FEATURE ARTICLE, JULY 2007

VELOCITY, SCARCITY AND THE 1031 EXCHANGE
Hall Financial Group discusses how TIC funds continue to gain buying power in an unpredictable marketplace.
Matt Mumford

Mumford

The 1031 exchange has both stimulated and mystified investors, economists and tax consultants for decades. The concept of taking capital gains from one property and rolling the gains into another property without paying tax on the gain stimulates the economy and triggers a number of price issues when exchange monies begin to compete with non-exchange monies. This competition is price inflationary to say the least.

Exchange money is not unlike an option in the stock market. When an under water stock option expires, it becomes worthless. In a 1031 exchange, if the replacement is not made within the time limits of the exchange period, the exchange money turns into a “pumpkin” and the exchanger is stuck with a tax bill. If the previously owned property has a significant amount of depreciation and recapture, the tax bill can sometimes even bankrupt a principal.

When confronted with the end of an exchange period (for whatever reason), investors become willing to take greater risks, pay higher prices and make radical decisions to preserve the exchange and avoid the dreaded tax bill from Uncle Sam.

What About Recent TIC Rules and the 1031 Exchange?

The dreaded Tax Reform Act of 1986 torpedoed the real estate market and brought much hardship to all facets of the real estate investment scene. Sixteen years later in 2002, the IRS issued the first positive set of new real estate guidelines (Rev. Proc. 2002-22), which clarified an investor’s ability to use tenant-in-common investments (TICs) as legitimate up-leg exchange vehicles for their exchange money. According to the Tenant-in-Common Association (TICA), the volume on TIC investments went from $167 million in 2001 to $1.8 billion in 2004, a 978 percent increase. One year later, TIC investments soared to more than $4 billion in 2005.

As laws have become more favorable for individuals to put exchange money into TIC investments, the buying power of TIC funds has gone up. TICs are like the mutual funds or hedge funds of the stock market, where many invest their money with a group of managers who are involved in the real estate market on a daily basis, creating tremendous buying power. As the TIC funds grow in size and strength, there is a great need for the TIC managers to place money with high quality real estate products, products that will give their investors great returns and, in turn, bring more money into the TICs through outside investment. In recent years, as construction prices have soared, it has become difficult to purchase newly built buildings with good cap rates, forcing TIC buyers to aggressively seek slightly worn or Class B level investments in real estate.

What Has This Done to the Market?

Because of a general overall increase in pricing and a reduction of cap rates, investors have been selling out of their current property portfolios and moving monies into properties with a higher leverage. Because of this, the supply of money available for investment in real estate has gone up but the number of investment grade properties has not kept up the pace. This creates the disparity between the cap rate reduction and the price increases on what were once mediocre properties. Risk premiums have also compressed, leaving a smaller and smaller gap between the cap rates on Class A and Class C properties.

In recent years, coastal small investors have made money in condos, single-family homes, duplexes, four-plexes and small commercial real estate investments. They have pushed the money into large apartments and TICs. It is not uncommon to see a California investor in his mid- to late-20s who owned an eight-plex in 2001 now owning a more than 200-unit apartment community in the Midwest funded with the equity from his exchange proceeds. As more of these investors begin selling out of their coastal properties, the inland properties become inflated and cap rates begin to drop. It becomes normal to see a single investor, a large TIC, a pension fund and an apartment conglomerate fighting over the same Class B apartment building, greatly inflating the purchase price.

Efficiency of the Market and the 1031 Exchange

The amount of information readily available to investors today has greatly enhanced the efficiency of the real estate market. Tax records, plat maps, loan notes, surveys, appraisals and just about every other real estate document in between can be located within a few minutes online. Before the Internet, much time was spent copying documents, ordering reports and even waiting in line at City Hall or the County Recorder’s office. The convenience of the World Wide Web has easily trimmed thousands of dollars off valuable transaction time.

Exchange accommodators can also be found quickly online and transactions can be executed with very little paperwork on the buyer’s side. It is not unusual for a buyer to put several properties under contract before his identification period ends to lower his risk. As the identification period nears, buyers will often drop several contracts keeping the real estate in play that he has found most favorable. This practice is becoming more and more common with sellers, who thought they had a contract at a great price, finding buyers dropping contracts at the end of the due diligence period — forcing them to take the property back to market. Sellers are becoming wary of this practice and are starting to require earnest money going hard in the first few days of a due diligence period. They are also often accepting offers with money at risk early in the game versus concurrent higher offers with nothing to lose.

As prices continue to go up, buyers become more aggressive, sellers become more prudent and TICs keep gaining power. It is true that the tax laws passed in 2002 favoring TIC investments have caused more money to flow into the market. But what will happen when the banks begin constraining funds earmarked for commercial investment and turn to seeking the risk premiums of the old days? Only time will tell.

Matt Mumford is the vice president of Frisco, Texas-based Hall Financial Group, where he serves as director of acquisitions.


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