As I drove to an appointment this morning, I passed a banner (pictured below) that asks ‘Why Rent?’ with the implied solution being the purchase of a San Francisco TIC (tenancy-in-common) unit. As a Realtor in San Francisco, you might think I’d be all over TICs as a great opportunity. You’d be wrong, and I’d like to explain why. But before I do so, a few caveats and disclaimers.
First of all, I’m not trying to single out the property that this sign is attached to. My comments apply generally to TICs in 3 – 6 unit San Francisco buildings, and particularly to any TIC interest that has fractional financing. The current rules that apply to TIC interests in 2 unit buildings (100% owner occupied, clean eviction history) can make them a more sensible purchase. I have personally purchased a TIC interest in a two unit building and converted it to a condominium, so I’ve been down that road and can talk about it at length. TICs also exist in buildings with more than 6 units, but the city at this time has an absolute prohibition on their conversion to a condominium, which makes them (IMHO) an even less sensible purchase than in a 3 – 6 unit building.
The Basic Concept of a Tenancy in Common (TIC)
The idea behind a tenancy in common is to take a multi unit building in San Francisco that has historically been rented and carve it up into units that can be individually owned. A condominium is the “traditional” way that homes in multi-unit buildings are legally separated so that ownership can be independently transferred, and mortgages can be secured against a particular residence. The city of San Francisco has strict rules (subject to change at the whim of the San Francisco board of supervisors) about converting a building into a condominium, so if you own a multi-unit building you just can’t go down to the planning department and say you want to become a condominium, which would be the straightforward way to subdivide a multi-unit building and sell of each of the residences.
Instead, the tenancy-in-common share was created, which gives a particular owner a percentage interest of ownership in a building, along with the exclusive right to occupy a specified unit. But because the building is still legally a multi-unit building, financing can’t be obtained in the same way as it can a condominium. The first solution was the ‘Group Loan’.
The Group Loan
In the group loan, all of the TIC owners in a building are on one combined/shared/joint/we’re-all-in-this-together mortgage. Which means that each individual on the mortgage is liable for 100% of the mortgage payment (not just their share) should someone else fail to make their payment. This is why prospective TIC owners would sniff through the finances of prospective members, since they wanted to feel good about their fellow TIC members ability to pay their share of the mortgage and property taxes. This shared risk was the primary deterrent for many people considering a TIC.
However, in addition to shared risk, a group loan has some other major flaws, particularly when it comes to transferring an interest in a TIC. In the sale of a TIC interest secured by a group loan, the transaction is considered a refinance by a bank because some – but not all – members of the loan are leaving and being replaced by others. The equity requirements in a refinance (particularly a cash-out refinance, which is what would be required to walk away with any equity) are dramatically stricter. And that’s before we even take into account an increase in interest rates caused by the refinance which is triggered by the transfer of a TIC share. Both of these issues were only theoretical when loans were easily obtained and interest rates were decreasing. But one day underwriting standards got realistic and interest rates started increasing, and these two issues quickly become major hurdles that caused massive heartaches and heartbreak, not to mention plenty of lawsuits and cancelled escrows. And at about this time, the fractional loan came along to solve all these problems, but…
To solve the problems of the group loan in a tenancy in common, some local attorneys and banks got together and started offer what is referred to as fractional financing. In fractional financing, the bank offers individual loans to each of the TIC owners, in theory making it easier to transfer a TIC share and avoiding the refinance, equity, and shared default risk of a traditional TIC group loan. I say ‘in theory’ because while that was the goal, fractional financing introduces its own set of challenges. What are those challenges?
In a nutshell, I think it is fair to call fractional financing “experimental financing” – when it first rolled out – roughly 2006, we did one of the first deals in the city that was a conversion of a group loan to fractional loans in a 6 unit TIC – there were about a dozen banks that were willing to offer fractional loans. At the end of 2011, depending on who you ask, there are between one and three banks that are still willing to offer fractional financing. While banks never suffered major losses on their TIC loan portfolio, they were all portfolio loans that weren’t resold on the secondary market. As banks have sought to diversify their portfolio holdings and preserve capital they’ve become less interested in offering TIC fractional loans.
So far, we’ve continued to see banks offer financing on TIC projects where they originally offered a fractional loan. But what if the one to three banks left in the fractional financing market change their mind and decide they want out of the business? If no buyer could get a loan from a lender, you could only sell to an all cash buyer or with seller financing, which obviously places severe limits on the number of eligible buyers, and the smaller the buyer pool, the lower the price will have to go.
Even if banks continue offering the financing, the rates and down payment requirements have also been harsh in comparison to condominium financing. In my experience, rates on fractional loans are usually a minimum of 1.5 to 2% higher than condo rates, and usually come with several pre-paid points, strict pre-payment penalties, and with rates that are never fixed for more than 15 years (but usually 5 – 7 years). In addition to the higher rates, banks are usually not willing to finance more than 75% of the purchase price, which means you need a 25% down payment.
TICs are generally of most interest to first time home buyers, and very few first time home buyers have 25% for a down payment. And yes, a seller can buy down both the rate and carry a portion of the financing which reduces the monthly rate and down payment required by the buyer. And that might be great if you are a buyer coming into a TIC and get the seller to buy down the monthly interest rate and carry a portion of the financing, but…
But someday you will likely be the seller, and will you want to buy down the rate for the next buyer? Will you want to lock up some of your equity in the form of a loan to the incoming buyer that doesn’t have the required down payment?
And, oh yeah, even with fractional loans the property taxes are still a shared risk (the property, regardless of the number of TIC shares, has one lot and block number against which the city will assess taxes). So while your potential exposure is much less, you still are jointly liable for the entire property tax bill.
So Why Rent?
That’s a lot of background to what seems like a simple question. But in the end, unless your circumstances are such that the disadvantages of a TIC in a 3 to 6 unit building outweigh the advantages, here’s my answer to why you should rent: Because TIC shares are less liquid and appeal to a smaller segment of buyers, the costs of entry and exit as well as the shared risks during ownership and around future financing possibilities usually means it makes better financial sense to continue renting and save your money towards a condo or single family home purchase instead of investing in a TIC share.
Or, as a mortgage broker I once worked with said, “If you’re going to buy a TIC [in a 3+ unit building], why don’t you just set your money on fire?”