FEATURE ARTICLE, MAY 2006

A NEW INVESTMENT CLIENT
The intersection of real estate investments and traditional securities requires new traffic signals and a new approach.
Jeff Young

Young

Many of these advisors are dual-licensed, meaning they have real estate licenses as well as their securities certifications. That and participation in the industry’s trade group, the Tenant-in-Common Association (TICA), have helped them to get up to speed in understanding and marketing these popular programs. Sponsors offering TICs often provide in-depth due diligence opportunities, and since most TICs involve a tax-deferred exchange as a 1031, qualified intermediaries (QI) assist the brokers in some of the more technical aspects of the exchange.

So while most investment advisors have risen to the necessary skill and knowledge level of the product to know whether a TIC is in their clients’ best interest, they are finding that knowing the product and knowing their client are two separate and distinct tasks, quite different from integrating a client’s investment portfolio that consists mainly of stocks, bonds, cash and “non-correlated” vehicles, such as REITs and commodities.

Prior to the Revenue Procedure 2002-22, which effectively allowed exchanging investors to participate in properly structured TIC properties that qualified as “like-kind,” the securities people were limited to investing clients’ investment portfolios into traded or non-traded REITs for a designated portion of their portfolio. Even then, that was not a particularly frequent exercise, as evidenced by the only relatively recent phenomena of having REITs available in many 401K plans.

For the securities brokers, fundamentally their main function is to design investment plans, invest the assets in mutual funds or stocks and bonds, and monitor those accounts all with an eye to timeframe, risk tolerance, client objectives, etc. In addition, they are often called upon for estate planning, college education services, retirement planning and insurance needs. Indeed, most clients who come to the financial industry for that type of help do so presumably because they lack the skills, time and/or experience to do so successfully on their own.

With the real estate owner wishing to conduct a tax-deferred exchange however, the advisor comes face-to-face with a new type of investor. Unlike his mutual fund counterparts, real estate investors are often well versed in the field. They have provided their own capital, conducted their own due diligence and individually assumed the risk respective to their real estate holdings. They have often done so with little or no assistance from outside parties, save lenders, agents and title companies. And many are highly successful in their endeavors, in addition to the real estate market having been very good to them, especially in the last few years.

Complicating this mix is the fact that until just a few years ago, real estate and stock investors stood in two separate and distinct camps, with just a few properly allocating equity and real estate holdings in a comprehensive portfolio.

More investors are crossing the line to incorporate real estate into a primarily equity/debt portfolio, and more real estate investors are beginning to diversify more into the stock market.

For the former, they are driven by the still not-so-fond memories of the 3-year bear market that began in 2000 and the desire to participate in holding hard assets, such as real estate. The attention given real estate and the tremendous increase in valuations has not escaped them either, though that may not, at least in the short run, be necessarily a good thing, given the compressed cap rates that exist today.

For the latter, many real estate investors, along with their baby-boomer brethren, are capitalizing on their properties’ appreciation and opting to relieve themselves of the day-to-day operation of their properties. And when they sell, that money needs a home. Some are opting to pay the tax and diversify the assets, especially as interest rates are rising and giving better returns in fixed-income assets and as dividends continue to receive favorable tax treatment. For many others, it means deferring taxes by investing in the TIC market, which, though certainly real estate, functions as a security in most instances.

Some observations can be made from the convergence of the qualified financial advisor and the TIC investor. For one, the real estate investor may have a greater amount of skepticism before jumping into a program in which he has little control and is part owner of an undivided fractional interest in a real estate holding. As in any investment, there is give and take. For relinquishing his former role as sole owner, there is relief from personal operations control and responsibility. For this, he presumably receives expert property management from the sponsor company and a steady stream of income from triple-net properties. And, as a TIC holder, the investor holds a non-recourse loan on the property.

This is where the advantage of the property being a security comes into play, as a Private Placement Memorandum (PPM) is required for each property being offered. This document needs to be thoroughly read and understood as to how the risks and features of the property are detailed. The advisor should walk the investor through the PPM and perhaps discuss it with the client’s other professional advisors, such as a CPA or attorney.

Another aspect that can result from an advisor’s participation is that the real estate seller may be encouraged to pay taxes on a portion of his or her sale in order to properly diversify the overall portfolio. Indeed, the various regulatory bodies that oversee the securities industry stress the significance of diversification and frown upon portfolios overly allocated to one asset class.

One area more problematic than others is the “financial sophistication” requirement of Regulation D offerings. While quantifying net worth is obvious, the sophistication level is more abstract. Indeed, there are real estate holders — farmers, as an example — who may have little or no experience whatsoever in other investment matters that may render them unqualified in terms of accreditation credentials. Obviously, those need to be examined on a case-by-case basis and it is up to the advisor and his client to make that decision.

As more investors move into the world of securitized real estate, it would behoove investment advisors to more fully understand their experiences and motivations and to recognize the cognitive differences between them and traditional investors with whom they are familiar. As well, sponsors and sellers of these properties need to continue to make every effort to offer quality property with reasonable expectations for this, the new investor. 

Jeff Young is senior vice president of First Financial Equity Corporation in Scottsdale, Arizona.

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