FEATURE ARTICLE, OCTOBER 2006

AN EXCHANGING MARKET
SCI Real Estate Investments discusses how 1031 exchanges are changing the real estate landscape in Texas.
Interviews by Lindsey Walker

The current climate for 1031 exchanges in Texas is hot and showing no signs of stopping. Texas Real Estate Business recently spoke with Tim Crockett and Eric Aronson, regional directors with SCI Real Estate Investments, to find out why more and more investors are warming up to the idea of using 1031s to grow their portfolios in Texas.

TREB: Describe the current climate for 1031 exchanges. Is it a buyers’ or sellers’ market?

Crockett: I’d say it’s sunny and hot – almost a global warming if you will, but in a good way. Since sellers have frequently depreciated their assets and, in a lot of cases, built up a significant amount of equity – they can benefit from selling. While buyers, on the other hand, can benefit from a new basis and buying a new property. So it really is good for both sides.

TREB: What trends are you seeing in 1031 activity?

Crockett: Ever since the IRS issued Revenue Procedure 2002-22, there’s been a huge increase in the number of investors taking advantage of 1031 exchanges. During the last 4 years, the trends have just been straight up since it enabled investors that were buying 1031s to buy larger properties. Before Revenue Procedure 2002-22, you had to be an institution to buy institutional-quality investments, thus the name. Now, by being able to combine money with other investors, 1031 money in particular, into a tenant-in-common ownership vehicle, smaller investors can buy bigger, higher quality properties that they previously could not afford.

TREB: What trends do you predict for 1031 activity in the next 2 years?

Crockett: I see a significant expansion as more and more investors learn about using the tenancy-in-common (TIC) position in particular to acquire real estate with their 1031 funds. And the more people I speak with, the more I learn that it’s still a drastically under-utilized investment tool.

TREB: In the current market climate, what are the benefits for a property owner doing a 1031 exchange?

Crockett: Quite simply, it allows an investor to use those funds that would have otherwise gone to Uncle Sam as taxes (typically 15 percent capital gains and as much as another 10 percent depreciation recapture — combining those is about 25 percent of the investor’s equity). An investor could either pay 25 percent of its available equity to the government as taxes or put into a new property as additional equity. It seems pretty logical to me, but it’s obviously a decision each investor needs to make on its own.

TREB: What types of buyers are seeking exchanges? What types of sellers are seeking exchanges?

Crockett: Only those buyers that decided to do an exchange before they closed their sale and engaged an accommodater or a qualified intermediary (QI) to assist with the process are eligible. It makes no practical difference to the seller whether the buyer of their property is doing an exchange or not. But, anyone planning to reinvest their sale proceeds into other investment real estate, in my opinion, should at least consider taking advantage of a 1031 exchange.

TREB: What property types are the most popular for 1031 exchanges? Why?

Crockett: Since the IRS defines “like-kind” as any real estate used in trade or business or held for investment purposes, we see all kinds. SCI however focuses on acquiring those assets we feel provide the best quality; new/like-new properties, well-located, Class A apartments and multi-tenant national-credit retail centers that generate good cash flow. But, when it comes down to the specific asset, investors should certainly evaluate the individual property, the market, competition and their personal investment goals and let that guide their investment decision.

TREB: How do you identify target properties for exchanges? Do you have developers/brokers you work with for certain property types?

Crockett: We have 14 full-time acquisition specialists that review hundreds of properties every month throughout the entire country to buy what we believe to be the best one or two. It’s kind of like panning for gold. We go through a lot of dirt to find those special gems that get into our portfolio. Last year we looked at more than 5,100 deals to buy only 18. This year we’re on pace to do even more. Co-investors obviously get a tremendous benefit from SCI’s seeing, comparing and reviewing that many properties.

TREB: Have investors fleeing the stock market for NNN properties affected the 1031 supply pipeline?

Aronson: Whether they’ve reallocated money from the stock market or other areas, there’s definitely a lot of cash out there that is seeking good deals. We’re seeing interested investors come from many varied places. 

TREB: What is the competition like for properties? How many buyers are chasing the same properties?

Aronson: We are seeing a lot of competition. But, it depends on the property and the market. Some deals are smothered by a lot of buyers of all different kinds, and some just plain aren’t. In some cases, we’re able to create a deal where a deal didn’t really exist by being creative and resourceful.   We’ve developed a strong reputation in the marketplace as a solid, dependable buyer, so, it makes our job a little bit easier when it comes to acquisitions. We can be very fast in closing and we bring a high degree of certainty of execution. When we go into negotiations with a seller, we are very confident and the seller knows we can close and close on time.

TREB: What areas in Texas attract the most 1031 exchange buyers? Why?

Aronson: 1031 exchangers come from all areas because there is a lot of equity all over the place....from commercial property owners in major cities to rural land owners that have seen their property come up in value. Austin and San Antonio are both great markets. I’ve also dealt a lot with people up in Houston and Dallas and Fort Worth. But, there are folks with a significant amount of equity and folks that are interested in 1031 exchanges all over Texas. We get inquiries coming out of the Rio Grande Valley, down on the coast and in a lot of rural areas. There are a lot of reasons why and many different kinds of investors that are seeking 1031 exchanges and seeking out TIC deals.

TREB: Are there any legal issues/proposed changes to 1031 laws that our readers should be aware of?

Aronson: I would suggest any investor seeking a 1031 exchange should consult a tax professional and an attorney.

TREB: What factors could affect the 1031 exchange marketplace in the next year or two?

Aronson: The same ones that have and will continue to affect us all of the time, such as market forces and supply and demand of real estate. Each investor should look at each opportunity in a separate light and should carefully review the overall environment — interest rates, the economy and more importantly the local market where the asset is located and especially the asset itself. We think that what we’re doing is applicable for all markets. We continue to be buyers of the highest quality of assets with the right tenant base and the right location where nobody can come along and build something that competes with us. We think that strategy will be a good strategy for security and growth in just about any kind of market.

TREB: Can you give any measure for how much the 1031 exchange market has grown in the last year? Do you expect this growth to continue?

Aronson: Certainly tenant-in-common 1031 transactions are on the rise.  Real estate professionals and investors are attracted to TIC deals because they like the idea of being able to invest in high-quality commercial property that they’ve typically been unable to access previously.  These smaller investors can now benefit from institutionally managed properties, stable cash flow, and strong growth potential.  It also allows for easy diversification.  By all accounts, the industry is just getting started.  In addition to our existing billion-dollar portfolio, SCI plans on acquiring another $600 to $700 million worth of tenant-in-common co-owned real estate this year alone and potentially more.   Tenant-in-common co-ownership is gaining more and more creditability and momentum each day.

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