San Francisco and the Bay Area Communities have enjoyed unprecedented increase in property values for the past decade and the end result has been the creation of a real estate market that may be considered the most expensive in the United States. While this has been a boon to owners of real estate, it has made entry into the real estate market by first time buyers particularly difficult. It also makes purchase of apartment houses, income property and condominiums a high cost task for anyone seeking to enter the market for the first time.
While the remainder of the Bay Area has seen slightly lower appreciation in values, it is safe to state that the entire Bay Area is one of the most expensive locales to enter the real estate market in the world. Studies bear this out, with the percentage of homeowners in San Francisco being among the lowest of any City in the world.
But the reverse side of this “problem” is that once you enter the real estate market you are likely to have an asset of increasing value, which remains an excellent investment. When combined with the significant tax benefits that one enjoys in home ownership, ownership of residential real estate in the Bay Area is one of the best investments available.
The question is how to break into that market. How does one manage the economics of buying the first home, the first condominium in such an expensive market?
Condominiums were long seen as the best and least expensive way for those with limited funds to enter the market and enjoy the appreciation and tax benefits that come with home ownership. The problem became that so many people wished to own condominiums that various governmental agencies feared that the supply of apartments would soon be eliminated as more and more apartment building owners converted apartment buildings into condominiums. The local governments such as San Francisco enacted various laws seeking to limit condominium conversions creating long waiting lists and drastically increasing the expense of such conversions. That resulted, in turn, in condos becoming increasingly expensive, though still less than single family dwellings.
A solution that arose for those still wishing to own their own homes in this expensive market was to create Tenancy In Common, a different form of common ownership of apartments, instead of condominiums. Tenancy in Common (“TIC”) allows many people to own the same building and if the correct joint ownership agreement is created, to enjoy many if not all of the benefits of a condominium without the long waiting list of condo conversion or the massive expense of filing all the requisite governmental documents that condominium conversion requires. There were drawbacks…the panoply of laws that had been enacted to protect condo owners was not available for TIC owners…but a well drafted TIC Agreement would solve most if not all of those dangers.
Thus a flurry of TIC projects and sales began and the local governments suddenly realized that their efforts to “save” apartments were floundering on a sea of TIC sales. They sought to enact various local regulations to classify TICs the same as condos and to limit the number that could be created.
But it was not so easy for local governments to do so. TICs had existed in common law for hundreds of years and were part of State law and a very widespread and useful method of ownership. The local governments found themselves fighting the various State laws and have not so far been successful in effectively restricting TIC conversions or sales. While the fight is not over, recent court decisions have seriously eroded the ability of local governments to restrict TIC sales and the market has revived in these types of ownerships. While condo conversion remains expensive and restricted, often costing hundreds of thousands of dollars in fees and requiring a decade on a waiting list, TIC conversion and sales remain much less expensive and an excellent way for prospective home owners to enter the market. There is no waiting list and the total cost of conversion can be far less than the protracted condominium conversion process.
But there are significant issues that must be confronted if one is to own or sell a TIC and the purpose of this article is to outline the basics of TIC ownership and the documentation necessary to minimize risks. A good attorney, a good realtor and a good certified public accountant are key professionals necessary to create and maintain a workable TIC structure and should be consulted before a TIC is purchased or sold and certainly before what was an apartment building is sold as numerous TICs. While the cost will still be far less than a condo conversion, one should expect to devote many hours and thousands of dollars in creating the ownership structure and management structure that will hopefully make the ownership work smoothly and avoid violating local and state law. But note that even if the cost is not minor that a single lawsuit arising based on poor creation of documents will easily cost ten times that amount. Prevention is the key and that requires professional creation of the documentation required for a workable TIC.
