1031 exchange strategies for triple net leased and tenant in common property

The strict and short timelines for 1031 transactions can be challenging for investors. The requirement to select replacement property within 45 days of the close of escrow of the property being sold must be carefully planned for.  This is especially true if the investor is seeking replacement properties that require little or no management, such as triple net leased (NNN) or tenant in common (TIC) properties. Even during a "slower" real estate market, attractively priced NNN and TIC properties sell quickly, and simply designating a property as a potential replacement does not mean it won't be sold to another investor. A NNN property requires the tenant to pay all normal expenses of ownership, including insurance, maintenance, and taxes. Generally, lease terms are 10-30 years and include rent increases. TIC refers to the form of asset ownership used, in which two or more persons have an undivided fractional interest in the asset. The ownership interests are not required to be equal, can be inherited and each co-owner has a separate deed. Generally a TIC property is professionally managed and the co-owner's responsibilities are minimal. Both NNN and TIC investments are very compatible with the time constraints central to a 1031 exchange. Documentation (due diligence) materials are either already prepared (TICs) or should be fairly straightforward (NNN)-lending transparency and certainty of close to the transaction. When a NNN property is the choice for a replacement, a good strategy is to submit a letter of intent (LOI) to purchase early in the 1031 identification period. An LOI is an efficient way to facilitate the negotiation process between buyer and seller, is generally not binding and simply serves as a guideline for a formal sale/purchase contract. Once the terms and conditions of a sale/purchase are agreed to a contract is prepared and the buyer conducts due diligence on the asset for an agreed period of time. A standard due diligence period ranges from 30 to 60 days. The time it takes to complete a contract can be a week or more and buyers who have not started early may not complete their due diligence before the end of the identification period. This underscores the need to proactively find appropriate properties early on in the 1031 process and to have a viable back up plan for designation of replacement property. Many 1031 investors negotiate concurrently on two, three or more properties. While keeping as many options open as possible may be seen as advantageous, at some point the seller of the properties will require non refundable deposits which will then limit the available options and time. This approach can consume considerable time for both the investor and seller, and could make sellers leery of dealing with 1031 investors they feel are "playing them." In addition to the wasted time on properties that will not be purchased, additional transaction costs for title, legal and due diligence fees on multiple properties are possible. TIC investors need to be careful that they don't wait too long to make their decision. All due diligence should be completed before the 45 days expires to make sure the properties identified are viable. If they discover the property is not a good fit (too much risk, for example) it is always better to pay the taxes than make a bad investment. The way to avoid this unfortunate outcome is to select and make a reservation on likely TIC investments and take advantage of the free due diligence period that TICs offer (typically a week to ten days).  If this is done early and the investment turns out to be inappropriate the investor then has time to make another selection before the end of their identification period. One issue for investors to consider early in the process is whether to proceed under the three-property, 95% or the 200% rule. TIC investors in particular are encouraged to take advantage of one if not THE greatest strength of a TIC investment, namely the ability to diversify with relatively small dollar amounts. All investing requires managing risk and one of the best ways to minimize overall risk is to diversify. Combining diversification with a clear understanding of the real estate being invested in (demographics, lease terms, quality of tenants, etc.) provides the investor the best chance of success. It should be noted that a significant advantage of choosing a TIC as a replacement property is certainty of close. Most sponsors will have a complete due diligence package available, providing transparency and allowing investors to minimize the potential for surprises.  For investors preferring NNN property, a TIC may be a good back-up plan. TIC and NNN investments both have the appeal of no management real estate. The obvious difference between the two is control.  NNN property is solely owned by the investor allowing for the maximum amount of control. TICs are generally owned by many and control is dictated by a co-ownership agreement that requires a consensus. As with everything in life there are compromises, in the case of NNN vs. TIC the issue is often weighing the ability to easily diversify vs. having the last word on when the property will be sold or refinanced. Christina Porter is an associate, at TM 1031, Los Angeles, Calif.