covering commercial real estate in texas texas

In recent years, rising prop-erty values and the growingpopularity of real estate as

an investment option havespurred interest in what is becom-ing an increasingly commonapproach to real estate investingand wealth building -- the 1031exchange. Named for section1031 of the Internal RevenueCode, 1031 exchanges provideinvestors the opportunity to defercapital gains taxes on a real estatesale, provided that the proceedsof the sale are reinvested in a like-kind asset.

Tenant-in-common (TIC)investments, an innovative

and popular choice for many1031 exchanges, provide analternative to sole ownershipof real estate and make it pos-sible for individual investorsto invest in the types of larger,typically more expensive commercial properties thatwould otherwise only beattainable by institutionalinvestors. A TIC investmentprovides an opportunity for agroup of co-owners to own aninstitutional-quality asset,each with a deed for a per-centage interest in the property. The advantages ofparticipating in a TIC formatwhen selecting the like-kindasset or replacement property

in a 1031 exchange includean additional measure ofsecurity and convenience thatcomes from a stabilized revenue stream, and from aninvestment structure thateliminates the need for prop-erty management and day-to-day oversight responsibilities.

But for all of its potential benefits, a TIC option is not without risk. While TIC invest-ments open up a broader rangeof possibilities and enhancedinvestment flexibility, they arealso inherently more complexand pose what can be daunting challenges with coordination andtiming. Simply put, with moreparties involved and more moving pieces, there is more thatcan go wrong.

It is always a helpful exercise forpotential investors to determinewhat they can do if things do notgo precisely as planned. Whatpreemptive steps can an investortake to mitigate risk and minimize exposure? What are theearly warning signs that theirexchange may be at risk? Andwhat options are available toinvestors if a TIC deal appears tobe going south?

Benjamin Franklin’s famousquote that “an ounce of preven-tion is worth a pound of cure”may be a centuries-old cliché, butit is advice that certainly holdstrue for investors looking toreduce their exposure and safe-guard their TIC investment. Themost significant step that a potential investor can take before moving ahead with a TIC investment for a 1031 exchange isto ensure that due diligence hasbeen performed and appropriatefinancing is in place. The best wayto do this is to work with a sponsor who is pre-capitalized.

Unlike some sponsors, who maybe raising equity from potentialTIC investors to purchase theproperty, a pre-capitalized sponsor purchases the propertyor properties before they sell the fractional ownerships.

Savvy investors are able toreduce their risk by working withpre-capitalized TIC sponsors, but,however, what some investorsmay not realize, is that even if asponsor is pre-capitalized, thatdoes not necessarily mean thatthe financing relationship issecurely in place. Particularly inthe context of today’s challengingcapital markets landscape, askingthe question “is your financing inplace?” is not just appropriate,but should be a fundamental prerequisite for any potential TIC investor.

Even with the financing inplace, investors should investigatethe details of the financing agreement. Examining the makeup of the in-place financingis not always easy, but it can provide critical information thatcan help avoid poor decisionsand future difficulties. Thefinancing structure can be relevant; if a group of investorsform a real estate syndicate, forexample, a common stickingpoint in that group dynamic is apotential inability to come to anagreement or fail to secure the financing.

The track record of the TICsponsor is vitally important information. With what is often avery significant investment atstake, investors need to have confidence that sponsors are notjust looking at the investment in avacuum; they need to be sure thesponsors are reviewing all information in the context of

TEXASREAL ESTATEBUSINESS

COVERING COMMERCIAL REAL ESTATE IN TEXAS

VOLUME 3, ISSUE 8 OCTOBER 2007

STRATEGIES FORPRESRVING A 1031EXCHANGE IN A DIFFICULTMARKET CAPITAL

local, regional and national markets, the site history, demographics, tenant specificsand all relevant information.Beware of casual projections; anunrealistic forecast is a recipe forpotential disaster. For example, ifmarket rental rates and resultingnet operating income (NOI) areprojected to grow at 6 or 7 percent, when historically orcomparatively they have grown atsomething closer to 2 percent,there may be cause for concern.Watch out for the hockey-stick-shaped graph, with a gently sloping “blade” that representspast NOI growth and a suddenly accelerating “shaft” thatshows overly optimistic future projections.

The private placement memo-randum (PPM) is a valuable document for TIC investors, providing complete and full disclosure of the proposed trans-action structure, risk and rewardpotential and company details. Itoutlines not only the investmentprojections, but the assumptionsupon which those projections arebased. Taking the time to double-check those assumptions andmaking sure that they are reasonable and make sense in the

specific marketplace is anothergood way to reduce risk. While anexperienced TIC sponsor mightbe able to readjust financialassumptions to mitigate leaserollover, rate changes and otherfactors, an investor can beexposed to increased and unexpected costs if a TIC offering is under-reserved.Without sufficient reserves, a TICsponsor may have to ask for additional capital from the TICowners, and these “cash calls”may be used for tenant improve-ments or other expenses. In general, investors should look toidentify well-rounded TIC sponsors with a corporate profilethat includes substantive realestate experience, proven investment expertise, and legaland accounting capabilities.

TIC replacement propertiestypically are chosen because theyallow investors to step away fromthe day-to-day managementrequirements as well as providinga compelling combination ofsecurity and reliable income.Perhaps the biggest challenge toinvestors, and the best way toavoid potential 1031 exchangepitfalls, is to identify and, if necessary, secure the maximum

number of suitable possiblereplacement properties in theevent that one falls through. Theobvious priority is to identify thebest possible replacement prop-erty, as well as quality back-upoptions – but also to ensure thatthese are properties the investorhas a reasonable shot at acquir-ing. Investors should familiarizethemselves with 1031. Ident-ification Rules used to identifythose properties. Most investorsadhere to the Three PropertyRule, where up to three potentialoptions are identified. Someexchangers may use the 200Percent Rule, which potentiallyallows for more than three identi-fied properties, provided that thefair market value does not exceed200 percent of the value sold.

Because Section 1031 of theInternal Revenue Code man-dates that investors have 45 days to identify the property or

properties they are looking toacquire as potential replacementproperties, and a total of 180 daysto close the deal and formallyreinvest the equity or profit –time is very much of the essence.Within 45 days, investors have areasonable degree of maneuver-ability, but outside of that time-frame, some tax consequencesmay become unavoidable.Because transactions are chan-neled through a QualifiedIntermediary who coordinatesand facilitates the 1031 exchange,and because of the sometimescumbersome and slow-movingnature of real estate transactionon this scale, it may be wise forinvestors to allow at least 90 daysleeway to purchase and close. If apotential property is not securewithin 90 days, it is critical to haveother possible options in place.

Preparing for every eventualityis, of course, impossible. But fullyunderstanding the requirementsand the risks, as well as therewards, of 1031 exchanges thatinclude a TIC property, is a bigstep in the right direction toward assuring a more secure, profitable real estate investmentexperience.““

This article originally appeared in Texas Real Estate Business, Volume 3, Issue 8, October 2007. ©2007 France Publications, Inc.

Fully understanding therequirements and the risks,as well as the rewards, of

1031 exchanges thatinclude a TIC property, is abig step in the right direc-

tion toward assuring amore secure, profitable real estate investment

experience.

— Michael Franklin andRobort Alter

FORT Properties

Michael FranklinExecutive Vice President

FORT Properties

Robert AlterVice President, Real Estate

FORT Properties