How Small Investors Can Get Into Big Real Estate

Tenant-in-common deals offer tax breaks, eliminate management headaches

In many parts of the country, small business owners have had a front-row seat for the commercial real estate boom. As owners or renters, they have seen values of office and industrial property soar. A lucky few have cashed in—by selling long-held buildings. But most probably figured they couldn’t play this game.

Frank Schmidt, a small business owner in San Jose, Calif., knew better, because his company, Schmidt-Prescott Group, is a real estate appraisal firm and he knew about something called Tenant In Common (TIC) financing, a relatively new concept in commercial real estate that lets small investors pool their assets to buy major properties. Often, they get into these tax-advantaged structures by selling their own property.

In 2003, Schmidt joined a TIC that bought Heritage Corporate Center, a business park in Santa Fe Springs, Calif., for $57.3 million. By the time the property sold this spring—for $84.2 million—he’d received an annualized return of nearly 57%, more than doubling his money.

“As a single player, you just could never afford a $75 million or $100 million property,” Schmidt explains. “For the small guy, the good thing about these TICs is you can get into institutional properties.”

TICs Swell

The TIC business began in the late 1990s as a way for small investors to pool their capital in so-called 1031 exchangeable properties. Under Section 1031 of the Internal Revenue Service code, an investor can defer capital gains taxes from the sale of real estate or other assets if the proceeds are invested in a “like-kind” property within 180 days. Until 2002, however, the TIC business was on shaky ground because the 1031 rule forbade exchanging real estate interests into partnerships. But in March of that year, the service spelled out 15 rules under which TICs could maintain non-partnership status and enjoy 1031 benefits: There can be no more than 35 partners, for example, and investors had to meet wealth requirements: $1 million in net worth or annual income of $200,000 for at least three years (or $300,000 per year for a couple).

Since then, the growth chart of the TIC industry has been nearly vertical, zooming from $167 million in invested capital in 2001 to $1.8 billion in 2004 and $3.2 billion last year, according to Omni Brokerage Inc., a TIC sponsor based in Salt Lake City. At the same time, the number of TIC sponsors has grown from fewer than half a dozen in 2001 to more than 100 today. The volume of TIC investments generated in each of the past four quarters has exceeded $1 billion, with volume this year is projected to reach $5.4 billion, according to Omni.

TIC Options for the Small Business Owner

Any small business owner who owns real estate—or owns a business that owns real estate—may be able to defer taxes upon the sale of that property through a 1031 exchange.

By investing in a TIC rather than purchasing another property with sale proceeds, the small business owner can tap the potentially superior returns available from institutional-quality real estate, which is more commonly owned by life insurers, pension fund, foundations and other institutional players.

“Tenancy in common is a bridge between non-institutional investors and institutional real estate,” says Todd Williams, director of TIC offerings at San Clemente, Calif.-based Argus Realty Investors. Argus, which sponsored the Heritage Corporate Center acquisition, is one of the nation’s largest sponsors of TIC/1031 exchange investments, with more than 120 property acquisitions under its belt and a portfolio of properties valued at more than $1 billion.

Another part of the 1031/TIC phenomenon is allowing investors to diversify holdings. The “like kind” rules are not narrowly interpreted, so you needn’t worry about finding an exchange property that is just like what you have to sell. “You can sell raw land and buy an apartment complex, or you can sell an apartment complex and buy a strip mall,” Williams says.

Finally, TIC investing takes you out of the property management business. That’s why TICs are popular with aging Baby Boomers, who are tired of maintaining and operating their rental properties, says Jeremy Brown, director of marketing at Omni Brokerage, another major TIC sponsor. In a typical TIC investment, the sponsor handles day-to-day property management for a fee.

How to Get In the Game

Don’t expect to match the 55% annualized return Schmidt got. The real estate market is cooling, so you may not see huge capital gains for a while. Still, cash-on-cash returns are currently around 6.25% annually, providing a respectable income stream.

Also, remember that a TIC investment is long-term. “You want to count on a seven- to 10-year hold and view it as an illiquid investment,” Brown says.

You also must do your homework—on the sponsor and the property. “You need to kick the tires and smell the air,” says Schmidt, who has invested in several TICs and insists on doing his own reconnaissance. “Even if you live in California and you’re buying something in Atlanta, if you’re serious about it, you need to make the trip to Atlanta just to physically look at the property.”

Schmidt recommends searching online for a sponsor that matches your investment objectives. “If you want to do a conservative play, look for a manager with conservative projections,” he says. Then research the sponsor’s track record. Remember that perhaps one in 10 real estate deals goes bad because of market conditions. A failure rate above that should be a red flag, he says.