They're the new 'in' thing, but are TICs here to stay?

What is a TIC? No, it's not a parasite, but rather an acronym for Tenancy in Common (TIC).

A TIC is an estate in real property under which each tenant in common has an individual possessory right in the entire property. Under the law of most jurisdictions, each tenant can compel a partition of property, unlike partners in a partnership or members of a limited liability companies.

Why have TICs become such a hot topic?

In March 2002, the Internal Revenue Service ("IRS") issued Revenue Procedure 2002-22 ("Rev Proc"), which contained clear guidelines on how to obtain revenue rulings confirming that a particular TIC qualifies for a 1031 Tax Free Exchange. Owners of TICs can sell existing property investments without taxable gain. No wonder the Rev Proc resulted in an explosion of interest in TICs.

In order to qualify for the benefits of the Rev Proc, the following tests must be met:

* Each co-owner must hold title to the property, directly or through a disregarded entity, as a tenant in common under local law.

* Number of co-owners is limited to 35 "persons".

* The co-owners are not to treat the co-ownership as an entity.

* The co-owners can enter into a limited co-ownership agreement running with the land.

* Unanimous vote of the co-owners is required for sale, lease, release of any of the property, negotiation or renegotiation of debt secured by blanket lien, hiring of a manager, or negotiation of management contract. On a decision requiring unanimous vote, a 75% vote by the TIC owners is usually sufficient to initiate an impasse resolution procedure. This procedure allows the TIC owners with 75% or more of the property to make an offer to buyout the dissenting owner(s) with the minority (25% or less) owner(s). The dissenting TIC owners can accept the offer, buy out the majority 75% owners at the same price per percentage ownership, or change their dissenting vote to the majority position.

* Generally, each co-owner must have an unlimited right to transfer, partition or encumber his or its interest in the property. BUT restrictions on these rights are not prohibited if the restrictions (1) are required by a lender and (2) are consistent with customary commercial lending practices. ALSO, restrictions are allowed that give co-owners, sponsor or lessee right to make first offer upon decision to transfer an interest or that give co-owner ability to offer his or its interest for sale to the co-owners, sponsor or lessee before exercising partition right.

* Upon sale of the property, debt secured by a blanket lien must be satisfied and then the proceeds must be distributed to the co-owners (i.e., there must be no provisions for collective reinvestment of proceeds).

* Proportionate sharing of profits and losses is required.

* Payment to a sponsor must reflect fair market value of the interest acquired or the services rendered and may not depend on income or profits derived by any person from the property.

There are two TIC structures. The most common structure of syndicated TICs involve multiple parcels of property which are owned by co-owners and leased to a single master tenant (usually the sponsor) with debt of the co-owners secured by all of the parcels. Another structure is where the investors own a single property as TICs and a sponsor manages the property pursuant to a management agreement. While interests in the property are real estate interests, the sale of TIC interests must be treated as a security. The TIC structure raises new levels of analysis for lenders and rating agencies.

Loan Issues. Because lenders are accustomed to (and from a servicing perspective, often only equipped to) dealing with a single borrower, it is important that a tenancy in common loan involving multiple borrowers be streamlined. Each tenant in common must be a party to any loan documents under the Rev Proc as well as for the benefit of the lender.

The loan documents and the tenancy in common agreement should be written to allow the lender to deal only with the manager. Notice requirements should be satisfied by notifying only such party. In addition to these administrative issues, the lender should make sure that it is named as a third party beneficiary under the tenancy and management agreements.

Furthermore, under the loan documents, each tenant in common should be treated separately in terms of representations, covenants and other guaranties, as appropriate. The loan documents should strictly prohibit bringing a partition action while the loan is outstanding, otherwise the prospect of a forced sale would loom perpetually through the term of the loan. Such restriction should also be covered by a recourse carveback guaranty by each tenant in common.

The lender must be sure that as part of both the tenancy agreement and the loan documents, any party desiring partition is required to offer to sell its interests to the other tenants and those tenants are required to purchase such interests. The Revenue Procedure expressly permits a first offer requirement. Finally, because of the uncertainty surrounding such restrictions under the common law and the Rev Proc, a legal opinion should be required from borrower's counsel concerning its enforceability. The opinion will most likely be a reasoned one. These recommendations comply with rating agency guidelines for tenancy in common transactions.

In order to deal with the bankruptcy risk inherent in a transaction with multiple borrowers, rating agency guidelines provide that (i) each borrower/tenant should be a bankruptcy remote special purpose entity, and (ii) non-consolidation opinions should be provided for each tenant in common. However some investors may hold interests in entities, which may not have sufficient flexibility to convert into an SPE. Remember, entities that become tenants in common will often have been in existence long before SPE requirements came into being.

How then does a lender protect itself? One thing a lender can do is obtain a recourse carveback guaranty from a creditworthy guarantor and make certain that such guaranty covers any bankruptcy filing, in addition to covering other steps which may be taken by a tenant in common to prevent enforcement of the loan documents.

Financing Issues: Financing of TIC properties offered for 1031 are traditionally non-recourse first mortgages. The TIC debt structure generally allows for the debt financing to be assumed. What becomes extremely problematic is an individual TIC owner's ability to finance its ownership interest on a non-recourse basis. Since the collateral in such a situation would typically be a "non-controlling" interest in a leveraged property, most lenders would shy away from providing this financing.

Additional Rating Considerations: The rating agencies are encountering more TICs, particularly in CMBS transactions. There are five other issues to consider in addition to those mentioned above:

1. Value: that the transaction reflect the true property values;

2. Forced Sale: the rights of tenants, creditors and tax authorities if the TIC is forced to sell its property by a bankruptcy trustee, by the IRS as holder of a lien against a tenant for unpaid taxes, or by a tenant seeking to partition the property. Although the SPE helps isolate the property from the risk of a forced sale, the risk remains that multiple tenants expose the property to the risk that the bankruptcy-remoteness of any one of them could fail, thus causing the collapse of the TIC.

3. Management: the extent to which tenants may delegate decision-making to a centralized management and mitigate risks associated with multiple tenants and administrative matters is crucial, but unclear under Rev.Proc. 2002-22.

4. Serial bankruptcy filings: is problematic if the tenants, in a coordinated effort, file for bankruptcy one after another, continually re-imposing the bankruptcy stay and thwarting the lender's efforts to foreclose.

5. Subordination and Standstill: of the rights of one tenant or groups of tenants to impose liens or enforce cross rights, remedies and indemnities should be limited.

The authors are members of the Urban Land Institute, and each are members of the Executive Committee of the New York District Council of the ULI. Sheri P Chromow is a Partner with the law firm KMZ Rosenman.; Jeffrey Baevsky is Senior Vice President with Wachovia Bank, N.A. Merrie S. Frankel is Vice President and Senior Credit Officer, Moody's Investors Service, and is a Trustee with the ULI.