Converting to TIC and Selling to Existing Rental Tenants
This Case Study involves the sale of an apartment building to a group involving the building’s existing tenants
Harry Chin has owned a six-unit building located at 2550 Hyde Street on San Francisco’s Russian Hill for 18 years. Each of the circa 1908 building’s three stories contain two units, all similar two-bedroom apartments approximately 1200 square feet in size. Each of the two top-floor units has Golden-Gate Bridge views. The lowest level of the building has three-car parking and an open storage area. There is a small rear yard and a small roof deck.
Five of the apartments are tenant-occupied month-to-month, with the following tenant and unit profiles:
- Unit #1 (1st-floor left): Renovated 2005, occupied by Jane Smith and Joan Day, 20-something roommates who pay $2200 and have lived in the building for 13 months.
- Unit #2 (1st floor right): Renovated 1992, occupied by the Han family (oldest member William Han, age 53) who pay $1147 and have occupied since 1992.
- Unit #3 (2nd floor left): Just renovated and vacant.
- Unit #4 (2nd floor right): Renovated 1996, occupied by Steven and Sarah Warsaw who pay $1335 and have occupied since 1997.
- Unit #5 (3rd floor left): Last renovation date unknown, occupied by Silvia Wong who pays $772 and has occupied for an unknown duration. She is 78.
- Unit #6 (3rd floor right): Renovated 1996, Occupied by Miriam Levi who pays $1,882 and has occupied since 2004.
Harry has decided to sell the building because he is tired of maintaining it and now lives in Belmont. He has had several Realtor listing presentations, and the consensus view is that the property would sell for about $2M as is with the existing tenants in place, and $3-3.6M as vacant and renovated TIC interests.
To evaluate whether selling the building as TIC interests is worthwhile, Harry has consulted with a landlord-tenant attorney, a TIC attorney, and a contractor. From the landlord-tenant attorney, Harry has learned that he could evict all of the tenants under the “Ellis Act”, but that the process will be time-consuming and expensive. All tenants will be entitled to at least four-months notice and substantial relocation fees. Harry has at least one “protected” tenant (Ms. Wong due to her age) who will be entitled to stay in the building for one year after an eviction notice is served and receive additional relocation fees. He also learns that many if not most tenants served Ellis-Act eviction notices in the past 18 months have claimed disabilities of some type entitling them to extended notice and additional relocation fees. These claims are difficult and expensive to disprove. In addition, eviction of a “protected” tenant will permanently disqualify the building for condominium conversion under current San Francisco law. Harry is advised to be prepared to spend $100,000 on legal fees, relocation fees, and tenant settlements, and to wait 18 months for the building to be completely vacant.
From the TIC attorney, Harry has learned that he will need approval from the California Department of Real Estate (the “DRE”) prior to offering TIC interests for sale. Obtaining DRE approval will take about six months and cost Harry a total of $15-20K for (in decreasing order of amount) surveying, homeowners association budget preparation (including a replacement-reserve study), legal costs, and application fees. Harry will also need to post a cash deposit or bond for six-months of HOA dues, with all funds (other than the cost of the bond) to be released back to Harry when the fifth sale closes. The TIC lawyer also advises Harry to consider forming a limited liability entity of some kind to act as seller in order to protect Harry from liability, at an extra cost of about $3,000 in professional fees and franchise taxes over two tax years Harry will still own the property.
The DRE approval will be valid for five years. Harry will need to inform the DRE how the sales will be financed, and is advised by the TIC attorney to specify individual TIC financing because it is most easily approved by the DRE and most popular with buyers. Since Harry’s current loan balance of $352,000 is less than the expected sales price of each of the shares, Harry will not need to worry about selling a certain number of shares simultaneously to generate enough money to pay off his existing financing, or securing partial releasing from his current lender to allow the loan to be paid off gradually.
Harry decides not to sell the building as TIC shares. He figures he would need to invest a total of $353K to prepare the building for TIC sales (consisting of $100K in tenant-related costs, $180K in renovation costs, $50K lost investment return over the course of the project and $23K in regulatory compliance). Assuming a sale price of $3M and a sales commission of 6%, he would make almost $600K more by selling TIC shares, but the process would require a considerable amount of work over 1-2 years. Harry also finds the idea of evicting tenants distasteful in general, is concerned about where Ms. Wong would go, and is quite friendly with Ms. Levi and the Warsaws.
