Written by: Julie Leupold, CREJ Assignment Editor,
Courtesy of the California Real Estate Journal
Two legal opinions validate a narrowly structured 1031 exchange as real estate instead of security, but insiders are skeptical
The 3-year-old tenant-in-common industry is like a toddler struggling to find its footing. Since the IRS formally recognized TICs as a viable avenue for 1031 exchanges in 2002, the real estate industry has struggled to find its place in the securities dominated transaction environment.
Recently, the real estate-structured TIC sale got a boost toward legitimacy after SCI Real Estate Investments, one of the largest firms to structure TIC transactions as real property sales, received two favorable legal opinions from the two largest TIC law firms in the nation.
The controversy of whether a TIC exchange should be considered a security or real estate transaction has haunted the fledgling investment vehicles since its inception. The majority of 1031 exchanges put into TIC deals have been labeled securities under 1946 Supreme Court decision that helped define a security. But as more investment capital is chasing any viable real estate asset in a saturated market, some brokers see room for a broader definition.
“This is an industry that has only been around for three years and it is still finding its way,” said Marc Paul, president and co-chairman of Los Angles-based SCI. “As long as you are buying good real estate and it complies from an exchange standpoint, that’s all an investor gives a damn about. They don’t care if a securities broker or a real estate broker gave them the deal.”
Nearly 90 percent of reported TIC deals, which hit $5 billion worth of property in 2004, are structured as securities – though Paul argues that real estate-structured deals will parallel that dollar amount in the next three to five years.
While the classification of the deal as a security or real estate doesn’t affect the way investors are taxed or receive revenues, it does matter in terms of the amount of involvement an investor has with a specific property and the way brokers are compensated in the deal.
This compensation is at the crux of the controversy. When a deal is completed as a security, a 7 percent commission is paid to a securities broker without any money going to a real estate broker who may have been instrumental in finding the property. As a real property sale, a real estate broker takes a 3 percent commission, giving the investor less up front costs.
“The only benefit [to structuring it as real estate] is it allows brokers to get compensated,” said Jim Shaw, president and chief executive officer of Beverly Hills-based CapHarbor LLC. “Generally speaking, real estate licensees do a much better job at representing real estate. No one can make the argument that securities brokers are better to represent the client.”
However, it is not this argument that is a stumbling block for companies like SCI and FOR1031 LLC, which handle the majority of real-estate structured TIC 1031 exchanges.
The test is based on the Supreme Court case SEC v. W.J. Howey Co. and is used to define what constitutes a security and narrowly defines most 1031 exchanges as securities.
According to the Howey test, and investment tat is based solely on the efforts of others is classified as a security. Since most TIC transactions are arranged and then managed by a sponsor for, on average, 20 to 25 investors, according to SCI, the individual buyers have very little to do with the property itself.
“The Howey test is a very clear test. It doesn’t leave a lot of wiggle room,” Shaw said. “There are a lot of transactions that aren’t sold through securities brokers, but they are below the radar screen so they aren’t scrutinized by regulatory agencies. It is like the jaywalking exception. Jaywalking is illegal everywhere, but how often do you get caught?”
However, SCI points to the 130,000-square-foot Casa Paloma Shopping Center in Chandler, Ariz., which was bought for $43.6 million at a 6.75 percent capitalization rate, and the $36 million retail center in the City of Industry acquired at a 6.94 percent capitalization rate, as prime examples of how to structure real estate deals correctly for TIC investors.
SCI and other firms that follow its format are scooting around this law by relinquishing control as a sponsor once the deal has closed. After spending $1 million in legal fees to make sure its business model meets SEC standards, SCI developed a model of exiting all decisions with the property in a sponsor’s capacity once a deed has been turned over.
However, the company typically invests 10 percent to 20 percent of its own money in each deal and therefore continues to hold a significant voting platform as an investor in terms of managing the property.
In this model, a TIC -appointed property manager would handle day-to-day management of the property, but get the vote of the investors to make any major changes to the asset. “You have to be a lot more careful of how it is structured, if you are going to sell a TIC as real estate,” said Jim Proehl, executive vice president and managing director of the western division for PM Realty Group.
Shaw warned that the restrictions might be too narrow to satisfy a wide variety or investors.
“In the case of the legal opinion, it is so narrow in scope that you have to forego any activity after the sale is closed,” Shaw said. “How many sponsors want to do that? Most sponsors want to stay connected and involved and most investors want that to be the case.”
Many of the investors getting into TIC transactions are looking for an ease of ownership with an institutional-quality asset, according to Proehl. In the capital-heavy market that has defined the past year in the industry, most individual investors are forced to join TIC groups in order to find a place for their 1031 exchange dollars.
“A lot of TIC investors are baby boomers that have owned real estate for a number of years,” Proehl said. “It is a good time to sell and take their profits and not have to worry about the management.”
But both Proehl and Shaw caution that such a high demand for property from these investors could cause them to jump too quckly into a TIC deal and end up with bad real estate.
“In this extremely fast-paced world that we live in, taking time is seen as a sin,” Shaw said. “The biggest issue is not whether it is security or real estate. These offerings are sold so quickly that in many cases it is just not possible for the investor to make an informed decision. If you don’t have to the time to do due diligence, does the structure really matter?”