Tuesday, October 29, 2013

How to Value a TIC

By Tim Husson, PhD and Carmen Taveras, PhD

For our second post of TIC Week, we would like to describe how to calculate purchase-date valuations of TICs. The vast majority of TIC offering documents include cash flow projections. As we described last week, we can use discounted cash flow analysis to determine the present value of the property based on those projections.  While the cash flows from TIC investments are more complicated than those of simple coupon-paying bonds, the underlying analysis is essentially the same.

Discounted cash flow analysis
A TIC investor's contributed capital buys her a fraction of the undivided property securitized and sold as a TIC investment. The investor is entitled to a proportional fraction of the TIC's annual distributions, as well as her proportional share of the property's net sales proceeds at the end of the holding period. These are analogous to the periodic interest payments and principal repayment on a bond, respectively, except that the amount of these cashflows varies based on certain assumptions, such as vacancy rate and rent growth rate (to name just a few).

To help illustrate our TIC valuation methodology we have created a free Excel spreadsheet that calculates the present value of a TIC investment per each $1 spent by investors. We use a stylized example of a real-world TIC to illustrate our methodology.

The TIC in our example obtains $20.5 million from TIC-owners and a mortgage loan for $37.7 million. The loan is interest-free for the first two years and pays an annual interest rate of 6.1%. The TIC buys a property for $51.4 million, pays $3.2 million in upfront fees, and sets aside $3.7 in upfront reserves. The projected base rent of the property is $5.4 million for the first year, with a 4% annual growth rate. Vacancy is expected to be 5% of base rent and expenses are expected to be 34% of base rent. Our TIC plans on holding the property for 10 years. At the end of the holding period, the TIC plans on selling the property for an estimated price of $60.9 million, obtained from dividing the Net Operating Income (NOI) projected for year 11 divided by the 8% cap rate at sale. The sale of the property incurs in fees that are projected to be 6% of the property purchase price. To calculate the present value of the TIC (as in our earlier post), we need to determine the discount rate that should be applied to the TIC cash flows. We obtain discount rates that vary with the risk-free rate and the TIC's leverage -- that is, the relative size of its mortgage loan and investors' contributed capital. Refer to our research paper (PDF) for more information on the literature supporting our methodology.

With these basic parameters, we project cash flow distributions to investors. In our experience valuing close to 200 TICs, TIC sponsors use reserves to keep the annual distributions as a fraction of investors' contributed capital (a ratio that TIC sponsors term "cash-on-cash" returns) close to 7%. Net proceeds from property sale is calculated after taking into account sales fees, any left-over reserve balances, as well as the mortgage balance.

We discount annual cash flows as well as the proceeds from the property sale to obtain the present discounted value of cash flows to investors. Dividing the total projected discounted cash flows by the investors' contributed capital, we arrive at the purchase date value per $1 spent. For our example TIC, investors suffer a purchase-date loss of $6.2 million, roughly 30% of their investment. In other words, the TIC is worth only 70 cents for every dollar of contributed capital by investors. As we will discuss in our post tomorrow, we find that using the unmodified projections developed by the sponsors, most TIC investors suffered purchase-date losses of 10-30% of their investment.

Sensitivity analysis
One of the major criticisms of TIC investments is that the sponsor's cash flow projections very often assume unreasonably aggressive assumptions for key parameters.  Typically, the cash flow projections included in the offering documents can be used “as-is” in calculating baseline purchase-date valuations, and then we can modify each of those assumptions in turn to see their effect on the projected value of the property.

In our spreadsheet, for example, if we determine that the actual market vacancy rate is 10% rather than 5%, we can change the value in the vacancy rate cell and see the effect on the net present value. A higher vacancy leads to lower projected revenue throughout the holding period and for the year after the holding period ends, lowering both annual projected cash flow distributions and projected proceeds from property sale. With a 10% vacancy rate, the TIC is now worth only 59 cents for every dollar of contributed capital.

Our Excel spreadsheet can be modified to value the vast majority of TICs. The cells with orange backgrounds are inputs and can be tailored to the specific TIC investment you may be interested in valuing.  We include inputs relating to the property purchase, rent and expenses, capital sources, property sale, and discount rate.

Implications
Many investors suffered crippling losses in TICs. Some may argue unconvincingly that the unforeseeable real estate crisis is to blame. But the reality is, that even at the time of issuance, the vast majority of TICs were lousy investments. The sponsor-developed projections implied large purchase-date losses, even taking the sponsor assumptions at face value, in the face of even a simple discounted cash flow analysis. In our work, we've found that many sponsors used aggressive assumptions to support unrealistically optimistic valuations.

We think that the incomplete risk-return analysis that investors received, as well as the large sales commissions charged by the independent broker dealers that pushed these products to their investors were some of the key drivers of the TIC industry's growth. Investors should be wary of TICs and any other similar investments.

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