Dwindling pipeline
Debt financing constraints are already affecting the pipeline of TIC offerings. “Those sponsors that didn’t lock loans aren’t going to do those deals,” says Snodgrass of Argus. Even those sponsors that have rates locked on pending loans are concerned that financing may fall through due to lack of liquidity in the CMBS market.

Argus, for example, has four TIC deals in the pipeline valued at about $350 million. “Even if you have a locked loan, that doesn’t mean it will be easy to get it closed,” Snodgrass says.

So far it appears that those loans are going forward, but ultimately financing will be subject to activity in the broader capital markets. “Some of our deals might not make it. If there is another glitch in the market, it doesn’t matter how much you rate lock,” Snodgrass says.

Although TICs are still working hard to uncover potential deals that make economic sense, the reality is that the higher capital costs have sidelined many sponsors. In a market where returns are already extremely tight, it is difficult to find deals that are economically feasible.

Many sponsors are sitting back and waiting for the dust to settle in the shape of a stabilized CMBS market or a drop in property pricing — whichever comes first. “What I hope is going to happen is that sellers are going to realize that the 6.5% cap rate that was there a few months ago is now a 7.5% cap rate,” Snodgrass says. “The only way that will happen is if they test the waters and there are no buyers.” (The cap rate is the buyer’s return in the first year of ownership based on the property’s net operating income and the purchase price.)

Size really does matter
Challenges on both the equity and debt side will create an even greater divide between the larger, sophisticated sponsors and the smaller firms that don’t have the resources to sustain volatility in the market.

“At SCI, we are raising more equity than we ever have in the history of the company,” says Marc Paul, president and co-founder of SCI Real Estate Investments, a real estate investment firm and TIC sponsor based in Los Angeles. In 2006, SCI purchased nearly $500 million in real estate.

Although Paul concedes that hitting its original $800 million acquisition target for 2007 will be difficult due to debt constraints, demand remains strong. TIC investors continued to show a voracious appetite for SCI’s Class-A properties — despite cap rates dipping below 6%.

In fact, Paul expects SCI to benefit from the debt crunch in the short term as demand heightens for the limited inventory of available TIC properties. SCI had locked loans on the acquisition of five new properties in early July. Even though lenders went back and repriced those deals at a higher rate — about 30 basis points higher, the end rates were still much cheaper than debt that is available today, Paul notes.

For example, SCI is marketing Austin City Lights, a 352-unit Class-A luxury apartment complex in Austin, Texas, that it acquired for $40 million. SCI is raising $20.1 million in equity, with minimum investments of $250,000. The property was purchased at a 6.13% cap rate, and expects to deliver a 5.56% cash-on-cash yield in year one.

Those sponsors that have offerings on the market are going to benefit from the existing demand because they have lower-cost financing in place. “There is a good amount of equity out there that is going to look for a home — especially in the short term over the next 30 to 90 days,” says Aaron Cook, executive vice president and national sales manager at CORE Realty Holdings, a securitized sponsor based in Newport Beach, Calif.

CORE currently has two TIC deals on the market, one of which is an offering for a $26 million retail property on the West Coast. Cook expects the property to fully commit the equity portion relatively quickly, in large part because the deal features an interest-only loan for seven years — financing that is impossible to find in the current market.

The sponsor has four additional deals in its pipeline that are still feasible today, even with higher financing rates. CORE tends to include ample capital for property expenditures in its underwriting, so there was a cushion already in place to absorb this financing hit, Cook notes. CORE also is exploring financing options other than the currently pricey CMBS lenders, including life insurance companies, banks and other balance-sheet lenders.

Lowered expectations
There is no doubt that the TIC industry faces a number of daunting hurdles in the coming months. Although Omni was originally predicting that securitized sponsors would raise $4.5 billion in equity in 2007, Nogales estimates that volume will likely be lower — between $3.2 billion and $3.8 billion due to current market constraints.

It is difficult to predict how much equity the industry will raise in 2008. “The longer it takes the capital markets to settle down, the bigger the hit we will see on the equity side in the coming year,” Cook says. “And I don’t think it will be a short-term fix in the capital markets. It will likely be the first quarter of 2008 before the capital markets calm down and become less volatile with greater liquidity.”

Those sponsors that can weather the storm will be in a strong position once the market stabilizes. Some industry observers point out that a growing investor pool will help to offset the hit the TIC industry is taking from the slowing residential market. Another factor that will help fuel investment dollars to the TIC industry is a growing distribution network.

“The TIC marketplace is becoming more established and recognized by traditional advisors,” says Omni’s Nogales. “So even though the interest from 1031s has slowed down, the number of investors and advisors who are aware of this product is growing proportionately.”