Crowdfunding seeks to correct some of the weaknesses of TICs.
Many investors seek to diversify their portfolios by passively investing in real estate. These investors want only a financial stake in the property, with no management responsibility. Before the advent of real estate crowdfunding, tenancy-in-common (TIC) investing was a popular way to passively invest in real property. Over time, several defects became apparent with TICs, defects which real estate crowdfunding platforms have sought to correct.
Real estate crowdfunding and TIC investing resemble one another in certain basic ways. Both provide:
- The ability to invest in private real estate deals.
- Proportional ownership of a property or of the owning entity.
- Participation in income and capital gains resulting from the property investment.
- Ability to pick specific investment properties rather than a pool of investments (such as with REITs).
Despite these general similarities, the two types of property investment differ in numerous ways. Let’s first examine the strengths and weaknesses of TIC investing.
Tenancy in Common Investing
TIC investments are ones in which multiple investors each have legal title to part of a property. The percentage owned by each investor is specified in the Tenancy-in-Common Agreement and is generally proportional to the size of each investor’s contribution. Ownership is in the undivided property rather than in specific apartments or units. The TIC structure can be used for residential or commercial real estate investments. Unless other arrangements are made, the ownership portion of a deceased TIC investor will pass to that investor’s heirs. All TIC investors have access to the property and share in costs and revenues. A correctly structured TIC investment may participate in a tax-free 1031 exchange for another property.
TICs were a popular means of passive investment some 10 to 15 years ago, but, over time, a number of issues surfaced that removed a lot of the luster from TIC investing:
- The unanimous consent of all tenants is required to make decisions about the property such as refinancing, selling, leasing, etc. This is often extremely difficult, especially with TICs that have up to the maximum of 35 investors.
- Any TIC investor has the right to force the partition of the property. This means that the investor can take ownership of specifically designated parcels or units. In lieu of this possibility (because of legal or logistical reasons), the investor can sue to have the property sold and the proceeds distributed. Some agreements attempt to remove this right from the investors by having each investor waive it, but the legal enforceability of the waiver is open to question. Forced partitioning is a negative to investors who want a dependable source of income.
- Many consumer complaints have centered on the lack of pre-sale due diligence by the property sponsor (usually, a brokerage), as well as the sponsor’s failure to monitor developments at the property. Lawsuits have touched upon problems such as cursory background checks, invalid appraisals and poor review of financial statements.
- FINRA arbitrators have expressed concerns about the large number of senior citizens investing in TICs. FINRA has questioned the suitability of this investment for seniors, in part because of the potential lack of liquidity should the investor wish to cash out. A lack of demand can cause a significant loss when selling a TIC position.
- An incorrectly drawn TIC agreement may lead the IRS to recharacterize the arrangement, thereby revoking access to Section 1031 tax-free exchanges.
- If a TIC investor declares bankruptcy, the value of the remaining TIC investments decreases, because the bankrupt TIC investor is no longer making fair share payments of expenses (mortgages, taxes, maintenance, etc.).
Contrasts to Real Estate Crowdfunding
PeerRealty, along with other real estate crowdfunding platforms, facilitates the purchase and sale of equity shares in private property deals. Currently, legal crowdfunding authority stems from the modification to SEC Rule 506 of Regulation D, allowing certain private placements to be marketed publicly while restricting transactions to accredited investors. Other bases for real estate crowdfunding are on the horizon, including Regulation A+ and Title III crowdfunding. The Reg. D crowdfunding process involves the sale of equity shares by real estate owners and developers, commonly referred to as sponsors. Section 1031 money may be used if the investor meets the regulatory requirements.
Real estate crowdfunding differs from TIC investing in several ways:
- There is no right to force partition.
- A single entity controls the property, making banks more willing to lend
- Decision making power vests with the manager, and investors are passive.
- The bankruptcy of a crowdfunding investor has no effect on other investors. Investors own shares of the sponsoring corporation, not of the subject properties.
- The minimum investment for many offerings is only $5,000, which is less than TIC deals generally require.
- Investors may receive a preferred return, which means cash flows go first to investors and then to the sponsor.
The era of real estate crowdfunding presents an attractive alternative to the often risky and murky world of TIC investing. No one can guarantee the outcome of an investment, but the due diligence PeerRealty undertakes goes a long way to reducing the risks of losses based upon misinformation. Over the next year, look for crowdfunding to spread to non-accredited investors, letting everyone gain portfolio exposure to this very important asset class.