Changing market conditions provide new opportunities for diversifying portfolios.
Several years ago, tenancy-in-common 1031 real estate exchanges were on a steady upward trajectory that seemed destined to continue indefinitely. Within the past year, however, the growth curve has flattened, with the securitized TIC market taking the majority of the hit, and many offering syndicators and sponsors have been forced to reduce staff as a result of the slowing market. A full-blown drought has not yet set in, but the pool of TIC investors clearly has dried up in recent months.
One reason the TIC industry’s growth has slowed is that fewer investors who fit the demographic profile of a typical TIC investor are participating in Section 1031 exchanges. In addition, investors who were in 1031s now are moving on to different types of investments and even reverting to direct purchases of real estate, despite the complications. Other issues such as rising interest rates, concerns about regulatory changes, and the inability of non-securities licensed agents to participate in the securitized TIC market may be affecting the industry as well.
Today’s TIC Market
First-year and overall returns on TIC investments are down significantly from recent years. Capitalization rates are at all-time lows in many markets and property values are highly inflated, resulting in lower yields that have likely raised investors’ concerns about the risk and quality of offerings.
Some riskier asset classes, especially those that are operator driven such as student housing and hospitality, are selling relatively quickly due to higher initial cash flow. However, the majority of offerings now are sitting on the market for extended time periods, some for up to 12 months. This is very different from a few years ago when most properties were selling in a week or less. There still are instances of offerings that sell out rapidly, but this is becoming less frequent as the flow of equity diminishes.
This year’s increase in interest rates has contributed to the TIC slowdown as well. A more recent rate trend suggests that some investors will continue to look beyond TICs for opportunities to gain attractive returns. In late spring, spreads on interest rates increased dramatically. This was in part because of the slowdown in the housing market, related troubles in the subprime lending arena, and more-stringent requirements set by the securitized mortgage industry. At the same time, the 10-year Treasury rate increased more than 1 percent over its lowest point. This combination of increased spread and base rates has had a significant impact on the TIC industry.
Earlier this year, interest rates for institutional quality real estate averaged 5.25 percent to 5.5 percent, while over the summer rates were closer to 6.5 percent to 7.0 percent as a result of spreads that increased from 95 to 120 basis points to 125 to 200 basis points. Beginning in July, spreads rose as high as 200 to 250 basis points. Although the industry is hopeful that this is a short-term spike, rates reached as high as 7.0 percent to 7.5 percent. This variability has directly affected TIC offerings, which typically have large front-end fees and are highly sensitive to interest rate volatility. Since capitalization rates haven’t changed, yields have dropped. With loan pools unloading at end-of-month and end-of-quarter cycles, the lending market has loosened up slightly. Although, it’s still challenging to obtain financing and spreads remain fairly high.
In addition, commercial real estate brokers not licensed to sell securities are barred from offering securitized TICs to their clients. Therefore, they can only access about 10 percent of the inventory available in the TIC market, which is a further restrictor to growth.
A number of developments, from falling interest rates to regulations allowing real estate brokers to conduct business in the securitized TIC market, could open the pipeline for a greater volume of equity in securitized TICs. But for now, the TIC industry has backed itself into a corner where it will remain if commercial real estate and securities industry professionals don’t think outside of the box.
Forward-thinking market players and their clients should consider diversifying their portfolios by adding alternative real estate investment products that allow them to weather market fluctuations and volatility.
Investors are diversifying their strategies by participating in non-exchange programs such as debentures, land entitlement and development, value-added, and rehabilitation funds. Other clients are seeking unique opportunities such as investing along the hurricane-ravaged Gulf Coast, where the Gulf Opportunity Zone Program offers an array of enticing tax benefits.
There also are a number of exchange vehicles on the market that can be tailored to investors with very specific goals, including the following opportunities.
Direct Investment Programs. These often are provided by the same sponsors who offer both securitized and non-securitized TICs. However, investors in direct investment programs obtain 100 percent ownership, not a share of the holding as a tenant in common with other investors. In addition, the securities industry is developing new structures in this area, which may further reduce the flow of exchange funds into TICs.
Umbrella Partnership Real Estate Investment Trusts. When investors sell property to a REIT in a 721 exchange, they are able to gain shares. It doesn’t give them the ability to sell and exchange down the road; however, this option may be a better vehicle for estate planning due to the flexibility it offers for succession.
Royalty Programs. Some investors are buying into energy programs that have a royalty interest. These programs are exchange eligible, allowing investors to maintain their interest for the lifetime of the program, but not allowing an exchange on the back end; however, they can park their money there for a period of time. There also is a secondary market in which royalty program investors may be able to sell their interests and exchange into other investments down the road.
These types of real estate investments may not be suitable for all investors, but they may provide commercial real estate professionals with a more diverse array of offerings to meet their clients’ particular financial planning needs.
While the TIC industry’s once-rapid pace has slowed somewhat, there are still opportunities for commercial real estate brokers in this arena. Developing broader sales channels, maintaining a conservative approach to underwriting, providing exceptional customer service, and upholding high ethical standards are critical components to long-term growth in the TIC industry.