BASIC FACTS YOU MUST KNOW:
1. DEFINITION OF TENANCY IN COMMON (TIC).
Tenancy in Common is a form of joint ownership of real property that can be achieved in any piece of real property. All Tenants in Common are named on the Title Deed and each owns a percentage interest in the property as a whole. Thus, if you and I own property as Tenants in Common, we each are listed on the title as “Tenants in Common” owning the property and each has ownership rights to the entire piece of property. Let us emphasize that: each of us has rights to the entire property. One should compare that to a condominium. In comparison, with a condominium, the portions of the property inside the apartment walls are owned by individuals, and everything else is owned by a group. In a TIC, a group owns the entire property. So how does one have exclusive right to one’s own apartment? That is accomplished by a carefully drafted written agreement executed by all owners, which provides each owner the right to live in or rent out a particular apartment along with other rights and duties. In effect, the agreement seeks to replace the legal structure that condos have written into the law.
2. WHY CREATE A TIC RATHER THAN MERELY USE THE CONDOMINIUM STRUCTURE?
San Francisco severely restricts both new condo construction and conversion of older buildings to condos, keeping the cost-per-unit of condos much higher the cost-per-unit of apartment buildings. In addition, TICs can often be converted into condos after a period of owner-occupancy. The conversion is voluntary with the TIC owners at a later date. While other Bay Area communities do not restrict condo conversion as much, it is usually much more expensive to create the copious documentation necessary for a condo conversion than for a TIC.
3. HOW ARE TICs STRUCTURED USUALLY?
In most TICs, a "relative value percentage" is assigned to the areas (dwelling. parking, storage, deck etc.) that each owner will occupy. The value is altered at times by unique factors that apply to a particular apartment within the building. Factors that affect relative value percentage include size, level within the building, light, views, and general condition. The percentages are typically determined through an appraisal process conducted by either the prospective co-owners, a real estate agent, or a licensed appraiser. A common approach is to value each unit as if it were a condominium. Recent sale prices for comparable condominium units can be used as a basis for this valuation. Once the condominium values are established, they are added together and each is divided into the total to yield the percentages.
After purchase, as required in the TIC Agreement created and executed by each owner, each owner occupies and maintains his/her assigned areas. The costs of maintaining shared areas, and most other building expenses, are divided according to relative value percentage. Each owner can sell his/her interest at any time. If the building is later converted into condominiums, each owner receives his/her assigned areas as a condo.
This structure is not “required” by law, but is normally recommended by experienced lawyers and realtors in the field. It has worked well for thousands of TICs and avoids many of the pitfalls inherent in TIC ownership.
At times a prospective TIC owner will only be able to make a small down payment but has good income, or, conversely, has a large down payment but limited income. This problem of equalizing how to own that structure as a TIC in light of those differences can be overcome by making each owner's percentage share of the loan different from his/her percentage share of ownership. Provided that the total of a particular owner's down payment and loan share equal his/her share of the building cost, this type of arrangement still works and is equitable.
For those times when the relative value percentage approach may not work, a real estate attorney must be consulted to strategize and help the co-owners develop an appropriate structure. Such structures will be known by the usual experienced attorney and are myriad. Above all, the final Agreement should be as simple as possible while maintaining ways to resolve disputes that are inexpensive and quick. Remember: when you plan to sell your TIC, the Buyer will want to know the Agreement is a good one and has worked well: in effect, you are “selling” the Agreement as well as the apartment.
4. LEGAL ISSUES INVOLVING TICs.
In 2001, the San Francisco Board of Supervisors overrode a mayoral veto to enact legislation introduced by Supervisor McGoldrick to slow down owner-occupancy of rental housing. Since the Supervisors could not prohibit group buying or owner occupying, they attempted to discourage this behavior by making it more risky. Traditionally, TIC Agreements give each owner the exclusive right to occupy his/her assigned unit so that one owner could not "invade" another owner's home. The new law makes these exclusive occupancy arrangements illegal and unenforceable on the theory that the co-owner unit invasion risk will deter group owner-occupancy.
