Investment Analysis

Hands-Free Investments

Today's commercial real estate clients seek high-quality, no-hassle deals.

N on-direct real estate investment choices run the gamut from tenancy-in-common interests and real estate investment trusts to net-lease properties and mutual funds. Such investments provide many of the same perks as traditional real estate ownership, such as a solid return on investment via cash flow and appreciation and in some cases even tax benefits. But the real attraction of these properties is a hands-off form of ownership that eliminates the day-to-day headaches of operating and managing real estate.

Such non-direct ownership is proving to be a big hit with real estate veterans and newcomers alike. "The huge amount of capital flowing into real estate as a product type right now is amazing," says Christopher T. Harman, CCIM, a regional director for SCI Real Estate Investments in Austin, Texas. SCI, which specializes in acquiring TIC properties, closed about $600 million in transactions in 2005 and expects to close between $800 million and $1 billion in TIC deals this year.

Demand for real estate is so strong that SCI's recent TIC offering attracted 30 investors and raised $9 million in equity in just 11 days. Typically, it takes 30 days to 90 days to fill most TICs' capital requirements. Investors paid a minimum of $250,000 to own a piece of the 224-unit Town East apartment complex in Mesquite, Ariz., which sold for nearly $20 million at a capitalization rate of 6.4 percent.

Commercial real estate professionals across the nation report an influx of interest in TICs and other non-direct forms of real estate investment. As clients seek to diversify their own portfolios, CCIMs and other real estate experts can broaden their services and experience to include a range of real estate products beyond four walls and a roof. The ability to structure deals both large and small in a variety of ways provides entry points for new clients and the diversity that meets established investors' changing needs.

Demand for Deals

Two different types of buyers are fueling the demand for non-direct real estate. Existing property owners - particularly aging baby boomers - are taking advantage of record real estate prices to cash in on values and shift to less management-intensive investments. At the same time, disappointed Wall Street investors are turning to real estate in search of higher returns. And, rapidly appreciating real estate is delivering. In 2004, for example, publicly traded equity REITs averaged returns of 31.6 percent compared to average Standard & Poor's 500 returns of 10.9 percent.

Investors' voracious appetites for real estate revved up after Wall Street's 2001 technology stock fallout. "The real estate industry is being looked at again as an investment vehicle, which it wasn't in the 1990s because people were in the stock market making 20 percent returns," says Robert A. Liebeck, CCIM, a broker-associate with MJ Peterson Commercial Real Estate in Amherst, N.Y.

That huge demand for real estate investments is having a significant impact on transaction volume and sale prices. More than $178.4 billion in properties traded hands during the first three quarters of 2005 - a 42 percent increase compared to the $125.3 billion in properties that sold during the same period in 2004, according to Real Capital Analytics. The total volume of investment activity is actually higher since RCA only tracks deals larger than $5 million. At the same time, the intense competition for real estate is putting pressure on returns as properties continue to sell for premium prices. In third-quarter 2005, the average cap rate was 7.0 percent compared to 7.7 percent during the same period the previous year.


Photo caption: The sale of this Overland Park, Kan., retail center was structured as a TIC transaction to give the investor added flexibility.
Photo credit: Greenleaf Properties

TIC Boom

One of the hottest forms of non-direct ownership is the exploding TIC industry. Securitized TICs alone were expected to raise nearly $4.2 billion last year - more than twice the $1.8 billion in equity raised in 2004, according to Salt Lake City-based Omni Brokerage. Omni tracks data from 59 TIC sponsors that sell TICs as securities in accordance with Securities and Exchange Commission regulations.

One big TIC draw is the ability to buy into larger, higher-quality properties since TIC investors acquire fractional property interests. For example, rather than spending $300,000 on a duplex, an investor can use the same $300,000 to buy a stake in a major apartment complex. TICs also have gained a reputation for providing steady cash flow. Although returns vary depending on the individual property and investment strategy, TICs typically generate cash on cash returns between 6 percent and 8 percent.

The surge in TIC investment is due in large part to 2002 Internal Revenue Service guidelines that qualified TICs as like-kind investments for use in 1031 tax-deferred exchanges. "That really created a springboard for this marketplace," Harman says.

"TICs have been around since the 1970s without the acronym but have been revived with a clever moniker, sanctification by the SEC and the IRS, and are marketed with zeal largely by ex-stockbrokers who know the sales business, the securities business, and the investment jargon," says Mike Hesse, CCIM, CPM, a real estate investment specialist at Denver-based Unique Properties.

