DBSI Failure Shows Spread of Turmoil in Real Estate

After hammering giant public real-estate companies, pain in the commercial-property market is now hitting some small, private investors. DBSI Inc., a privately held real-estate firm that catered to mom-and-pop investors, filed for bankruptcy protection last week, tossing into turmoil at least 8,500 investors and nearly 240 commercial properties valued at $2.4 billion in over 30 states. A DBSI attorney, Stephen Burr, says, "the bankruptcy filing was necessary to create an orderly process for the maximum return for all DBSI's creditors including its investors." Mr. Burr declined to comment further and company officials couldn't be reached. The collapse is the latest example of how commercial real estate is entering its worst period since the early 1990s. While public companies like mall operator General Growth Properties Inc. and warehouse owner ProLogis have seen their stocks drop on credit worries and falling rents, privately held DBSI's downfall shows the problems that can face the many small real-estate owners who fly below the radar of public markets. "Whatever a depression is, in the real-estate industry, we are in one," says Richard Lipton, a partner at law firm Baker & McKenzie LLP who specializes in real-estate investments similar to the ones used by DBSI. DBSI, based in Boise, Idaho, and founded in 1980, was a leader in so-called tenant-in-common, or TIC, real-estate transactions. The appeal of TICs is delaying payment of taxes. When landlords sell properties for a profit, they normally have to pay capital-gains taxes. The Internal Revenue Service, however, allows owners to delay paying these taxes if the proceeds are invested in another property within 180 days. In a TIC, an individual buys a slice of a property along with other investors, while a sponsor, such as DBSI, manages the transaction. Private real-estate investments, including TICs, partnerships and other property vehicles, are among the most popular forms of investment after stocks. Private investors control roughly 36% of the $4.7 trillion commercial real-estate market, including $3.4 trillion of debt, according to Raymond Torto, chief economist at CB Richard Ellis, a brokerage and research firm. For many years, investors had to put proceeds from an old property into a new, wholly owned property, to benefit from the special tax treatment. But a 2002 IRS ruling made it easy for landlords to instead invest in a TIC, an arrangement where a number of owners have fractional shares in a property, such as a strip mall or office building. TICs exploded in popularity after the rule change. In 2005, the most recent figures, 293,676 individuals took part in so-called 1031 exchanges, referring to the section of the federal tax code that TICs use to defer capital-gains taxes, according to Internal Revenue Service figures. TIC investments are down substantially in 2008, as financing markets have dried up and some investors elected to pay capital-gains taxes in advance of a possible capital-gains tax increase under a Democratic administration. Fueled by cheap lending and the commercial real-estate frenzy that followed, new TIC equity investments grew to $3.7 billion a year in 2006 from less than $356 million a year in 2002, according to Omni Real Estate Services, a Salt Lake City TIC brokerage and research firm. That equity bought $8 billion worth of property in 2006, using debt that was often sold on Wall Street as commercial mortgage-backed securities. DBSI which operated under names such as Spectrus Real Estate and For 1031 LLC, stood out from other TIC sponsors by guaranteeing returns that investors would receive from properties -- 6.5% and growing over time to 12% annually -- whether or not the property performed well. Typically, the return on a TIC investment varies according to the performance of the individual property. Under the DBSI arrangement, if one property wasn't performing well, DBSI could use profits from another to make up the difference. It also could use the fees and markups it made arranging new TIC deals to feed the older ones. But when the market seized, there wasn't enough cash to meet its obligations. Investors were attracted to the guarantee. "It's like buying a bond. You trust the people you buy it from," says Betz Frederick, who along with her husband Harold made three TIC investments in 2007 through DBSI, including two on office buildings in Omaha, Neb. The Tempe, Ariz., couple, both mathematics professors who hold Ph.D.s, were attracted by DBSI's long history, and that the couple wouldn't have to care for the properties like their previous real-estate investments. "DBSI had been around for 29 years," Ms. Frederick says. "We were tired of doing toilets and trash." The company stopped making monthly distributions in October, sending its far-flung TIC investors panicking. "It really is devastating for a lot of us that trusted them," says Ruth Cook, a 72-year-old widow from College Park, Md. She relied on a $440,000 DBSI investment to generate $2,000 a month, or about half her living expenses. It isn't clear yet how much money people will lose through DBSI, according to DBSI bankruptcy filings and people familiar with the matter. Some will be forced to inject more capital or lose their properties to foreclosure. Other investors could emerge relatively unscathed if their underlying properties are performing well. Before anything can be settled, DBSI's investors are left to deal with one of the hairiest legal unravelings in real-estate history. "This will be an order of magnitude that has not been seen in terms of the complexity," says Bradley Williams of Best & Flanagan LLP, a Minneapolis law firm that represents a lender who holds mortgages on some DBSI managed properties. Each TIC investment, which owns a single building, contains as many as 35 investors who must make all major decisions unanimously. Previously, a modest-size regional property player, DBSI jumped on the TIC bandwagon after the IRS ruling. DBSI collected more than $1 billion in investor equity through TIC offerings, amassing a sizable portfolio of office buildings, strip malls, medical buildings and apartments. DBSI also had investments in raw land and development projects and raised $275 million from thousands of small investors through private bond placements. It owns several small technology companies. DBSI's chief executive, Douglas Swenson, blamed the company's downfall on the "unprecedented events" in the real-estate and financial markets, and rising operating costs and weakness in leasing, according to its bankruptcy filing in Delaware federal bankruptcy court. Some critics say DBSI's business model was broken from the start. "The way their real-estate TIC offerings were made...was unsustainable," says Paul Mangiantini, a Boise attorney who has sued DBSI in Idaho State Court on behalf of several investors. His suit alleges, among other things, that DBSI collapsed when real-estate markets prevented the company from sourcing new deals to feed what it owed on the old ones. Wayne Duling, an Agoura Hills, Calif., resident who invested in two DBSI properties, regrets the whole episode. "I would have rather just paid the taxes, had the money safely in the bank," he says. "Everybody will tell you that."