In 2002 the State Court overruled the ability of the Board of Supervisors to enact such Ordinances, thereby seeming to make TICs once again fully viable. The Board of Supervisors has sought to appeal that decision but most legal authorities think that their chances for success are small.
The prohibition on exclusive occupancy rights that was passed by the Board applied to all co-ownership groups (whether formed as TICs, partnerships, corporations, LLCs or anything else). It affects any owner who purchases after August 8, 2001, even if he/she purchases an interest in an existing TIC. Owners who purchased before that date retained their exclusive occupancy rights. Groups consisting entirely of family members (including domestic partners), and groups that own two-unit properties, are exempt.
The exclusive occupancy restrictions have been suspended for all groups pending the outcome of the above described legal challenge. Even if by some chance the original law is upheld, TICs in San Francisco can remain viable if the Agreement contains provisions to discourage co-owner unit invasion and compensate the affected co-owner in the unlikely event an invasion occurs. It is unclear whether the lack of exclusive occupancy rights will discourage prospective TIC buyers. Since the 2002 Court decision, there has been a marked increase in enthusiasm for this type of ownership of property in San Francisco.
It should be noted that this risk exists only for San Francisco; though it is possible other jurisdictions will seek to pass such ordinances if the Board is able to overcome the current decision of the Court. And while that risk is certainly there, all the indications are that TICs are going to be allowed to continue unrestricted by the Courts and that local regulations to avoid that will be struck down.
THE TIC AGREEMENT: WHAT IS IT AND WHAT MUST BE INCLUDED.
Each Agreement will vary based on the unique needs and desires of the Owners or of the person first converting an apartment building into the TIC building, but certain common provisions almost always exist. Among them are:
· Provisions providing for nonjudicial resolution of any disputes, often using mediation and private arbitration and avoiding the high expense of legal battles in Court:
· Appropriate separation of the property into "individual” and "group" components relating to usage rights and maintenance responsibilities;
· Description of the owners' financial obligations including initial deposits, reserve accounts, mortgages, taxes, common area maintenance and other expenses; nomination and method of selecting professionals to represent the owners (lawyers, accountants, etc.)
· Formulas for determining each owner’s monthly payment in advance and periodically adjusting the amount;
· Management of the property, including accounts receivable, accounts payable, regular reporting maintenance and janitorial;
· Rules governing usage of the property by the owners (e.g. pets, noise, floor covering) including enforcement provisions;
· Meeting and decision making procedures;
· Provisions defining when a default has occurred and describing remedies;
· Policy in the event of death or bankruptcy of an owner;
· Sale of interests, group approval of prospective purchasers, and rights of first refusal; and
· Provisions to anticipate and remedy the effect of alterations in the law.
Any good attorney will have literally dozens of additional provisions tailored to the unique requirements of the TIC. Given the critical nature of the TIC agreement in the operation and value of the property, it is vital for the Agreement to be correctly drafted and attempts to use forms or “standard” agreements often result in dispute and reduction in the value of each owner’s apartment within the TIC.
Most TIC Agreements are kept “in reserve” by the owners and only used in the event that normal relations among group members break down. While it is useful to have owners' rights and duties well defined, relying on the agreement to dictate response to actual events is often counterproductive. The give and take of typical ownership arrangements requires flexibility and good will.
Even the best agreement cannot resolve all unanticipated issues arising and the Agreement, while vital for the future of the TIC, does not take the place of common sense and mature compromise on issues. The goal should be to develop a consensus that all owners can accept even though some may believe that the agreement dictates a more personally advantageous decision. If a consensus cannot be reached, the TIC agreement can provide a final resolution.
WHO HAS THE POWER TO DECIDE IN A TIC AGREEMENT?
In most Agreements, each owner has one vote though certain Agreements provide for percentage ownership based on monetary value of the interest owned (e.g. you own 50% of the value of the TIC so you get to vote 50% of the voting shares.) Usually, routine decisions are made by a majority. Major items such as sale or refinancing of the building, and expensive non-emergency repairs or improvements generally require unanimity or a supermajority (e.g. 75% approval.)