Last year, Hesse represented a client that sold four student rental properties in Boulder, Colo., and rolled the $2 million in equity from the sale into three different TIC investments. The student rental properties sold for a cap rate of about 5.5 percent; the TIC investments averaged about a 7.5 percent cap rate and included a Las Vegas office/warehouse, a Dallas office building, and a Raleigh, N.C., office building. So not only did the client get a better value on the purchase, he also diversified his portfolio and shifted into a less management-intensive investment, Hesse notes.

Capitalizing on Opportunities

While selling securitized TICs requires a securities license, real estate professionals can create real estate-based TIC opportunities. For example, Overland Park, Kan.-based Greenleaf Properties opted to bring in a TIC investor instead of a limited partner when it sold an interest in a 10,000-square-foot retail building. Greenleaf structured the investment as a TIC interest so the investor has the flexibility to re-sell his share to someone else in the future, says Walter S. Clements, CCIM, president of Greenleaf Properties. Essentially, the TIC investor can re-sell his share without waiting for the property to sell.

Greenleaf owns 75 percent and the private investor owns 25 percent. "The [future] benefit for us as a developer is that we can find another investor to buy his interest or perhaps allow the investor to exchange into another property," Clements says. Greenleaf built the retail property in Overland Park in 2004 and opted to sell a stake last year to raise additional capital.

TICs' increasing popularity also is prompting brokers such as Liebeck to consider getting a limited securities license. Brokers without a securities license still can sell shares in non-securitized TICs, but a limited securities license enables them to capture fees in the sale of securitized TICs. Typically, brokers with clients interested in a TIC refer clients to a TIC sponsor or securitized TIC broker.

Yet a securities license is not the only way brokers can cash in on the TIC market. SCI, for example, is a non-securitized REIT that is set up on a real estate platform rather than a securities platform. That structure allows SCI to pay finders' fees and work directly with the real estate brokerage community. SCI pays a 3 percent referral fee on the equity investment and also puts that broker's name on a protected list for three years. For instance, if a broker refers a client to SCI that ends up investing $1 million in equity in one of the company's TICs, the broker gets paid $30,000. And if that client decides to invest another $1 million the next year, the broker gets paid another $30,000.

TIC Concerns

Despite TICs' increasing popularity, many investors are still wary. Entrepreneurial investors, in particular, don't want to buy fractional interests, notes Bill Kohlhepp, CCIM, a senior associate in Marcus & Millichap's Fort Lauderdale, Fla., office. "Once you are in a TIC investment, you have very little say about what happens with the property, and a lot of investors are used to having total control," he says. However, TIC investors do maintain some control through voting rights and many have a voice in decisions such as who is hired as a property manager.

Another criticism is that TICs lack liquidity, as there is no proven secondary market for re-selling TIC shares. If an investor wants to sell out of a TIC, then either the entire TIC group must agree to sell the property or the investor must find someone else to buy its individual TIC share.

Even without an established secondary market, Harman believes that liquidity is not a problem. Because TICs can have up to 35 co-investors, there is a ready supply of qualified buyers at hand. SCI has had only three cases in the last three years where a client has opted to exit a TIC early. In each case, other investors within the TIC bought out their fellow investors.

However, TICs are most appropriate for long-term investors. For example, SCI structures most of its deals with a plan to hold the property for seven to 10 years. Since TIC buying didn't take off until 2002, many of those properties have yet to sell. But in the next two years, more TIC deals will begin to cash out on sales opportunities. "The hope is that those investors will invest in another TIC opportunity and maintain their 1031 exchange," Harman says.

Triple-Net Options

Despite TICs' current run, the vast majority of 1031 exchanges are dominated by triple-net deals or net deals of some kind, Kohlhepp notes. He recently represented a client who sold a West Palm Beach, Fla., shopping center for $6 million and bought three single-tenant net-lease properties - a dollar store and two restaurants - in different parts of the country. The goal was to spread the risk around geographically and buy properties with solid credit tenants while shifting to a less management-intensive real estate investment, Kohlhepp notes.

Triple-net lease investments create a much-needed option for property owners that want to sell existing properties and reinvest the capital to avoid capital gains tax. For example, in San Francisco's North Bay market, owners would love to cash in on record apartment pricing. "The question we hear everyday is, 'I would love to sell, but what would I do with the money?'" says Dave Buurma, CCIM, a vice president in the multifamily division at NAI BT Commercial in Napa, Calif. The solution for many is to buy into triple-net lease properties, he adds.

