The TIC Corner
by D. Andrew Sirkin
Editor’s Note: This “TIC Corner” is the final part of a three-part case study of the sale of an apartment building to a group including the building’s existing tenants. The first part appeared in the January 2007 issue of SF Apartment Magazine and the second part appeared in the April 2007 issue.
In the first part of the series, the owner of a San Francisco six-unit building, Harry Chin, had decided not to evict tenants under the Ellis Act or pursue a tenant-in-common sale on his own. Following an inquiry from Sarah Warsaw, one of his tenants, Harry agreed to hold the building off the open market to allow a group of tenants to put together a viable purchase offer. In the second article in the series, prospective buyers—including the existing tenants and some friends—decided who will participate, coped with an elderly tenant who could not purchase her unit and a family of tenants who would have preferred not to, and determined the pricing of the ownership shares. After soul searching and compromise, it was decided that the group would be composed of five purchasers, including three existing tenants and two nontenant couples. The one senior tenant will not purchase, but will remain as a tenant.
It is now time for a written purchase and sale agreement between the buyer group and the seller. Chin does not want to continue to wait without further assurance that the buyer group will perform. The buyers do not want to invest further effort and money in the purchase process unless they can be sure that Chin will not sell the building to someone else. Since there are no realtors involved in the process, and none of the buyers have purchased before, the group decides to enlist the help of their TIC attorney to prepare a purchase offer. Using the local standard form contract, the attorney lists the names of each of the buyers on the first page, taking care not to specify that particular buyers are purchasing particular apartments. The attorney explains that it is essential for any purchase agreement involving an apartment building that has not been legally subdivided to avoid any implication that individual units are being sold.
After the seller accepts the offer (with the price agreed upon during the preliminary discussions between Chin and Warsaw), the buyers open escrow, order inspections and begin to fill out the loan applications provided by their mortgage broker. A few days later, Warsaw receives a call from Miriam Levi, one of the other tenant buyers. Levi was discussing the purchase at a social event, and was strongly advised by an attorney she met to obtain one of the new fractional TIC mortgages, rather than buy with a group loan. The attorney explained that, with an individual loan, she would not have to worry about losing her home or damaging her credit as a result of nonpayment by another owner. Perhaps more importantly, she would be able to resell much more easily, since each buyer could apply for his/her own individual loan in whatever amount was needed, rather than have to assume or refinance a large group loan. Upon receiving this advice, Levi contacted a lender that offers these fractional loans, and determined that the interest rates and terms were similar to those proposed by the group lender. In light of this information, Levi suggests to Warsaw that the choice of financing be reconsidered.
Warsaw contacts the group’s mortgage broker, who agrees to evaluate the buyers’ loan applications using the underwriting guidelines applicable to fractional financing. But several days later, he informs Warsaw that two members of the group, the Han family (another tenant buyer) and Warsaw herself, cannot qualify for an individual loan. In the case of the Hans, the problem is the 10% down payment, which is less than the minimum required by the fractional lender. In Warsaw’s case, the income ratio and credit score do not meet the lender’s guidelines. Moreover, the broker explains, it is impossible for some buyers to have fractional financing while others share a group loan because the two types of financing are not compatible. Any group loan must be in the senior-most secured position on 100% of the building, which would mean that any fractional loans would be junior in foreclosure priority. This arrangement would not be acceptable to the fractional lenders, who will insist that each fractional loan be in the senior-most secured position as to the fraction of the property owned by its borrower.
The mortgage broker’s information troubles Levi and some of the other buyers, who had already changed their mindsets and assumed that they would be able to have the benefits of fractional financing. They ask if it’s fair that the financial weakness of certain group members force others to accept riskier and less advantageous financing. Not knowing how to respond, Warsaw contacts the TIC attorney, who suggests a telephone meeting involving the entire buyer group.