A few days after deciding to list the building for sale as is for $2M, Harry receives a telephone call from Sarah Warsaw. The appearance of Realtors at the property, coupled with Harry’s comments over the years that he was fed up with building management, have suggested to Ms. Warsaw that Harry might be preparing to sell. Was it true? Would the Warsaws and their neighbors and friends be evicted? Ms. Warsaw explains that she and Steve have been thinking about buying a home and spending weekends touring open houses. From this she had learned two things: First, that she and Steve could not afford to buy anything comparable to where they now lived, and second, that most six-unit buildings were being vacated by their owners to prepare them for TIC sales. Based on this information, she had started to dream about buying 2550 Hyde and had explored the idea with Ms. Levi who was also interested. Ms. Warsaw asks: Would Harry consider giving them time to put together an offer? What price would he want?
Harry has learned from experience to be careful what he says to his tenants, even those who he feels he knows and trusts. He wisely decides to have another brief conversation with both his landlord-tenant attorney and his TIC attorney before answering Ms. Warsaw’s questions, and simply tells her he will investigate and get back to her. The landlord-tenant attorney confirms that Harry should be cautious, but explains that discussion of a possible sale is okay provided Harry confirms, both orally and in writing, that he has not approached the tenants about a possible sale to them, and is not requesting that the tenants vacate. The TIC attorney explains that Harry cannot offer TIC shares to anyone, including his tenants, without DRE approval, but that so long as Harry only offers to sell the entire building to a particular buyer or pre-formed buyer group, no approval is required. The attorney advises Harry not to discuss a sale of a fractional interest with any of the tenants, and to only accept an offer on the entire property in a single contract. The TIC attorney also notes that it generally takes a tenant or tenant group a considerable amount of time to congeal, put together an offer, obtain financing, and close the transaction, and that Harry should be prepared to wait at least 3-4 months to close such a sale.
Harry ultimately decides that while it might require more effort and time to sell to his tenants, it would be something he would feel good about and was worth the effort of an attempt. To partially compensate him for the delay and risk of failure, he decides not to offer the property to the tenants at price which would reflect the absence of a sales commission, meaning that a sale to his tenants would yield him $120K more than a market sale using a Realtor. Then, he calls Ms. Warsaw back, and explains that he will hold the property off the market for 45 days to give her time to put together a firm offer of $2M, taking the time to explain the caveats recommended by his attorneys. He then confirms the same information (including the caveats) in a letter which he arranges to hand deliver the following day, obtaining Ms. Warsaw’s acknowledgement of receipt on a copy for his files.
Excited about the prospect of buying the building, Sarah immediately convenes a meeting of the tenants., Recognizing that there is a vacant unit in the building, Sarah also invites two close friends who are home shopping, and suggests that other tenants do the same. To her delight, all of the tenants attend along with three other couples who are home shopping. But as the meeting wears on, little is accomplished. No one in the group is willing to commit without more information on the pricing of the shares, space assignments, and an explanation of tenancy in common basics, and no one seems to know how to obtain this information. Ms. Wong cannot see how she could go through a purchase at 78 (even if she could scrape together the money), and Mr. Han cannot understand why it makes sense to buy when he can occupy as a tenant for $1147 a month.
Undaunted, Sarah contacts a TIC attorney recommended by a Realtor friend. The attorney explains that without accurate pricing, down payment, and monthly payment information, it will be impossible for anyone to meaningfully evaluate purchasing, and that work on the management and ownership structure would not be worthwhile without a viable (meaning full or almost full) group. The attorney also mentions that reluctant tenants are sometimes induced to reconsider purchasing once they understand that a new owner has the legal power, and a strong financial incentive, to evict the tenant under the Ellis Act.
The attorney recommends that Sarah start by contacting several local lenders to determine the typical down payment requirements, and terms and conditions, associated with loans to TIC groups buying six-unit buildings. He explains that both individual and group financing is available, and suggests Sarah check into both.
