Other Lease TermsSuperior Interests

The TICking Bomb of Building Ownership

timebombOccasionally, we hear of a tragedy where a bomb explodes in a former war zone.  Likewise, in commercial real estate where most markets have recovered from the recession, there is a time bomb of building ownership that can be disastrous for office tenants.  That ownership structure is a TIC (Tenancy-In-Common).  In this post, I outline what is a TIC, the challenges they present and how tenants can safeguard their interests.

What’s a TIC?  Among the legal ways to own real property is “Tenancy in Common” (TIC).   In simple terms, Tenancy In Common is a form of shared ownership which can be in unequal sizes and freely transferable.  While the origins of TIC are rooted in old English law, about 15 years ago it became a popular investment vehicle for commercial real estate for two primary reasons: (1) capital gain deferral through tax-free 1031 exchange after issuance of a 2002 IRS guidance; and (2) access to larger investments outside the reach of many individual investors while being relieved of active management of the property.  While TICs, as explained below, have lost their luster, some buildings are still owned under this structure.

Here’s how it typically works.  A TIC promoter (“Sponsor”) finds a property (usually a large property) and the Sponsor sells TIC interests (analogous to purchasing stock in a corporation) to investors.  The Sponsor will then arrange for financing as well as management and leasing of the building.

TIC Ownership Challenges:  The IRS allows up to 35 TIC investors which is not uncommon for many office buildings that are owned by a TIC.  Another significant requirement that makes TIC ownership problematic is that all major decisions (i.e., financing, sale) require unanimous consent of all investors.  Where a TIC investor does not consent to a major decision after 80% of the fellow investors have agreed, that dissenting investor’s interest can be acquired by any other TIC investor.   For all other matters, a simple majority is needed for approval.  The daily leasing and management activities, however, are handled by an outside property management and/or leasing firm.

When the TIC Explodes:  When the building is well occupied and cash flowing, life is good.  Trouble occurs when there’s a major cash flow disruption, as most of these TIC owned buildings are financed with debt.  That cash flow interruption typically happens when the building loses a major tenant and is unable to meet debt service.  Alternatively, we have seen the slow-motion car crash where the anchor tenant has moved out and continues to pay rent, but the underlying loan is maturing which the TIC owner is unable to refinance due to the drop-in valuation after losing the tenant.

As a financing decision requires the unanimous approval of all investors, that’s a major challenge when there are likely 35 individual investors (who typically are complete strangers to one another) attempting to negotiate refinancing or loan modification as that typically requires that the investors contribute more equity to offset the drop-in value.  The refinancing becomes even more challenging when the underlying loan is held in a CMBS (a commercial mortgage backed securities) where there are multiple layers of lenders.  See our prior post on what tenants should know about CMBS financing.

As we all know what happens when we have too many cooks in the kitchen, these buildings typically are unable to refinance which leads to default and ultimately foreclosure. Without cash flow, the building is unable to be maintained which impacts existing tenants.  The vicious cycle begins as they are unable to lease space to any outside tenants to back-fill the vacancy because they do not have monies for leasing, e.g., construction allowances, brokerage fees, etc.…

How Tenants Can Safeguard their Interests: Here are some things tenants can do to protect their interests.

  1. Know your landlord.  When exploring properties, have your broker provide due diligence on the buyer and thoroughly vet the ownership group.
  2. Know your building.  When exploring properties, even where the building is not currently owned by a TIC, is the tenant base diverse enough to avoid the major cash flow interruption should a major tenant(s) leave?  What is the status on the debt?
  3. Does your lease have service interruption remedy language in the event the landlord is not providing necessary services that are mission critical to your business?
  4. Along those lines, does your lease offer limited self-help remedies for landlord default?
  5. Does your lease require that the landlord obtain Non-disturbance agreements from current and future lenders which will preserve your lease in the event of foreclosure?  See our prior blog on Non-disturbance agreements.

 

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