Real-Estate Investors Become Adventurous
By RAY A. SMITH From The Wall Street Journal Online
Real-estate investors are pouring money into programs that allow them to own a slice of a commercial property while deferring capital-gains taxes. But growing competition is leading some to buy riskier assets.
The latest sign of this is a deal by Argus Realty Investors LP, which expects to announce today its acquisition of a 470,755-square-foot office building in Thornton, Colo., north of Denver, for $36.8 million -- a property that is 80% leased, has a dated exterior and is located in one of the nation's weaker property markets.
Such a transaction is unusual for Argus, since its tenant-in-common programs typically have invested in properties that are entirely leased at full price. It also marks a departure for tenant-in-common programs in general, which tend to invest in buildings that are almost completely leased by solid, long-term tenants.
Tenant-in-common programs are a type of 1031 or like-kind exchange. In a 1031-exchange transaction, real-estate owners defer capital-gains taxes on the sale of property by purchasing another property of equal or greater value. In tenant-in-common programs, sellers can buy interests in properties, as opposed to buying entire properties, to qualify for the deferment.
Argus, a San Juan Capistrano, Calif., real-estate firm, raises capital for these properties from investors, who can get the tax benefit while putting up less cash than would be required to buy an entire property.
Tenant-in-common programs have exploded in popularity since the Internal Revenue Service gave them its blessing in 2002. The programs raised about $756.1 million in equity in 2003, up from about $166.7 million in 2001, according to Omni Brokerage Inc., a Salt Lake City investment adviser that specializes in finding replacement properties for investors. The industry is expected to raise about $1.9 billion in equity this year, according to Omni. The programs have become so hot that the National Association of Securities Dealers and the Securities and Exchange Commission have been looking at how these interests are marketed and sold in order to make sure guidelines and rules regarding sales are being appropriately followed. One issue for regulators is whether these investments are securities or real estate, since different rules apply for each. Tenant-in-common programs typically have invested in well-leased shopping centers, apartments or office properties. Strong demand for those kinds of assets has pushed prices way up, which has, in turn, driven down returns on those properties. That is prompting some investors, including normally conservative tenant-in-common programs, to get a little more adventurous and look for properties that can be bought for less than replacement cost, revamped, and filled with new, higher-paying tenants.
In Argus's case, the firm is buying North Valley Tech Center in Thornton from Radiant Partners of New York. The property was built as a shopping mall in 1967 and converted into an office building in 1998. Argus paid $78 a square foot for the property. Replacement cost is estimated at $120 to $130 a square foot. Argus has earmarked $250,000 to upgrade the facade on the rambling building, which has 15 tenants.
While such transactions have upside potential, there are risks. For starters, the local real-estate market might not turn around as strongly as hoped. In addition, if the program uses some of the investor's exchange proceeds to fund the renovation of the property, then that money could be subject to the capital-gains tax on the original property since it technically wasn't used to fund the purchase of the second property, says Louis S. Weller, a principal at Deloitte & Touche LLP's national real-estate tax-services group in San Francisco.
What is more, tenant-in-common programs are supposed to be passive, with limitations imposed on the level of services that can be provided to tenants. If not, the program may be recast as a partnership, which would eliminate the tax benefits of the transaction, says Robert D. Schachat, director, real-estate group, of Ernst & Young LLP's national tax department in Washington, D.C. The rules are vague in this area.
