Rolling Up and Recapitalizing the Distressed Tenancy In Common (TIC) Deal
Author: Michael Tuchman
This article outlines a strategy for mitigating losses from distressed commercial real estate owned in syndicated like-kind exchange tenancy-in-common (“TIC”) structures. By rolling-up and recapitalizing a TIC deal, investors can minimize the risk of foreclosure and possibly preserve invested equity. Through a roll-up and recapitalization strategy, lenders can engage in productive work-outs, averting the outsized write-downs attendant to holding distressed TIC debt.
Since the Internal Revenue Service issued Revenue Procedure 2002-22 (and indeed before), a taxpayer selling investment or business real estate has had the ability under Internal Revenue Code (IRC) §1031 to defer gain on the sale of investment or business real estate by exchanging such real estate into a fractional interest in new replacement real estate. A taxpayer could of course acquire full ownership of a replacement property, but a transaction in fractional TIC format allowed the taxpayer to acquire instead a small part of a larger, presumably more stable and professionally managed asset.2
Following the issuance of Revenue Procedure 2002-22, a large industry grew up around the marketing and sale of fractional TIC interests in real estate to investors and business owners who preferred to roll over their equity into new real estate rather than pay tax on their gains. By some estimates, as much as $10 billion of real estate assets are held in syndicated TIC structures.
As with the commercial real estate market generally, many TIC-owned properties are now in distress, or will be when they come up for refinancing in the next year or so. Certain attributes of TIC-owned real estate make the distress more acute, and precisely because of this, sophisticated investors with an eye on distressed real estate are beginning to focus on the more lucrative opportunities involving distressed TIC-owned properties.
The attributes that make TIC deals particularly vulnerable to distress (and therefore possibly more attractive to distressed real estate investors and distressed debt buyers) include:
- Ownership of TIC property is highly fractionalized – usually up to 35 co-owners, most of whom do not know one another and have highly varied experience in the ownership of commercial real estate.
- Unanimous approval of TIC investors is required for decisions involving the sale, lease and financing of the property. As a legal matter, this means that unanimity is required for just about any “work-out” with a lender.3
- There is no expectation (and for many, no ability) on the part of TIC investors to contribute additional capital to a property.4
Couple these attributes with the following factors:
- The absence of a reliable point person for communication with co-owners. While some sponsors or broker-dealers of the distressed TIC deal can be helpful, many are no longer in business, or if in business have limited administrative ability and/or financial wherewithal to provide meaningful assistance. Some sponsors and broker-dealers are understandably concerned about potential liability to investors and opt to stand aside rather than possibly increase their legal exposure by involving themselves in a work-out. Other sponsors have attempted to take advantage of what should be worthless master lease intermediary positions to extract a price for cooperation.5
- Lenders who are uncertain about how to manage the work-out of TIC-owned real estate. Many TIC transactions were financed with securitized debt. Those familiar with this product understand the difficulty of negotiating with a securitized loan servicer.6 Other lenders are still determining their strategy for distressed commercial properties generally and do not know how to manage the peculiarities of TIC deals.
- Lawyers. Many of the lawyers in the TIC area are good tax lawyers who know how to structure tax-compliant TIC investment offerings, but lack the commercial finance experience necessary to lead a work-out and may allow tax considerations to get in the way of commercial solutions. Legal advisors must recognize that the paramount issue is now the TIC investors’ equity investment, with tax considerations generally subordinate.7 Add to that the possibility that many of the up to 35 co-owners will have their own lawyers, some of whom will have no familiarity with TIC deals.
It is all dysfunctional, to say the least.
A pragmatic assessment of most distressed TIC-owned real estate would lead most lenders to foreclose on their borrowers rather than confront the likely futility of negotiating work-outs with up to 35 co-owners. For similar reasons, a pragmatic assessment by prospective purchasers of distressed real estate would lead most purchasers to devote their time and money to a deal where one person (instead of 35) can decide whether to take the loss and sell the property.
We take a more optimistic but still pragmatic view. The view begins by accepting rather than ignoring the embedded dysfunction. By ignoring the peculiar attributes of TIC structures, investors and lenders merely defer them, and ultimately are overcome by them. By addressing TIC structures strategically, the likelihood of a good result for new investors and a satisfactory result for the original TIC investors and the lender is increased.
Our experience with distressed TIC-owned real estate suggests that the best course of action is often the adoption of a roll-up and recapitalization strategy. The roll-up and ”recap” strategy addresses the following issues, among others:
- Scarcity of equity capital. If equity is scarce, it should be used to top-off existing capital rather than substitute for original TIC investor capital (that the market is not likely to recognize any longer).
- Scarcity of debt capital and stricter underwriting guidelines. Even for stabilized properties without operating distress, there is a large class of TIC-owned properties that may fail because of an inability to refinance in 2009 and 2010. The securitized loan market that financed many TIC-owned properties is largely gone in terms of originating new loans. Insurance company and bank lenders, who are making fewer loans today, will be disinclined to finance properties with multiple owners, something that they did only begrudgingly before the current market difficulties. Permissible loan to value percentages have fallen, and reserve requirements have increased, making funding increasingly scarce.
