COVER STORY, NOVEMBER 2005

TIC MARKET TAKES OFF
The 1031 exchange market is picking up steam as more and more investors utilize the tenancy-in-common investment structure.
Kevin Jeselnik

The 1031 tax-deferred exchange has long been utilized to complete acquisitions and dispositions of assets while deferring the payment of capital gains taxes incurred in the transaction. In the commercial real estate market in 2004, the 1031 market comprised approximately $224 billion in exchange activity.

Now, it has become increasingly difficult to discuss 1031 activity as it relates to commercial real estate without giving much time and consideration to tenant-in-common (TIC) investment. Last year, the TIC market encompassed approximately $4 billion in transactional volume. That number is expected to increase to $10 billion this year. While that is a small slice of the total 1031 activity in the real estate market, the TIC industry is doubling in size each year.

Heartland Real Estate Business recently spoke with three professionals — Dan Werry, managing director of Minneapolis-based 1031 & TIC Investments, a branch office of Omni Brokerage of Salt Lake City, Utah; Stephen Corea, senior vice president of acquisitions for Triple Net Properties of Santa Ana, California; and Rob Hannah, principal and CEO of Chicago-based TSG Real Estate — that are familiar with the 1031 and TIC markets in the Midwest about the present and future state of the industries.

HREB: What is the current state of the 1031 market in the Midwest?

Werry: The biggest challenge for buyers is finding properties that cancel out and create cash flow. The activity has definitely increased; [sales activity in] my market has doubled year-over-year for the last 4 or 5 years.

I still think that the real estate market is a seller's market, with one exception. Some of the smaller investment properties have been a little top-heavy as far as pricing, and have cooled off a little bit. But I haven't seen a lot of prices softening as much as marketing time expanding.

Corea: [The market] has never been better. It is a trend that is growing stronger and stronger in lock step with the demographic trend of people getting older and less interested in being a hands-on manager of their own personal real estate.

It's a seller's market regardless of whether you are an exchange buyer or not. There is so much capital in the marketplace looking for a home, that sellers definitely have a lot of power to influence the direction of a transaction.

Hannah: The market right now is white hot. It is extremely aggressive. According to a study performed by Deloitte, the 1031 marketplace last year represented approximately $224 billion worth of exchange.

HREB: To what can you attribute the industry's growth over the past few years?

Hannah: In terms of tenancy-in-common, the growth is tied to two things. One is supply — you have to have enough product to grow the marketplace; and two is familiarity and comfort with the product itself and the people that are providing it. [The TIC market] continues to grow at roughly 200 percent per year.

Werry: [The growth] can be attributed to two different aspects. One, the increased valuation of properties has made it more difficult to find properties that provide cash flow, forcing the investor to move into a different asset type and be more competitive in this new asset class; and two, the demographics of the aging baby boomers. Those two keys are reasons why 1031 exchanges have increased in popularity, as well as tenant-in-common investments.

HREB: What trends are you seeing in the marketplace?

Werry: In the small to medium-sized market, from $800,000 to $3 million, investors have found it very challenging to find a property that makes financial sense for investment real estate as far as cash flow and providing a decent return. So, we've seen increased sale prices, which mean compressed cap rates, and investors in general have been going to outlying markets, poor credit-quality tenants and less established brands.

It's because of those stresses on finding well-valued real estate that investors have been looking more and more seriously at, and actually deciding to invest in, tenant-in-common investments. By selecting the tenant-in-common investment, investors have been able to go into a marketplace that is less competitive compared to the $1 million to $3 million range. So, they have been finding properties that they can get at a good value with good tenants and good cash flow and not go into outlying areas where they might be more susceptible to market cycles. So, the increase activity has definitely steered more investors into the tenant-in-common arena.

HREB: What kinds of properties are most popular?

Hannah: Statistics would show that multifamily and office have been the most popular nationwide. Supply is a critical component to the growth of the industry. We have not seen as much of those two products in the Midwest. Multifamily assets in particular are not as common here in the Midwest. Here, we tend to see a lot of industrial transactions and a lot of retail transactions.

Corea: Triple-Net Properties focuses primarily on high-quality investment-grade office but we are becoming active in apartment syndications as well. Different syndicators have different strengths and it seems like all properties are in demand. The bulk of the capital appears to be going into office properties.

HREB: How do you identify properties to acquire for 1031 exchanges and TIC investments?

Corea: We are always actively engaged in identifying properties to offer to investors. We feel it is important to be, in many ways, like a retailer. We always have to have inventory; we always have merchandise. We work very hard to market ourselves to the real estate brokerage community — that is where the properties are to be found.

Werry: It comes down to due diligence. We categorize [each property] by looking at the market, and evaluating the property, the tenants, the leases, the financing and the management structure. Thorough analysis and visiting the properties will help the clients better understand the property. Probably the biggest benefit [of thorough due diligence] is that the client can compare and contrast several properties quickly. So in addition to being able to move into a passive role, now it is a little easier to complete the 1031 exchange because a lot of the information is at the client's fingertips.

HREB: What areas in the Midwest are garnering the most attention from this investment sector?

Werry: I would say it's the central business districts, such as downtown Minneapolis, St. Paul and Chicago, and some parts of Iowa. In the Midwest you want to be in the CBDs, because that is the most reliable area. When you work with investors nationwide, [the central business district] is an area that they can understand and identify.

Corea: We really like Chicago. We just acquired 123 N. Wacker, a 540,676-square-foot office tower, from Prentiss Property Trust. Earlier this year, we bought 411 E. Wisconsin Avenue in downtown Milwaukee and we are looking at some other properties in suburban Milwaukee. We're analyzing the Minneapolis market — I think that is another market that will have opportunities. But we continue to follow the Chicago market pretty solidly.

HREB: What can we expect to see out of the 1031 and TIC sectors over the next year?

Corea: I expect next year that we will see some cooling, and I use that term loosely. I think the market will be less frenzied. Interest rates will stay relatively unchanged. There is supposed to be a large influx in capital from the pension fund world coming into both the real estate market and the mortgage market. I think you will see a continuing escalation of rents and tightening of markets because there is very little construction of new supply coming online. I think you will see a decline in vacancy, a strengthening of rental rates, a decline in concessions and tenant improvement allowances. So I think 2006 will be a really good year.

Hannah: I think the TIC investment structure is on sure enough footing that it should continue to grow dramatically from this point onwards. The biggest threat we have is really on the 1031 side and not on the tenancy-in-common side. Tenancy-in-common is growing beyond 1031. TSG Real Estate estimates that approximately 20 percent of its transactions are being sold to investors that are not completing 1031 exchanges but are simply looking for passive real estate investments. Those numbers will continue to grow over time, as this becomes a more accepted means of investing in real estate.


©2005 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.