DAY-TO-DAY COSTS. HOW ARE THEY HANDLED?
It costs money to maintain and repair a building as well as to pay taxes and the various utility costs that are associated with both the individual units and the common areas. Building expenses are divided into "individual expenses" and "group expenses". Individual expenses include maintenance and improvements to unit interiors, personal property insurance, and separately metered utilities: they are paid directly by the individual owners. Group expenses include mortgage payments, building insurance, property taxes, maintenance and improvements to common areas, and shared utilities like water and trash removal; they are paid through a TIC bank account using a monthly assessment system. Under this system, each owner makes a single monthly payment to the TIC account.
The monthly payment is based upon the total of the owner's share of each of the anticipated group expenses. To allow good budgeting and protect against default, even semi-annual and annual expenses, like property taxes and insurance, should be included in the owners' monthly payments. Further, such medium and long term costs that one can predict, such as roof replacement or painting of the exterior, can be budgeted long in advance and included in the monthly payments in small increments.
WHO MANAGES THE DAY-TO-DAY MATTERS?
TICs usually elect a authorized manager (usually a group member) who is responsible for the usual operations of the TIC matters including collecting monthly payments, paying bills, keeping the books, and arranging repair. The group meets periodically with the manager to determine the anticipated expenses for the next quarter including mortgage payments, taxes, insurance, utilities and replenishment of reserves, and then establish each owner’s monthly payment. This is a serious and often time-consuming task and it is either spread around among the members on an annual basis or some form of compensation is paid. The TIC can hire a professional manager and add that cost to the monthly assessments.
HOW DOES A TIC OWNER SELL HIS/HER OWN INTEREST?
By law, TIC interests can be sold at any time for any price the market will bear. However, a good TIC Agreement will provide that the group approves of the qualifications of the purchaser. This is important since otherwise a new buyer could come in who could entirely disrupt the smooth operation of the TIC. Reasonable criteria should be set out in the TIC Agreement.
In San Francisco, TICs are a well-known commodity and a vibrant market exists for them. Their relatively low price has caused them to be in constant demand and the ability to sell them is improved if the TIC Agreement is a good one and the TIC has a history of resolving its problems and paying its bills. One of the first things a Buyer should look at is how well the TIC has run and whether it can handle problems in the future. Remember, when you sell your TIC unit, one of the things you are selling (or buying) is the Agreement that allows it to work well.
HOW ARE TIC RE-SALES FINANCED?
Usually the TIC will not refinance the property when a single owner sells. Instead, the buyer will join the other owners as a borrower on the existing loan, and will assume the seller's percentage of the outstanding loan balance under the TIC agreement. Thus, it is vitally important that purchase money loans for TICs be assumable. It also makes sense that to minimize the fees and inconvenience associated with loan assumption, that the TIC obtain a loan that allows a "partial redemption" (This means allows substitution of a buying partial owner for a selling partial owner.) Such partial assumptions are less expensive than full assumptions, and do not involve re-qualification by the entire owner group.
If the TIC interest being sold has dramatically appreciated in value, there will be a large difference between the sale price and the seller's percentage of the outstanding loan balance. If the buyer does not have a large down payment, the seller may chose one of the following alternatives:
a. Accept some of the down payment as a note payable in the future and secured by the property, or
b. Increase the size of the existing loan (if allowed by the lender and the TIC agreement), or
c. Arrange to refinance the property.
A good TIC agreement will spell out what options are available for the owners.
HOW DOES A TIC PROVIDE THE SAME TAX BENEFITS AS OTHER RESIDENTIAL REAL ESTATE?