- Emotional refusal to capitulate on price. Many TIC investors may be reluctant to sell and recognize their losses. Their equity may in fact be gone, but among the 35 or so investors in a TIC deal (some lacking good financial, tax and legal guidance), there are certain to be some hold-outs when it comes time to make a decision to sell.8
- Phantom income. For some TIC investors, their deferred tax liability may be greater than their equity investment in the new property. It is possible that an investor who loses his entire investment still has a sizeable tax to pay when the property is sold or foreclosed. Such an investor is less likely to accede to an otherwise reasonable purchase offer, much less walk away.
- Potential cancellation of indebtedness income on work-outs involving write-downs of debt that do not qualify under exceptions in IRC §108.
It is with these and other challenges in mind that we have worked with a number of investor clients to “roll-up” and “recap” a TIC into a limited liability company or limited partnership that looks like the more traditional syndicated partnership. The typical roll-up/recap we have constructed has the following attributes, responsive to many of the challenges of TIC-owned deals and their lenders:
- The new investor (usually an institutional investor or fund) forms an entity (typically an LLC) to which the property will be transferred by the TIC investors. This can be done in a variety of ways, including by conventional property deeds or by merging existing special purpose entities owned by the TIC investors into one surviving LLC.
- The investor brings new equity capital to the LLC only to fund (i) projected operating deficits; (ii) reserves for new tenant improvements and leasing commissions; (iii) the projected equity gap on a future refinancing of the property; and (iv) transaction costs. No new capital is used to pay investors any part of their original investment, as that would be a poor use of scarce equity.
- The TIC investors’ contribution of the property to the LLC is structured as a tax-free contribution to the LLC under IRC §721. As a technical tax matter, this also requires paying careful attention to the allocation of liabilities to avoid deemed distributions under IRC §752. Usually all or most of the TIC investor’s deferred gain can continue to be deferred.
- In connection with the conveyance to the LLC, state and local transfer taxes are managed and title insurance is brought current.
- The new investor controls the LLC.
- The lender now has a single point of contact who has both the authority to deal with the lender and an economic stake in the performance of the property. A work-out can be reliably negotiated and agreed.9 This should be contrasted with most current TIC work-outs, where well-intended sponsors and broker-dealers have neither the authority to deal nor the financial incentive to make them a good bargaining partner for the lender.
- The LLC provides for a multi-tier distribution waterfall that recognizes the TIC investors’ original capital in whole or in part. An example of a distribution waterfall we recently developed for a performing property facing refinancing risk is as follows:
- 100% to the new investors, until they have received an 18% internal rate of return (IRR) on their new investment.
- 50% to the new investors and 50% to the TIC investors, until the TIC investors have received one-half of their original capital back.
- 80% to the new investors and 20% to the TIC investors, until the new investors have received a 24% IRR.
- 50% to the new investors and 50% to the TIC investors, until the TIC investors have received the remainder of their original capital back.
- 60% to the new investors and 40% to the TIC investors.
There are many variations of this distribution waterfall, but the point is to compensate the new money well, commensurate with the scarcity of capital and risk, while leaving room for the possibility that TIC investors can some day recoup their investment in the property, which is the inducement for them to cooperate.
The roll-up/recap strategy addresses the challenges of the distressed TIC deal by:
- Directing scarce equity capital to where it should be used, at the property level (rather than to pay phantom equity of the TIC investors).
- Allowing TIC investors to deal with emotional refusals to deal by recognizing their original equity within a market-based distribution waterfall.
- Compensating new equity capital well, recognizing its scarcity and the attendant risk.
- Centralizing control for effective asset management.
- Centralizing control in a way that will allow for a constructive work-out with a lender.10
- Allowing TIC investors to continue to defer all or most of their historical gain, avoiding phantom income.
- The roll-up/recap is not without some disadvantages:
- TIC investors may not be able to roll over their gain on the later sale of the property by the LLC.11
- Costs of tax compliance for the LLC, given that the property will be contributed with widely varied income tax basis.12
- Costs of securities law compliance (disclosure documents and filings) in connection with the roll-up.13
- Professional fees for implementation that are necessarily greater than those in a conventional non-TIC setting.
Without seeking to minimize these disadvantages, they are small in comparison to the disadvantages that befall a conventional approach to distressed TIC deals. A new investor looking for a bargain is likely to find time and resources wasted by making a conventional offer to TIC investors when the decision whether to take the offer has to be made by 35 old investors (not to mention the sons-in-law of a few of them). A lender holding TIC paper is likely to find itself with out-sized costs of foreclosing on multiple titleholders, bankruptcies and attorneys for debtors who do not understand the structures of their clients’ deals. A TIC investor looking for solace will find that and not much else with lawyers focused on tax issues (missing the broader point of preserving the investment), or focused on chasing after the possibly empty pockets of a sponsor or broker-dealer.
