I have been an investment banker for almost forty years, advising institutional clients such as corporations, municipalities, and not-for-profit organizations on complex project financing.
In 2004, one of my limited partners asked me to look into the fractional ownership of commercial real estate. The tax law had changed two years earlier and for the first time, an investor could sell their commercial property, and 1031 exchange into a larger property (or portfolio of properties) as a fractional owner. Various forms of real estate partnerships and syndications have always been around. The ability to do a 1031 exchange into a fractional ownership was brand new.
My partner was an older gentleman, who wanted to sell his investment properties and defer the taxes through a 1031 exchange. However, he wanted the ability to widely diversify his portfolio, similar to the approach he took in his securities accounts, and he wanted reputable, third- party managers. He planned to travel, and pretty much do anything other than manage those properties. He trusted my ability to evaluate the sponsors (as these real estate management companies are called), analyze the individual deal structures, and recommend whether these were sound investments.
I immediately saw the value of a fractional ownership exchange. There is a sizable demographic of property owners who are looking for exactly this form of investment – a way to sell their own property and exchange into a much larger, investment grade property with professional management.
The tax law change occurred at about the same time as a boom in commercial real estate, in the post-dot.com economy. As such, the fractional ownership “industry” took off almost immediately. Fractional ownership falls under the regulatory authority of the SEC, and are classified as securities, not real estate. The partnership structure has to meet strict IRS guidelines for the 1031 tax-deferred exchange to be deemed valid.
The first fractional ownership version was a tenant-in-common structure (TIC), in which the investors were collectively the owners of the property. The TIC sponsor had responsibility for the day-to-day tasks, but the investors had voting rights on the major issues. This was an important feature at the time, since many investors were initially reluctant to forfeit all decision-making authority on an investment that they had always controlled themselves.
As in most industries, particularly those experiencing a booming demand, there were a few large, well-established TIC sponsors, with a track record of success in various market conditions. There were many more new sponsors, who recently hung out their shingle to take advantage of the easy money.
I advised on and executed a number of TIC investments for my partner; and through a network of colleagues and commercial brokers, began a rather robust side business as a TIC advisor.
In 2007-2009 the real estate bubble burst. Many of the new, undercapitalized TIC sponsors failed. Ironically, the voting rights feature turned out to be a fatal flaw in the TIC structure. Small problems became big problems as critical decisions could not be made. Investors failed to respond, refused to vote, or fought among themselves, and the necessary voting majorities were never achieved. Many TIC sponsors (and brokers) disappeared, went broke, or were sued out of existence. I spent the next ten years working on real estate restructurings and bankruptcies.
I largely withdrew from the investment advisory side of the business until the spring of 2020, when a former client asked for my assistance, and it was clear that real estate, and factional ownership, was back in full swing.
The TIC structure has been largely replaced by the Delaware Statutory Trust (DST). Investors collectively own the trust, which owns the underlying real estate. A significant difference is that the DST sponsor now has all the decision-making authority. There are no voting rights granted to the investors; which is frankly the better approach, and is what investors truly want.
Advising individual investors, even wealthy and sophisticated ones, has been quite a different experience. Institutional clients are, first and foremost, managing other peoples’ money. There is an objective, arm’s length approach. In the institutional world, we tend to have a similar perspective. We all went to the same schools, were trained in the same principles, and tend to speak the same language. There is generally an investment thesis or strategy that imposes a disciplined approach, which governs most choices and decisions.
Individual real estate investors, on the other hand, are risking their own money; often a significant percentage of their net worth in a single property. They have personal and family issues to consider. The stakes are much higher. The decision-making process is often more emotionally driven. Fear and greed play a much bigger role, especially during market extremes.
Bear Market Real Estate will be a written and video series created to address the themes and issues that frequently arise with prospective clients. The series hopes to offer a perspective that is often missing from other advisers, brokers, or in the financial media. I am reluctant to call it advice, since I have reached an age when the smug certainty of youth has (mostly) long passed. A discussion is perhaps a more appropriate tone.
Why is the series entitled Bear Market Real Estate? Because frankly no one listens in a bull market. Who needs advice when you’re making money, when your decisions are proving to be correct. The pain of falling prices, the pain of being wrong, is often quite helpful in facilitating a discussion. Many of the topics will touch upon financial and economic issues. Much more will focus on the emotional issues – concepts common in the securities markets, which have somehow slipped from the vernacular of real estate investing.
Let’s see what we can do about that.