankfully, current market conditions seem to be making an impact. Experience has shown that many of the deals that have failed were deals in which investors were chasing yield, and not focusing on the quality of the sponsor and the underlying real estate fundamentals. With the high cost of debt making achieving high yields on equity even more difficult, look for investors and their representatives to look more favorably on safer deals with safer sponsors. In this environment a "safe" yield of 6.5 percent does not look so bad.
- Closing Risk. Closing risk is potentially devastating and not appropriate for the vast majority of TIC investors. Sponsors who can demonstrate unconditional control over properties and debt at the time of offering will have a very significant advantage in the coming year. Sponsors who have found relatively reasonably priced, long-term, nonrecourse debt will have an even greater advantage. What sponsors will be able to do this? Only those with a strong balance sheet and unblemished long-term relationships with lenders still in the market. This factor may push investors to larger, more established sponsors.
- Cap Rates. As the fall of cap rates in the years of readily available, low-cost debt demonstrated, cap rates are almost entirely a function of the ability of real estate buyers to leverage their investments aggressively. As the days of low-rate, high loan-to-value, interest-only debt disappear, expect cap rates to go up significantly. Instead of buying at a 6.5 percent cap rate and trying to squeeze out a 7.5 percent yield, TIC sponsors may well start paying yields that are lower than cap rates because of the cost of debt, for example, paying that same 7.5 percent yield on a deal that they bought at a nine percent cap. This will take some time to shake out, but simple math will drive this conclusion.
- Nontraditional Debt. The collapse of the
commercial mortgage-backed securities (CMBS) market has made
traditional low-cost, long-term, nonrecourse debt the exception
rather than the rule. Even the better sponsors are looking to
portfolio lenders who do not do long-term, fixed-rate debt.
Investors will face a variety of new risks: refinancing risk,
interest rate risk, and partial or full recourse risk. A more
subtle risk will be posed by sponsors having to assume some
recourse liability. That may not sound like a problem for
investors, but what happens if the lender makes demands on the
sponsor's guaranty, forcing the sponsor, and not the lender, to
foreclose on the investors? This scenario would be a plaintiff
lawyer's delight. Sponsors will have to be very careful in
drafting their risk factors on all of these issues, as will
investors and their representatives in weighing these risks.
Another debt issue is the lack of mezzanine debt, even while offering periods stretch out. Look for sponsors who use their own equity or low-cost seller financing to bridge this gap. - Delaware Statutory Trusts (DSTs). The current market conditions may finally push the DST structure into a meaningful presence in the TIC industry. The B-piece buyers in CMBS loans kept DSTs out of the market, but now the CMBS lenders are gone. The pressure to simplify transactions to encourage new lenders to enter the market calls out for the DST structure, which although complicated in general, is actually much more lender-friendly, as it involves only one, not 35, borrowers. Lenders and investors who used to fret about the "springing" limited liability company in a default scenario with DSTs have now seen that traditional TIC structures may be even worse than DSTs in a workout, as no one is in control. If DSTs become more common, investors will benefit in many ways: lower minimums, more diversification with multiple property deals, no carve-out guaranties, and no signing loan documents. Overall, 2009 may be the year that DSTs become common.
- Politics. The Democratic Party is now finally in control of the national political scene and is proposing billions, even trillions, of incentives to restart the economy. That will have many impacts on the TIC industry, from the status of the capital gains tax and the future of current estate tax laws to overall economic and financial policy. The beneficiaries will be those who understand the changing economic and tax policies and who respond quickly to those policies.
- Oil and Gas. Even in this interval of depressed oil and gas prices, look for TIC and non-TIC oil and gas programs to continue to take market share from real estate sponsors. Oil and gas royalty program offer diversification, little closing risk due to the absence of debt, and projected above-average cash-on-cash returns. The challenge will be to educate broker-dealers, representatives, and investors about the risks as well as the potential rewards of oil and gas investing. Also important is working with sponsors to get a clear picture of how projected returns are calculated for oil and gas investors, who are used to internal rate of return-based total return projections. As the oil and gas sponsors improve their offerings and can demonstrate track records, and as more investors and their representatives learn the basics of oil and gas investing, those in the oil and gas segment should prosper.
All in all, 2009 does not look to be a return to 2005 – 2006. Hopefully, later in 2009 things will start to improve, and everyone will be more optimistic by this time next year.
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