Most net-lease transactions are structured as triple-net leases, which leave tenants responsible for payment of taxes, insurance, and maintenance costs. In addition, because most net-lease properties involve a single tenant with a long-term lease, owners rarely have to deal with tenant rollover, which significantly minimizes leasing and marketing responsibilities. Typical triple-net lease tenants include national retail chains, particularly drugstores and fast-food outlets, although many corporations and regional companies also structure triple-net leases for office and industrial properties.

"A lot of these people have been owners for a long time and are flat-out tired of the hassles of directly owning real estate," Buurma says. For example, he recently represented a client who sold a California winery and rolled the proceeds into a triple-net lease industrial building. The main motivation was to buy a less management-intensive property. And because net-lease deals typically are structured with long-term leases - 15 years to 20 years - they create stable cash flow for the owner.

The biggest obstacle for net-lease deals is that intense competition is driving up prices. Buyers in California, for example, are seeing cap rates on triple-net leases dip below 5.5 percent. Investors who look elsewhere, such as in the Midwest, are finding cap rates between 6 percent and 8 percent. Yet experts are optimistic that returns will begin to inch higher as interest rates climb. "Cap rates are going to have to return to normal because interest rates are continuing to bubble up," Buurma says. As the cost of capital increases, investors will begin demanding better cap rates, he adds.

Brokers that have access to the national triple-net lease market have a significant advantage in identifying and closing deals for their clients. For example, NAI BT Commercial has been brokering triple-net lease transactions for nearly 20 years, and the company has its own triple- net lease division. "In today's market, it is a huge plus to have that capability," Buurma says. The company has the expertise and established relationships that enable brokers to find triple-net lease properties before they hit the market. In some cases, the company has locked in triple-net lease deals with developers before construction of the building is complete. "If you wait to find it on LoopNet, it is probably too late," Buurma says.

The Mainstream Market

Although TIC and net-lease deals mainly attract seasoned commercial real estate investors, the increased accessibility of real estate via mutual funds and REITs is attracting mainstream investors. Novice investors can buy into a real estate fund with less than $1,000. "Investors are looking at real estate as the fourth asset class for investment portfolios, and financial planners have embraced that concept," says Donald A. Miller, chief real estate officer at Atlanta-based Wells Real Estate Funds.

And this trend could be just the tip of the iceberg. Despite the substantial amount of capital flowing into real estate, the percentage of individuals that own real estate in one form or another is still relatively low, Miller notes. "So there is substantial growth still left in this segment," he says.

Public, non-traded, exchange-traded, and real estate mutual funds have benefited from the struggling stock market. Publicly traded REITs raised $28.5 billion during the first 10 months of 2005 compared to $38.7 billion raised in 2004, according to the National Association of REITs.

"What the typical investor experienced with the tech bust was pretty unsettling. From their standpoint, when you go through an event such as that, you want something that provides a different level of safety and comfort," says Jason Mattox, a senior vice president at Dallas-based Behringer Harvard. In addition, publicly traded funds provide the added comfort level of having to follow SEC guidelines and reporting procedures, he adds.

Since Behringer Harvard introduced its publicly registered non-traded real estate funds in 2003, the company has raised more than $1 billion. Clients range from public institutions to private individuals that are investing in real estate for the first time. One of the ways that Behringer Harvard is working to turn first-time investors into lifetime clients is by providing a variety of public and private investment vehicles that offer different strategies and risk levels ranging from aggressive opportunity funds to more conservative income-focused funds.

Of course, a number of factors could cool interest in real estate investment - chief among them being a decline in real estate market performance, a rise in interest rates, and an improved stock market. However, those investors that have gotten a taste for real estate are likely to continue to consider real estate a good diversification strategy.

Different investments, whether they are stocks or real estate, will always go through market cycles where there are surges or dips in the ebb and flow of capital. Yet, generally speaking, a piece of most investment portfolios will be in real estate, Mattox notes. "We believe that it is a long-term trend," he says. "Investors, having gone through the tech bust, have an understanding that diversifying their portfolios to include at least some real estate makes sense."

Beth Mattson-Teig

Beth Mattson-Teig is a business writer based in Minneapolis.

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