Most if not all of the standard tax benefits available to homeowners or property owners remain available in a TIC arrangement. Owners who reside in the property can deduct their mortgage interest and property taxes, and often may avoid capital gains tax on resale. Owner who rent out their premises can declare their income and expenses, including depreciation, and may undertake a tax-deferred exchange.
HOW DO RENT CONTROL LAWS AFFECT TICS?
Notwithstanding the efforts of tenant activists to ban TIC ownership, TICs are more popular than ever. But recent changes in San Francisco's rent control laws have further restricted the ability of TIC owners to occupy their new homes if tenants are present.
Only one "Owner MOVE-IN" eviction per building is allowed, and this type of eviction is limited to situations where the tenant is not a protected elderly, disabled or terminally ill person. The evicting owner must hold a 25% ownership interest and meet a variety of other qualifications. Where more than one eviction is necessary, the tenant is protected, or the owner does not qualify under "Owner Move-In" rules, all tenants in the building can be evicted under the "Ellis Act", but subsequent rental of the property is severely restricted. All of these laws are complex and anyone contemplating a TIC purchase of a tenant-occupied building should seek legal advice before buying.
WHAT OTHER LEGAL RESTRICTIONS APPLY TO TICS?
The California Department of Real Estate (DRE) has recently taken the position that it is illegal to form a TIC in buildings of five or more units unless the building has received a form of DRE approval called a "Public Report". This position conflicts with the opinion of many attorneys who believed that a Public Report was not required for groups of 5-10 provided two simple DRE forms were signed and filed. Until the courts decide whether a Public Report is actually required, it will be risky to form a TIC in buildings of five or more units without a Public Report, and sellers should consider obtaining one. Fortunately, the DRE has stated that a Public Report is not required for resale of an interest in an existing TIC, even if the TIC has never had a Public report. The DRE has also stated that it is now willing to issue Public Reports for new TICS for the first time. Please consult an attorney regarding the latest developments in this area.
ARE TICs SO COMPLEX OR RISKY THAT ONE SHOULD AVOID THEM?
One reason TICs cost less than owning your own single family dwelling or buying a traditional condominium is that the purchase and sale is a bit more complicated and there is a higher degree of risk in the law sometime altering or the interaction with other owners being subject to some friction. But note that all forms of co-ownership forms (TICs, condominiums, cooperatives, partnerships etc.) involve the risks of sharing use of property with others and relying on them to fulfill their obligations to you.
The level of risk depends on the portion of the property that is co-owned, and the size of the obligations that are shared. For example, condo owners co-own relatively little of the building (e.g. structural elements, systems, common areas), and share few obligations (e.g. maintenance and insurance of the co-owned areas, staff salaries), making the risk relatively low. Thus while condo owners need to worry about such issues as whether their neighbors will be capable of group decision making, be considerate in their use of the common areas, and pay their home owners' association dues, they need not worry about whether their neighbors will make mortgage payments.
The extra risk of TIC ownership arises because the local governments such as San Francisco are trying to limit them (without much success) and also because the owner group is collectively responsible for all obligations of ownership. If a TIC owner fails to make a monthly payment and mortgage default results, the lender could foreclose on the entire building causing all of the other owners to lose their homes and possibly their equity.
The following steps minimize the risk of TIC ownership:
- A complete investigation into the background a qualification of potential co-owners;
- An exhaustive evaluation of the property and financing;
- Creation of a customized TIC agreement that ever member of the group fully understands;
- Using a month assessment system for payment of group expenses;
- Establishment of a default reserve fund; and
- Strong procedures to enforce the TIC agreement, and buy out a defaulting owner or an owner who causes needless problems within the TIC.
SO, HOW DOES ONE FORM A TIC OWNERSHIP STRUCTURE? WHAT NEXT?
