Due Diligence and the 1031 TIC
By Robert L. Cain
You could make a fortune, or at least good money, without having the management hassles. You could lose every penny you invested. That’s the dilemma of the 1031 TIC. The 1031 TIC is a 1031 Exchange into a Tenant in Common, an investment where you own an undivided share of an investment property. In that investment, you don’t have any management hassles. All that is taken care of by the company that manages the investment property. What you lose is control of the management. That’s the downside because the management company in many cases can make decisions that are not ones you would make.
A 1031 TIC has the same IRS rules as a regular 1031 Exchange, which I won’t go into here because you may already know them. If you don’t, go to the IRS website, specifically to www.irs.gov/instructions/i8824/ch01.html. There are also other documents explaining exchanges on the website. The difference between a simple 1031 Exchange and a 1031 TIC is that you don’t buy the entire property; you buy a percentage of the property with an undivided interest.
The effect is that it’s much like investing in the stock market. When you own stock, you cede all but minimal management control to a board of directors and the company management team. If the team is effective, if the company is run well, your stock makes money. If not, the stock declines in value and you lose money. Same with a 1031 TIC, only worse. You could lose everything if the property goes into foreclosure.
What we’ll look at here is the due diligence we need to perform at least to increase the chances that our real estate investment will make us money.
These exchanges can be made into three different kinds of commercial properties, office/retail, industrial, and multifamily. The return on each depends on the amount of risk an investor might face, that is, how likely the investor is to end up completely out of luck. The lowest return and thus lowest risk is multifamily. The reason is that even with some vacancies, the property will show a positive return. With retail space, depending on the number of tenants, vacancies could mean that there is little no income. And considering how difficult it can be to lease retail and office space, the vacancies could last for months and then result in the landlord having to give rent incentives to tenants further reducing the income. Likewise with industrial properties. The point is, the more tenants and units in a building, the lower the risk to the investor.
Even so, we have to choose. A retail property could be almost risk-free depending on the current tenant. But remember, major corporations rarely own their own properties because they are stuck with them if that particular location doesn’t perform to the company’s satisfaction. With a leased space, they can close them down leaving the landlord with an empty shell that could be difficult to rent. A case in point is Kmart. Kmart had three Tucson locations and closed two of them. The one they left open was the one where they owned the building. The other two buildings were leased.
Thus, when you have the notion of investing in a retail space such as a single-tenant property, carefully investigate the tenant or tenants in addition to the caveats I will mention later. Even with a multi-tenant retail space, look at the leases in addition to the tenants’ financials to see how solid the leases are.
Snyder Kearney is a Columbia, Maryland, law firm that “keeps its friends and clients up-to-date on issues and current events relevant to alternative investments.” It offers the following due diligence checklist for prospective exchange investors.
- Offering documents: Private Placement Memorandum (“PPM”) and appendices;
- Operative agreements: Tenant in Common (“TIC”) purchase agreement and escrow instructions; TIC agreement; management agreement; master lease;
- Loan documents: mortgage, note, guaranty, environmental indemnity;
- Tenants: current rent roll, leases, tenant financial statements, SEC filings for public company tenants, other tenant credit information;
- Tax: tax opinion, representation letter, PPM disclosure;
- Third-party reports: appraisal, environmental, property condition;
- Property: site visit;
- Market: sales and rent comparables, area analysis;
- Title: title commitment, Schedule B exception documents, survey; and
- Projections: sponsor projections in PPM, sponsor Excel or Argus file.
The exchange company will most likely offer all of these documents to prospective investors as part of the material they provide about the property they are offering. Doubt everything. Double check everything. Have a qualified real estate accountant examine the figures. Then decide.
The following appear to be some of the items that a prudent person would investigate in connection with a review of a 1031 Offering sponsor. This is the company that is putting together the 1031 Exchange and that will possibly also be the management company, though not necessarily.
- Organizational structure and control;
- Material contracts;
- Litigation;
- Regulatory compliance;
- On-site management interviews;
- Background investigations;
- Reference checks;
- Management and staff capability analysis;
- Review of policies and procedures;
- Financial statement review;
- Prior performance review;
- Prior performance disclosure;
- Overall performance;
- Identification of problem properties; and
- Analysis of internal controls and procedures.
If you are an experienced real estate investor, you know how to do this due diligence already because you do much of it on prospective tenants.
A 1031 TIC can be a good investment. But just like buying an investment property, due diligence is essential if we expect to actually have a positive cash flow and to turn a profit when the property is sold. The due diligence is different. With an investment property you are going to buy, due diligence includes inspection of the property, a rent survey and research on the comparable sales in the area, especially as they relate to investment properties and the income approach to valuation. With a 1031TIC property, it’s more like buying company stock. Before you jump into the promise of no more management hassles, no more holiday phone calls, and no more evictions, think about money hassles, and how much you stand to lose if you invest poorly.