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Many users of the popular tenant-in-common (TIC) investment vehicle in commercial real estate are hoping they have the stamina to withstand a double blow — more expensive debt financing and a pullback in buyer demand. Turmoil in the debt markets has slammed the brakes on what had been a booming business.

The implosion of the subprime lending market in residential real estate first began to emerge in February, throwing the debt markets into a tizzy globally. Months later that downturn spilled into the commercial mortgage-backed securities (CMBS) market as bond buyers grew ever more skittish.

The much wider spreads that began surfacing in the CMBS market in July have thrown TIC sponsors for a loop as they scramble to line up alternative financing sources and reprice deals.

Still, the first-half figures for deal volume mask the market turbulence. During the first six months of 2007, the TIC market was rolling along at a healthy clip with only a slight dip in equity pouring into the market. Securitized TIC sponsors — those that sell TICs as securities in accordance with the Securities and Exchange Commission regulations — raised $760 million in the first quarter and $875 million in the second quarter, reports Omni Consulting and Research in Salt Lake City, Utah.

Although still a sizable chunk of change, the $875 million of equity raised in this year’s second quarter was down from peak levels reached in the latter half of 2005 and early 2006 — including three consecutive quarters that surpassed the $1 billion mark.

“Until we had the subprime market go haywire on us, we were on track to have another increase in the third quarter,” says Manual Nogales, vice president at Omni Consulting.

Driving forces behind TICs
The TIC structure enables an investor to own an undivided fractional interest in a property in one of two ways: TIC interests can either be sold as securities by registered representatives, or TICs can be structured as real estate deals that are not bound by SEC rules.

Many small real estate investors prefer TICs because they provide an opportunity to purchase a stake in higher-quality properties than what they could afford on their own. Investors also like the prospects of a predictable income stream and minimal management responsibilities.

This investment vehicle is fueled predominately by investors who are pursuing TIC properties as part of a 1031 exchange in order to defer capital gains taxes from the sale of another property. The vast majority of TIC investors are selling residential properties such as rental homes, duplexes and small apartment buildings.

Ripple effects of subprime
A slowdown in the residential sector has had an immediate effect on the TIC industry. In recent months, equity pouring into TICs has fallen off as the volume of existing home sales — which dropped 8.5% in 2006 — is forecast to drop another 6.8% in 2007, according to the National Association of Realtors.

“There absolutely has been a slowdown in exchange buyers in the last 24 months,” says Bernie Haddigan, a managing director at brokerage Marcus & Millichap Real Estate Investment Services in Atlanta. Although data on the national volume of 1031 activity is scarce, Haddigan estimates that the number of 1031 transactions is down 25% to 40% compared with 2005.

That slowdown has been most noticeable in California and Florida. Soaring residential property values that fueled significant sales activity in the Golden State have flattened in the past two years, subsequently cooling the white-hot 1031 market. At the same time, rising insurance premiums and the softening condo market have contributed to slower 1031 activity in Florida, Haddigan notes.

Despite the cracks beginning to appear on the demand side, some of the biggest TIC sponsors say they have yet to experience a decline in business activity. How could that be?

Top sponsors such as Argus Realty Investors LP of San Clemente, Calif., have benefited from a significant decline in active TIC sponsors. Currently, there are about 40 to 50 active sponsors in the securitized TIC market compared with about 70 a year ago — a drop of more than 40%, according to Omni.

“On a broad scale, the TIC industry has been ticking right along,” explains Tim Snodgrass, president of Argus. “This year, we’ve closed on four properties, and business has been robust.”

For example, Argus purchased the $160 million Wachovia Center in downtown Raleigh, N.C., in March, raising $42 million in TIC equity in just 30 days. Although activity at Argus is on par with the level of activity in 2006, most securitized TIC sponsors have averaged only one to two deals year to date.

Survival of the fittest
The higher cost of borrowing is expected to narrow the field of sponsors even further in the coming months. CMBS lenders that are still quoting deals have increased spreads from 105 to 120 basis points over the 10-year Treasury yield to about 200 basis points over the past few months. For example, a loan that was priced at 6% several weeks ago is now priced at about 6.8%.

Sponsors tend to favor CMBS money because its trademark tight spreads make it one of the cheapest sources of debt. The higher-priced capital is a death knell to acquisitions that were already offering slim returns due to intense competition in the commercial real estate arena.

“The bull’s-eye of hitting cash-on-cash returns is so narrow that even the slightest shift in the cost of debt financing will make that property no longer viable for the TIC marketplace,” says Nogales of Omni Consulting.

Although there are already deals in the pipeline that have locked in debt financing, the impact of those lending hurdles will begin to emerge at the end of the third quarter. “We will see deals tabled while the lending situation is resolved and sponsors wait for the marketplace to level out,” he says.