As new investors look for opportunities, as lenders look for alternatives to foreclosure, as existing TIC investors look for something better than capitulation (with a tax hit to-boot), approaching the distressed TIC deal with a sound business strategy is essential. A successful strategy will of necessity confront rather than ignore the challenges of this unique asset class. Though borne of the tax code, the successful strategy for distressed TIC deals will put tax considerations in their appropriate place. Those looking to profit well or minimize losses will take up the charge through business structures like the roll-up/recap.
1 Michael Tuchman is a partner with the law firm of Levenfeld Pearlstein, LLC, Chicago, Illinois, with a concentration in Section 1031 exchanges and tenancy-in-common (TIC) programs. Tuchman represents TIC sponsors, TIC lenders and funds formed to purchase distressed TIC properties and distressed TIC loans. He is the author of the Swap ‘til You Drop™ series of articles on like-kind exchanges available at www.lplegal.com/mtuchman.
2 Revenue Procedure 2002-22 provides ruling guidelines that suggest how a taxpayer can purchase a fractional interest in replacement real estate that should not be treated as an interest in a partnership that owns real estate (acquiring real estate through a tax partnership is not permitted by the Internal Revenue Code).
3 Some TIC programs allow the sponsor or majority of owners to buy out minority owners who stand in the way of a transaction. While such a tool would be useful, it begs the question whether anyone is prepared to fund the buy-out price, or whether a buy-out price can be established without litigation.
4 Under most TIC programs, investors are responsible for their share of capital needs, but the enforcement mechanisms are usually weak or absent. Most TIC investors are actually special purpose limited liability entities that do not have any assets apart from their interests in the property. In any event, the “psychology” of most TIC investors is inconsistent with the notion that investors will ante up additional capital. Consistent with that, most TIC loans are non-recourse, except for so-called “bad boy” carve-outs.
5 Many TIC deals were structured with master leases interposed between the TICs and property tenants. A master lease allows the property to be managed by the master lessee entity (usually a sponsor affiliate), averting the difficulty of obtaining unanimous TIC approval for individual leases in a multi-tenant property. Some master leases were mere tax-driven administrative constructs that did not have independent economic significance. Others were intended as a way that the sponsor could earn additional income by profiting from effective management of the property. In the bankruptcy of DBSI, Inc. et al (Delaware, Case No. 08-12687), once a leading TIC sponsor, the bankruptcy court is now attempting to untangle a complex web of transactions and TIC investor losses, while the debtor/sponsor is seeking “compensation” for the master lease positions that pulled many of its properties into bankruptcy in the first place. See Tenancy in Common Association’s January 21, 2009 letter to US Bankruptcy Court Judge Peter Walsh.
6 Sophisticated distressed debt buyers have a number of strategies for buying, managing and selling pools of securitized debt. The ability to manage individual securitized debt work-outs varies depending upon the servicer’s authority under the original syndication, the servicer’s appetite for risk and the servicer’s business acumen.
7 For some TIC investors, the deferred tax liability could be greater than the amount of their equity investment. Thus the subordination of tax considerations does not mean that they can be disregarded.
8 There may be TIC investors who really do “get it,” and understand that their legal ability to hold out and be a spoiler for the other investors may get them a higher price for their fractional interest in the property.
9 The roll-up/recap will usually require lender consent, so the implementation of the roll-up/recap is done in conjunction with the negotiation and execution of the work-out.
10 Where a property cannot attract additional capital from a new investor, the lender is faced with the prospect of funding the property itself (whether or not it takes the property back in foreclosure). Often the lender will hire consultants to manage the property. Looking at prior real estate cycles, lenders and their fee-paid advisors did a terrific job of managing assets poorly. The roll-up/recap is also a strategy for a lender who may not wish to foreclose on the 35 or so TIC investors, who will provide additional funding for the property (whether it likes it or not) and who is willing to strike a deal with an entrepreneurial asset manager to assume the “general partner” role in the rolled-up entity – with a carried-interest-like incentive to manage the property well.
11 While some pre-sale planning to position for a future IRC §1031 exchange may be possible, it is difficult to provide assurances about this up front. In our experience most TIC investors will appreciate that tax considerations have to be subordinated to current efforts to recoup or stabilize their investment.
12 See, among other things, IRC §704(c) and related regulations, including under IRC §704(b).
13 The new money investor may be viewed as offering a security (an interest in the roll-up LLC) to the TIC investors in exchange for the TIC investors’ interest in the real estate.
© Michael J. Tuchman, February, 2009. All Rights Reserved.
About the Author
Michael Tuchman is a partner in the Corporate Practice Group and leads the Taxation Service Group and the Exchange Service Group, concentrating in corporate mergers and acquisitions, commercial real estate development and joint ventures and Federal income taxation.
Michael began his practice in 1984, focusing on transactional and international taxation. He currently serves as special counsel to several prominent pension funds, foreign governments, real estate investment trusts and other institutional investors. He has written numerous articles and is a frequent speaker on transactional and taxation matters.
Published with permission. Originally published on The National Law Review (http://www.natlawreview.com)