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A few years ago tenant-in-common market was huge with the industry doubling size each year from 2002 to 2006. TICs enabled investors to pool money to purchase large commercial real estate assets. It was a way for small investors to get exposure to commercial real estate. It was also a way for 1031 investors to pool funds and buy larger assets. More than 60 TIC sponsors emerged to fill the demand for the product at the industry’s height.

But there was always something a little funny about the concept. A question plagued sponsors. Were TICs securities or were they straight real estate investments? The difference had big implications.

As this recent story from NREI describes it:

On one side are sponsors that sell TICs as securities, and subsequently follow Securities and Exchange Commission (SEC) rules for the marketing and sale of those securities. On the other side are those sponsors that follow a traditional real estate model in which they package and sell TICs as fractional ownership.

Real estate-based TICs have been able to avoid SEC oversight, thereby giving them greater flexibility in marketing real estate to potential investors. But the future of real estate-based sponsors is now in doubt.

The SEC recently issued a letter that effectively reinforced its opinion that TICs are securities. That letter is giving many real estate sponsors pause because continuing to sell TICs under the real estate model could leave them vulnerable to legal action for not following SEC rules and regulations.

The SEC was pretty definitive in its statement that it viewed TICs as securities.

In part, the debate was triggered by concerns of abuse. With TICs treated as securities, it meant you could only buy into an investment through a registered representative and the whole thing was subject to SEC oversight. For TICs that treated it as real estate, however, no oversight was necessary and the potential for fraud was greater. There were also always questions about the ability of investors to pull money out of TICs early and TICs are just as flummoxed in dealing with declining property values as every other commercial real estate owner. Selling properties for less than the sponsor paid would wipe out part of each investor’s equity. As a result, TICs drew their fair amount of suspicion even during good times.

As we reported in 2006:

TICs, like any type of real estate investment, can be loaded with risk. One concern is that 1031 investors have been jumping into TICs too quickly — focusing on the benefit of deferring capital gains taxes without fully considering the ramifications of making a bad real estate investment.

The biggest pitfall associated with a TIC investment relates to the exit strategy. The property needs to be sold or refinanced at the end of the holding period, which is typically between five and seven years. Ideally, owners are hoping for a gain, but the challenge for some may be preventing a loss.

Just to break even, a TIC property needs to be sold for the original purchase price plus the up-front fees associated with TICs. Those fees can be costly, ranging between 8 percent and 12 percent of the original sale price depending on the sponsor. “The risk, particularly if cap rates move up, is that the exit price is not achieved,” says Keith Braddish, a senior director at New York-based CBRE/Melody. The firm provides mortgage debt and bridge equity for TIC sponsors.

The other option for pulling equity out of a property is to refinance. However, that also could be difficult in the future, particularly for properties that are paying interest only and have not made a dent in the loan value. Many of the recent and current TIC deals have been able to secure record-low rates between 5 percent and 6 percent, Braddish notes, and and it’s anyone’s guess as to where interest rates will be in a few years.

In addition, TICs have been widely criticized for their lack of liquidity. There is no established secondary market for the resale of TIC ownership. TICs are usually set up with right of first refusal, which allow existing owners to buy out another investor who might choose to sell his or her stake prior to the sale of a property, Braddish notes.

So far, incidents where owners have wanted to sell early have been rare, and those that have sold have found eager buyers within their own group. Nevertheless, the fear is that if a TIC property is not performing up to expectations, an owner may have to sell for a discount or be stuck with his or her ownership in the property.

All the risks laid out in that story have come to pass. It could prove to be a very dicey time for TICs. Even the Tenant-in-Common Association changed its name in June. It’s now the Real Estate Investment Securities Association and has a broader mandate now, not limiting itself to TICs.

The most egregious case to emerge so far of alleged abuse is that of DBSI Inc.

The Idaho-based firm actually controlled two companies–Spectrus, which sold TICs as real estate, and DBSI Securities, which sold them as securities. DBSI was forced into bankruptcy last November. And stories like this have emerged.

Dykstra is one of about 500 Minnesotans and 8,000 investors nationwide whose finances have been ravaged by the collapse of DBSI Inc., an Idaho company that specialized in supposedly worry-free real estate investments. Investors like Dykstra bought a small piece of an office building or shopping center from DBSI in exchange for “guaranteed” annual returns of 6 to 10 percent, depending on the property.

With cash from these investors, DBSI assembled a portfolio of more than 240 properties nationwide, worth an estimated $2.6 billion. But last fall, the private company abruptly stopped paying investors and filed for bankruptcy. Thousands of people, many of them retirees, found themselves paying lawyers and dealing with far-flung properties they knew little about.

So is there a future for TICs? Or was the structure a product of the frothy market conditions prior to 2007? In the best of times, TICs offered smaller investors another way to buy into commercial property or for investors in smaller properties to pool funds and buy larger ones. Is there still demand for this kind of structure going forward? Or will we see TICs fade?