1. Group members who are considering to join together in this form of ownership should first evaluate each other's financial statements, and undertake the professional building inspection and loan application processes, which are common to all real estate purchases. Accepting the financial statements, approving the building condition, and obtaining a satisfactory loan should all be preconditions to a groups' obligation to buy a building. If you are a person intending to sell to a group of potential Buyers, you, yourself, create the TIC Agreement and make the requisite investigation of the people buying to make sure that you are not creating a TIC structure that will not work and will result in angry Buyers suing you later for “getting them into” a poorly working TIC.
2. The group also has a series of formation meetings. An attorney experienced in TIC formation should raise and explain the many important issues associated with group ownership, and help assess the advantages and disadvantages of various approaches. If you are the Seller of the TIC structure to new Buyers, you arrange the meetings and attend them with each new Buyer who comes into the process, “birthing” the new TIC. Through this process, the group's members thoroughly develop and test their ability to get along, solve problems, and make decisions. They also create the framework and spirit necessary for successful response to unforeseen future events. It is common for the person who first creates the TIC to continue in the structure, retaining an apartment or two but it is not necessary so long as the structure created is well conceived with an excellent agreement executed by all the new owners.
The attorney thus must prepare a comprehensive written agreement that is specifically tailored to the unique needs of the particular building and owners, including their personalities and needs. Each participant may then have the draft agreement reviewed by their own attorney and accountant, and bring the comments of these outside experts before the group for discussion and further revision of the agreement. Good CPAs and real estate professionals are often included in the discussions to assure good tax and property advice is obtained.
It is time consuming and complicated for those not used to it, but no more complex than the initial formation of a condominium and far, far less complex than the turmoil that occurs if one waits until there is a dispute and ends up fighting in court. Here, an ounce of prevention is worth a pound of cure.
WHAT IF AN OWNER BREACHES THE AGREEMENT AND FAILS TO MAKE A PAYMENT?
If the group determines that the non-paying owners' situation is temporary, they may make a loan from the group reserve account. Otherwise, depending on their agreement, the group may have a variety of harsher options including eviction, forced sale, and foreclosure. It is vital for these powers to be spelled out clearly in the Agreement both to protect the group and to make sure the defaulting owner is aware of the risk he or she runs and does not breach the Agreement.
HOW CAN I GET INVOLVED IN A TIC GROUP?
You can either join an existing group, or create a new one. Put simply, your first decision will be whether to join an existing TIC group by buying a single TIC interest that is available for sale, or to create a "new" TIC as one of the founding members or, if you are selling your own building you already entirely own, being the sole founding member and selling units to new members as they buy in.
Joining an existing TIC group involves less risk because the group will already have developed a "track record" of successful decision-making and regular monthly payments. An existing group may also be farther along in the process of qualifying the building for conversion to condominiums.
If you opt for a "new" TIC, there are four possible ways to proceed:
- Assembling your own group of family or friends, then working with a qualified Realtor to locate a building. After you find a building that the whole group likes, you will need to agree on the assignment of percentages and units
- Joining an individual or group that is in the process of buying a building but has an available unit. A Realtor can help you find such an individual or group and then evaluate the qualifications and suitability of the potential co-owner(s).
- Working with a Realtor to find a multi-unit building, and creating ownership structure, then locating co-owners for the other units
- If you own a building and wish to sell parts of it as TICs, then finding a realtor or attorney who is familiar with the methodology and who will put together a package for entry of new TIC owners and place the units on the market.
WHY TIC AND NOT ANOTHER FORM OF OWNERSHIP?
It all comes down to money. Buying a TIC is far less expensive than a single-family dwelling or a condominium and if you are planning to sell a building, is far less expensive with a much shorter time to fruition than condominium conversion. In a market known for its high cost and constant appreciation, TICs may be the best…and perhaps the only…way for many to enter the home owning market. There are disadvantages and some higher degree of risk perhaps, but the alternative to taking that risk and engaging in the complex ownership of property…may be no ownership of property at all. The very popularity of this form of ownership is evidence that thousands of people have concluded that this is an intelligent and appropriate way to purchase that “first home” in this market.