July 05, 2007
Author: Deborah Frohling
Organization: Arent Fox LLP
While an investment in both a tenant in common transaction and a syndicated real estate limited partnership provide an investor with an investment in real estate, the similarities end there. The investor profiles are as different as the initial investment decision and the exit strategies. While each type of transaction has its place in one’s overall investment portfolio, the approach will be very different for each investor.
TIC syndications are structured so that they qualify as real estate for tax purposes even though most are sold as securities for securities law purposes. They are primarily used by investors who are completing Section 1031 tax-deferred exchanges, including complying with the strict time periods required. TIC investors receive a deed evidencing their investment and ownership of the property. TIC investors are also borrowers (typically through a single member LLC which is disregarded for tax purposes) under the generally non-recourse mortgage loan documents secured by the property. Lenders may require TIC investors to sign personal guaranties for certain “recourse carve-outs” on the loan. Major decisions relating to the property (sale, refinancing, leasing and the annual renewal of the management agreement) must be approved by all TICs, thereby creating the potential for deadlock in the event that any one TIC disagrees. Most TIC agreements provide a voluntary mechanism to buyout a recalcitrant TIC. The IRS guidance limits the number of TIC investors to 35 in any one transaction. Because TICs are direct owners of the real estate, in the event that additional funds are necessary to fund the operations of the property, each TIC would be responsible for its pro rata share of such funds. The average cash investment in a TIC interest is approximately $400,000.
Syndicated Real Estate LPs
Real estate LP interests are securities for securities law purposes and partnerships for tax purposes. The term LP is used herein but includes LLCs (the newer and currently preferred entity form). An LP’s primary tax advantage is as a passthrough vehicle that is not taxed on an entity level. The LP owns the property and is the borrower under the mortgage loan; therefore, the general partner would provide any required guarantees on the loan. An LP investor receives a certificate relating to its percentage interest in the LP. A limited partner typically has no personal liability under LP Agreement, thus an investor’s liability is capped at the amount of its investment and would not be required to contribute any additional cash to the LP. The LP can act, in most cases, either through the general partner alone or, if a vote is required, then by a majority. There is typically no requirement for unanimity. The minority can be shut out of the process. There is no IRS limit to the number of investors in an LP; however, for securities law purposes, a sponsor may limit the number of investors to less than 500. A minimum investment in an LP can be as low as $5,000, and is typically around $25,000.
Now that some TIC investments have been around for a few years, the exit strategy is looming on the horizon. While there are companies who specialize in creating a secondary market for selling and buying LP interests, there has been no secondary market for TIC interests created to date. A TIC interest differs fundamentally from an LP investment in two very important ways: the investor has a direct contractual relationship with the lender and the evidence of investment is a recorded deed. In an LP deal, there is only a certificate that can be assigned to the next investor with typically only general partner approval. In order to transfer a TIC interest, the lender must approve the potential investor as a new borrower under the loan. In a typical TIC transaction, (1) there are a maximum of 35 investors, (2) there are state and county real estate transfer requirements (including costs, which can be significant) and (3) there is no uniformity to the loan agreements. In an LP investment, there can be hundreds of similarly situated investors. The next 12 to 24 months should see some significant movement in finding a viable alternative exit strategy for TIC investors as offerings continue to mature and investors who have been holding their investments for a couple of years look to exit. Stay tuned for the continuing developments in this area. So, if you want to make real estate a part if your investment portfolio, there are many ways to do it, including both TICs and LPs. However, before making any type of investment, consult a qualified business, financial or tax advisor to determine what is appropriate for your particular situation.
Deborah Froling, Esq. is a partner at Arent Fox LLP, Washington D.C.