The attorney agrees that forcing all the buyers to accept inferior financing because of the problems of just two is unfair, but advises the group to weigh this unfairness against the benefits of having the financially weaker members participate. He notes that, because the financially weaker group members are both existing tenants, insistence on individual financing would force the group to either maintain more of the building as rental property or displace long-term tenants, including the one who had been most instrumental in pulling the group together and arranging the sale. The TIC attorney suggests several measures to address concerns about group financing. First, he recommends that each buyer review the loan applications and credit reports of all of the other buyers, to satisfy themselves that the risk of buyer default is minimized. He explains that the lender originating the loan will only evaluate the group’s collective financial strength, and that this evaluation is not sufficient to determine the likelihood of default by any particular co-owner. He also mentions that although there have been many thousands of TIC groups formed with group loans over the past 25 years, none have ever defaulted on their mortgage.
Next, he recommends that the group set a timetable of five to seven years for replacing the group loan with fractional loans. This time period is likely to allow the building to appreciate sufficiently so that the Hans’ financing will constitute less than 90% of the value of their share, and will provide an opportunity for Sarah’s income and credit score to improve. The attorney suggests that the group consider a provision that would force a sale by any co-owner who could not obtain fractional financing at the specified time. Prior to that time, any co-owner who wanted to re-sell would have the right to force the group to refinance the group loan if the seller’s share of the loan was insufficient to meet his/her buyer’s needs, but only provided the buyer did not absorb more than his/her proportionate share of the available equity, the buyer or seller paid all refinancing costs, and the other owner’s monthly payments did not increase.
The group decides to accept the TIC attorney’s recommended compromise, and proceed with the group loan. With the group’s approval, the attorney then gathers the information required to prepare the TIC agreement. He works through a number of issues with the group over the course of an hour, including prices and down payment, reserve amounts and timetables for both a maintenance/replacement reserve and a default reserve (used to pay the bills if a co-owner defaults), allocation percentages for each type of ongoing expense, space assignments relating to parking, storage and outdoor area, management and bill payment structure, meetings and decision making, and house rules.
Using this information, the attorney subtracts each buyer’s down payment from his/her share of the price to determine his/her loan amount, then divides each buyer’s loan amount into the total loan to determine each buyer’s debt percentage. This percentage will determine each buyer’s share of the monthly payment as well as each buyer’s share of the obligation to repay any loan balance that exists at the time of refinancing. Each buyer’s mortgage payment, along with his/her share of the property tax, insurance, shared utilities (such as water and garbage), management fees, and maintenance (including maintenance/replacement reserves) will be paid into the group account monthly as “dues.” The dues are based on an annual budget so that they are the same amount each month.
The attorney takes special care to address issues relating to the co-ownership share associated with the unit occupied by the elderly tenant. This share will be co-purchased in an even split by two of the buyers. The attorney creates debt and expense allocation percentages for this share, and establishes monthly dues for the share, just as if it were being bought by one person, noting that in the future it may be resold to just one person. He then prepares a separate co-ownership agreement for the two co-owners who are splitting the share. The separate agreement states that these two co-owners will be sharing the income and expenses associated with the share equally, and also addresses management and maintenance of the tenant-occupied unit, future resale and refinancing, and the agreement by the co-owners to allow the elderly tenant to remain in occupancy.
As the closing date approaches, two new obstacles appear. One of the buyers receives notice of a job transfer and announces that he and his wife need to withdraw, and the lender requests evidence from the California Department of Real Estate that the sale is permitted without DRE approval. The TIC attorney advises the group that, because it does not have DRE approval for a TIC project, it is probably not permitted to offer the withdrawing buyer’s share for sale to the general public. The evidence requested by the lender is available in the form of a letter from the DRE, but only provided that the group has come together “naturally” as opposed to through the marketing of TIC interests. Fortunately, Levi’s parents decide that they will buy the final share to use when they visit their daughter and for a permanent home following retirement, and after some last minute scrambling to get the parents approved by the lender, the loan is approved. The DRE letter arrives a few days later and, finally, escrow closes.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or SF Apartment Magazine. The information contained in this article is general in nature. Consult the advice of an attorney for any specific problem. More detailed information on this topic is available online at www.andysirkin.com. D. Andrew Sirkin’s law practice is devoted exclusively to tenancy-in-common, equity sharing, investment partnerships and other co-ownership matters. Copyright © 2007 by SF Apartment Magazine. All rights reserved.