Fractional Properties can be an effective way to invest in institutional quality real estate for those looking for little to no-management responsibility. Because the investor owns a fraction of the property the amount of equity (cash) needed is considerably less than what would be required to own the entire property outright.
One of the major strengths of this type of ownership is the ability to more fully diversify real estate holdings to reduce risk. All Fractional Properties that TM 1031 Exchange Inc. offers are 1031exchange compliant.
A Bit of History
Tenant in Common or Fractional ownership of real estate originated in Old England in the 1600's when it became possible for the commoner to own land. The quality farming acreage was too expensive for the former serfs to purchase on their own so several joined together as Tenants in Common.
Today the Fractional Property concept allows real estate investors to purchase a fractional ownership interest in institutional grade real estate. Unlike investing in a REIT or mutual fund, investors can do a 1031 exchange with their smaller and frequently management intensive real estate for Fractional interest in larger institutional grade property.
In 2002 the Internal Revenue Service released Revenue Procedure 2002-22 regarding Fractional ownership of investment real estate. This set of 15 guidelines reduces the risk of an IRS challenge if an investor wished to do a 1031 exchange from a sole ownership property to fractional ownership.
Benefits of Fractional Investments
Little to no-management responsibility.
Ability to invest in institutional quality properties at a fraction of the cost of buying the whole property.
Ease of diversification to reduce risk.
Selection of properties both with and without debt.
Prepackaged due diligence to facilitate the selection process.
Pro-rata share of all net monthly income, tax benefits, and appreciation/depreciation.
Potential deferred current and future capital gains taxes.
Investment can be scaled to fit 1031 exchange requirements
Income typically distributed monthly with periodic operating reports.
Fractional owners typically exit when the entire property is sold. Owners may also sell their individual interest at any time (one of the guide lines in Rev Proc 2002-22). On sale the owner can either pay capital gains and recapture taxes or do another 1031 exchange. As with all real estate, Fractional Properties are not liquid like a stock or bond. The degree or liquidity or lack of liquidity will vary with each property and if sold as a security (limited resale ability) or real estate (free to sell as any other real estate).
Sponsors assemble the initial Fractional offering. Good Fractional Property sponsors provide a valuable service in selecting properties, arranging financing, helping to assemble due diligence material etc. Sponsorsí post-closing roles can vary. It is important for investors to remember that they are investing in real estate, not the sponsor or the sponsor's business.
Common Sense Approach to Fractional Properties
As with all investments the investor would be wise to follow their money. For Fractional Properties what this means is that at the end of the day the safety of the investor's money is directly related to the quality and price the investor paid for the underlying real estate plus any added complexity of the form of ownership. It is not a function of the quality of the sponsor or the sales representative for the property.
Who sold the Fractional Investment to the investor, who the sponsor was or what some third party might say or promise will not correct the risks associated with subpar and/or overpriced real estate or an ownership agreement with draconian fees or other traps. The investor's money is going into a deeded interest in real estate and is not ultimately dependent on the efforts of others so understanding the intrinsic value of the real estate and the unique form of ownership is crucial before investing.
As with any other real estate investment, investors should be proactive in fully understanding each property's real estate fundamentals. These include but are not limited to quality of tenants, leases, rent rolls and expiration/option dates, price being paid for the interest vs. similar whole properties, past operating performance, operating projections with assumptions, loan terms and documents, third party reports, demographics, if in over or under supplied market, physical characteristics, and risk disclosures and assessments. The risk associated with the actual ownership document whether a security or real estate should be carefully reviewed and understood.
The Sponsor's qualifications and historical performance should also be carefully considered to help evaluate their credibility as a source of information, and as a property provider.
The biggest risk outside of bad real estate for this type of ownership is lack of control, excessive fees and inherent conflicts of interest between ownership and those managing the investment. The key to successfully investing in Fractional Properties is matching the type of property with the characteristics of Fractional Property Ownership.
Common Objection to Fractional Ownership
The most common concern is that the investor does not have 100% control of the property. This can be addressed with the DST structure where a trustee has management responsibility or investing in Fractional net lease properties (no management) real estate.
Fees charged by the sponsor and other third parties should be carefully looked at and compared to other offerings. The three areas to examine are the fees associated with the original offering, fees during the hold period, and any exit fees on sale. Careful consideration should be given to whether or not the fees are justified and if the agreement creates any future conflicts of interest.
A comparison of the price paid for a Fractional Property should be carefully compared to the price that would be paid if the investor were to purchase 100% of the property. This comparison will give the investor a good sense of the cost of investing in this form of ownership, added risk to their capital, and possible degradation to the income stream from the property that could be caused by excessive fees.
The advantages of Fractional ownership come at a price, the question being, is the price being paid worth the added benefits of this type of ownership. The fees should be reasonable for value and services delivered and compare favorably to other offerings and investment alternatives.
To avoid concentrating risk in one property or location investors should consider diversifying their risk by investing in different types of properties and tenants and by different geographic location. While single sponsors may offer multiple Fractional Properties investors would be wise to consider multiple sponsors to minimize the possibility of future sponsor performance issues.
Investors should carefully weigh the pluses and minuses of Fractional ownership before investing.
In addition to understanding the real estate they are considering investor should carefully review the ownership agreement and other related documents with their legal and accounting professionals before making a final investment decision.
Fractional Property Alternative
100% ownership of NNN Properties provides hands free income while retaining 100% control of the property and avoids the fees associated with Fractional ownership. The reason that an investor would not pursue this type of investment generally are because either the investor lacks the cash to buy a whole property or wants to avoid concentrating too much money in one property.
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