Next, Sarah should convene another group meeting to see if the group can reach a consensus on the relative value of each apartment (along with any parking, storage, decks etc. that will go with each apartment) as a fraction of the proposed $2M price. Initially, he explains, the valuations should be based only on the qualities of the physical spaces such as their size, location within the building, views, and condition. Once the basic values are established, adjustments can be made for non-physical factors such as rents being paid by the current tenants, the fact that an apartment is vacant, or financial hardship. The attorney says that most groups are able to agree on this valuation on their own, but that valuation assistance from Realtors, appraisers and other professionals is available for those that cannot.
Sarah is skeptical, but decides to follow this advice. In preparation for the second meeting, she tells each tenant to come up with his/her opinion of the value of each of the six apartments, making sure that the total equals $2M. At the meeting, before allowing anyone to reveal their value opinions to the others, Sarah explains the valuation procedure recommended by the attorney. For each apartment, there will be five valuations (one from each tenant). The highest and lowest valuation for each apartment will be discarded, and the middle three valuations will be averaged. The resulting values for each apartment will be totaled, and then each apartment’s value will be divided into the total to yield a relative value percentage. The percentages will be multiplied by the $2M price, to determine the initial valuations. To Sarah’s great surprise, everyone in the group feels that this process is neutral and fair, and agrees to be bound by the result whatever it turns out to be.
Following the value determination, the group applies the down payment and monthly payment information that Sarah has gathered from the TIC lenders. It becomes immediately clear that several of the tenants do not have the down payment and/or monthly income required for purchase without further adjustment. At the same time, it is clear that all the non-tenants attending the meeting are very motivated and qualified, which has the effect of making the financially weaker tenants nervous. The group decides to adjourn and seek further outside advice. As the meeting ends, Ms. Wong explains that she cannot purchase, and makes an impassioned plea to be allowed to stay on as a tenant. She explains that she has lived in the building for 30 years, and has nowhere else to go. Ms. Smith and Ms. Day, two young students sharing a unit at market rent, also state that they will not purchase, but agree to move voluntarily if asked.
The TIC attorney suggests a meeting to be attended by as many prospective purchasers as wish to attend. In the event, only the Warsaws, tenant Miriam Levi, and the three interested non-tenant purchasers, come. None of the attendees are willing to evict Ms. Wong even if there is a legal right to do so. The attorney recommends that the group consider two alternative approaches to keeping Ms. Wong in the building as a tenant: (i) have the buyer group as a whole jointly purchase and hold the share associated with Ms. Wong’s apartment, or (ii) have one or more (but not all) of the purchasers take the Wong share. In either case, the valuation of the Wong share should be reduced to reflect the fact that it cannot be owner-occupied and will generate little income for the foreseeable future.
The meeting then moves on to a discussion of the share associated with the Han family apartment. It is clear that the Han’s cannot purchase unless the price of their share is reduced, and they are permitted to make a lower percentage down payment. The attorney notes that the Han situation will be influenced by the group decision to keep Ms. Wong in the building as a tenant. Specifically, the Hans may be angry that they are not being offered the same deal as Ms. Wong, and evicting the Hans under the Ellis act (if they choose not to purchase) while leaving Ms. Wong as a tenant makes the eviction more complex and expensive (although probably not impossible). The attorney suggests that the Han share be reduced in price to reflect it lower rent, and also that the Hans be permitted to make a 10% down payment. Noting that several prospective group members wish to make larger down payments than the minimum required by the lender, the attorney suggests group rather than individual TIC financing, so that the extra down payment funds and loan qualification strength of some buyers can offset the Hans’ lower down payment and weaker financials.
The last part of the attorney meeting goes particularly well. The two non-tenant purchasers who are friends of the Warsaws agree that they will jointly purchase the Wong share if the price is reduced 25% below its valuation, and also agree on which apartment each of them would occupy. After adjusting the values of the other five shares upward to compensate for the discount, the Warsaws and Ms. Levi agree to this proposal, and the third prospective non-tenant purchaser is disappointed but understanding. A detailed pricing and down payment proposal for the Hans is then prepared, and it is agreed that Sarah will meet privately with them to present it.
