Michelle Napoli is editor of TIC Monthly, from which this article is excerpted.

Editor's Note: First of a two-part series.Napa, CA—One of the topics the Tenant-in-Common Association will discuss at its annual conference in Las Vegas next month is "What Happens When a Deal Goes South?" While the notion of underperforming assets may not be a pleasant topic to dwell on, it brings up important issues such as underwriting assumptions and investor communications that have the potential to affect the success or failure of a sponsor's business and the long-term good standing of the industry.

TIC deals act like investment real estate in any ownership structure: some deals perform as expected, some overperform and some underperform. Real estate is fraught with potential problems and, in theory anyway, TIC investors should be well informed of that reality.

But as the TIC business reaches a certain critical mass, more deals that are problematic are bound to occur. As they come to light, how they are handled--along with the unavoidable attention they will draw--may help determine what, if any, fallout results.

Lately, the market has been full of chatter about the performance of many of the multifamily property investments of a particular sponsor, Napa, CA-based U.S. Advisors LLC. While interested parties sort out the facts and information, at least a few broker-dealers have pulled back from selling any new offerings from U.S. Advisors. TIC Monthly asked CEO Kevin Fitzgerald whether it is true the company is coming out of pocket to cover master lease rent payments for some of its properties because the properties' operating incomes are insufficient. "Absolutely, yes," he responds.

He stresses, however, that this is the case for only a portion of the company's multifamily properties--not a majority of its portfolio, as some have suggested--and that in at least some cases, the sponsor projected property operating deficits for the first several years, given market conditions, and the fact that, in some cases, it purchased properties with significant vacancies. "It's better to buy too early than too late," says Fitzgerald. "Our investors have substantial embedded gains."

According to prior performance information provided by U.S. Advisors to TIC Monthly: "As of Dec. 31, 2005, 24 properties have incurred operating deficits at the master tenant level not covered by any reserves or income guarantees which required funding by the members of the master tenant entity. So far, three properties that had incurred operating deficits are now generating cash flow in excess of the master lease payment requirements."

"In the aggregate, as of Dec. 31, 2005, U.S. Advisors, CBREI, the CBREI/U.S. Advisor joint venture and co-sponsors have subsidized $9.5 million of rent payments; however, operating deficits include property and asset management fees paid to affiliates of any sponsor or co-sponsor of approximately $5.5 million," the information continues, referring to the company's joint venture partner CB Richard Ellis Investors LLC. "In spite of this, there has been a positive net cash flow from master tenant operations of approximately $11.5 million due to $21 million in gains from the sale of master tenant long-term leasehold interests in properties sold as of 12/31/05."

Of the company's 75 deals, says Fitzgerald, in only one case--a retail property in Dallas--did U.S. Advisors have to cut distributions. In the case of the underperforming multifamily assets, master lease payments continue to be made to the investors. But those investors in those multifamily deals may not realize just how the properties are performing, since while they continue to receive their checks, they are not being provided with any kind of performance report. For its commercial property investors, says Fitzgerald, "extremely detailed" quarterly reports are provided. That is not the case with its multifamily properties, which due to the master lease agreement are "in effect...100% occupied," says Fitzgerald.

To be sure, U.S. Advisors is not alone in having underperforming assets. Other sponsors have had or currently have problematic deals, and there will most certainly be more to arise in the future--but they all bring up important issues. Stay tuned for the next issue of TIC Monthly, which will address the related topics of performance information transparency, underwriting standards and the communication of property-level operating information to investors. As one source noted, the topic is not about U.S. Advisor, per se, but about how all industry participants handle these thorny issues. "The important thing from an industry standpoint," the source says, "is perhaps that the nonperformance of some TICs in the market isn't a dirty little secret."

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Underperforming Deals Take Center Stage

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