Sarah’s meeting with the Hans is tense and inconclusive, but after several days of consideration, Mr. Han unenthusiastically agrees to the proposed terms. The group will be composed of five purchasers including three existing tenants and two non-tenant couples. One non-purchasing tenant will remain as a tenant, and the other will vacate. The purchase will be financed with a 75% LTV TIC group loan with partial assumption features to allow resales without refinancing. All of this, along with the space assignments, pricing, and down payments, is captured in a short-form memorandum of understanding signed by each prospective group member. With these pieces in place, the group, assisted by their TIC attorney and mortgage broker, is ready to write an offer on the building.
It is now time for a written purchase and sale agreement between the buyer group and the seller. Harry 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 Harry 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 these 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 Harry and Sarah), the buyers open escrow, order inspections, and begin to fill out the loan applications provided by their mortgage broker. A few days later, Sarah receives a call from Ms. Levi, one of the other tenant buyers. Ms. 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 non-payment by another owner. Perhaps more importantly, she would be able to resell much more easily, since her 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, Ms. 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, Ms. Levi suggests to Sarah that the choice of financing be reconsidered.
Sarah contacts the group’ mortgage broker, who agrees to evaluate the buyers’ loan applications using the underwriting guidelines applicable to fractional financing. But several days later, he informs Sarah that two members of the group, the Hans and Sarah 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 Sarah’s case, the income ratio and credit score is 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 Ms. Levi and some of the other buyers, who had already changed their mindset and assumed that they would be able to have the benefits of fractional. They ask if its fair that the financial weakness of certain group members force others to accept a riskier and less advantageous financing. Not knowing how to respond, Sarah 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 weight 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 5-7 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 which would force a sale by any co-owner who could not obtain fractional financing at the specified time. Prior to the 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 (i) the buyer did not absorb more than his/her proportionate share of the available equity, (ii) the buyer or seller paid all refinancing costs, and (iii) 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 which 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 the dues 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 by two of the buyers 50/50. 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 (“DRE”) 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, Ms. 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 escrow closes.
About the Author
D. Andrew Sirkin is a recognized expert in fractional ownership and other co-ownership SirkinLaw APC was a pioneer in the area of tenants in common (TIC) arrangements involving occupancy rights assignments, which are often used as a substitute for subdividing a property when true subdivision is impossible or unduly expensive. In 1985, Andy Sirkin created the legal and transactional structure which has become the industry standard for this type of TIC. Over the succeeding years, Andy’s innovations have included being the first state-approved real estate instructor for occupancy-based TICs, being the first to obtain state approval for a large-building TIC sale, being the first to convince institutional lenders to offer individual TIC financing, and being the first to develop the loan documents and lender underwriting guidelines for fractional TIC financing. In recent years, the type of co-ownership arrangement Andy conceived nearly 25 years ago has grown to comprise approximately 1/3 of all attached-home sales in San Francisco.
SirkinLaw APC has prepared close to 3,000 occupancy-based TIC agreements for properties of every size and type, and continues to assist in the vast majority of these transactions in California. This unmatched level of experience allows us to offer time-tested approaches for the vast majority of co-ownership situations, to quickly and effectively solve problems, and to produce documents that are clear, easy to navigate and read, and efficient and cost-effective to enforce. We continue to improve our documents each month as we encounter new situations and learn more about what TIC arrangements perform best in the real world. We also share our accumulated knowledge, and support real estate professionals and the TIC community, by continuously publishing new articles on our website and offering free educational workshops.
Our tenancy in common practice involves general advice and counseling, TIC agreement preparation, loan documents, and ongoing consultation to developers, seller, Realtors and TIC owners, on either a flat fee or hourly basis. We have a well-deserved reputation for returning calls promptly and providing fast turnaround times. But more important, we are known for finding creative solutions, calming fears, and finding common ground, so that transactions and relationships work. Although our role usually begins at the time the tenancy in common is first formed or sold, we are committed to remaining available to solve problems throughout the life of each TIC. Contact us via our contact form.