November 11, 2008 - DBSI, Boise ID

Real estate investment firm DBSI files for bankruptcy as investors pursue litigation

DBSI Failure Shows Spread of Turmoil in Real Estate

A strategy for unlimited growth is the holy grail of business. DBSI, a Boise real estate investment firm, appeared to have found it.

President Douglas L. Swenson, an accountant, founded the company 29 years ago. It grew modestly until 2002, when Swenson and his team began marketing shares of ownership in commercial buildings around the nation to investors. The shares took advantage of a provision in federal tax law that lets investors avoid certain capital gains taxes.

Helped by the real estate boom, profits for DBSI and its investors grew effortlessly - and fast. The value of its assets grew from several million dollars in 2002 to $2.6 billion in 2008, said Paul Mangiantini, a Boise lawyer who represents investors.

But the mirage evaporated this year as the economy soured. This fall, the company began delaying payments to 12,000 investors around the globe, saying income from some rental properties is no longer enough to cover debt payments. It suspended all sales activity, closed sales offices around the country and laid off most of its staff.

Investors - some of whom had millions of dollars invested in DBSI-run properties - filed 10 lawsuits last week in Boise, alleging the company collected $500 million in illegal profits as a result of fraud. DBSI and more than 100 affiliated companies responded Monday by filing for bankruptcy.

Earlier this year DBSI said it manages more than 18.6 million square feet of space in 280 properties with a total value of more than $2.65 billion. Among them are 16 commercial properties in the Boise area. Kastera Homes, a home builder in the Treasure Valley, is a DBSI subsidiary.

Until closing all operations in October, DBSI had at least two companies that sold fractional ownership investments in real estate called tenant-in-common investments. One, Spectrus, sold them as real estate. The other, DBSI Securities, sold them as securities.

Both sought to shelter investors from taxes. Under Section 1031 of the U.S. tax code, investors who sell a property and make a profit can avoid paying capital gains taxes by re-investing their earnings in other property. So-called 1031 exchanges were a driving force in the commercial real estate explosion in the first half of this decade.

When the section was written in 1929, "It was intended to allow farmers to trade property," said Patricia DelRosso, president of the Tenant-In-Common Association in Indianapolis, a nonprofit organization that represents TIC securities brokers and dealers.

DelRosso said the industry took off in 1999 after the Internal Revenue Service and the Securities and Exchange Commission said TICs qualified as exchanges under section 1031.

Instead of farmers swapping fields for pasture, the new investments targeted retiring landlords who were tired of dealing with "tenants, toilets and trash," DelRosso said.

DBSI and other TIC "sponsors" buy shopping malls, office buildings and other commercial property and offer investors the opportunity to buy a portion - a fractional share - of a property.

An investor could quickly sell a four-plex and use the proceeds to buy a half dozen deeds in office buildings, collect regular payments based on tenants' rent, and leave all the work to DBSI under a "master lease."

Early in 2007, DBSI began an aggressive initiative to buy land for development. Three sources who have worked with DBSI, but asked not to be identified, said the land became a drain when the economy turned and the land sat undeveloped. They say shrinking cash flow from sales and continued debt and tax liability put the company over the edge.

But it was DBSI's practice of pooling cash reserves for all the properties into a single general fund to pay expenses, taxes and loans that sent investors to court, Mangiantini and others said. They said DBSI used proceeds from profitable properties and new sales to prop up the unprofitable ones.

The practice was legal but "unsustainable," Mangiantini said. "When sales stopped there was nothing to fall back on, and instead of losing a few underperforming properties, the whole thing collapsed."

One investment broker, who asked not to be identified because he still does business with the company, told the Idaho Statesman that "people are terrified." He said DBSI is pulling out of all its master leases, beginning with the worst properties first.

Mangiantini says DBSI's master lease arrangement makes DBSI's TIC investments securities subject to strict federal disclosure requirements to protect investors. But some were being sold as real estate, whose disclosure requirements are weaker. That has drawn the attention of Idaho securities regulators.

"Both federal and state law would call a TIC with a master-lease provision a security," said Marilyn Chastain, head of the Securities Bureau at the Idaho Department of Finance.

Chastain wouldn't say if her agency is investigating DBSI.

According to the U.S. Securities and Exchange Commission, "a security is an investment in a common enterprise with reasonable expectations of profit derived solely from the efforts of others, i.e., investing money into a business where a profit is gained without effort on the investor's part."

DelRosso, of the Tenant-In-Common Association, said a federal investigation wouldn't surprise her.

"Anytime a securities sponsor is challenged, state and federal regulators will be in there," she said. "Real estate is a buyer-beware transaction. I'm an advocate of working within a securities form, because there is much more protection for the investor."

DelRosso believes DBSI, like the rest of the real estate industry, is a victim of constricted capital markets.

"I'm sure they had loans and lines of credit coming due and couldn't find replacement financing," she said.

Mangiantini says DBSI did not disclose important information to investors who purchased investments from the real estate division - things like the existence of property appraisals and the fact that DBSI bought properties as little as a week earlier for millions less than it was selling them.

Original story - IdahoStatesman.com

November 17, 2008 - Update from Wall Street Journal - Below

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. [TIC Tactic]

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."

Original story - WSJ.com

Update January 15, 2009

DBSI sued by Idaho regulators

The Idaho Department of Finance has filed a civil lawsuit again DBSI, alleging the company engaged in a scheme to defraud thousands of investors through the sale of unregistered securities by unregistered dealers.

Boise news outlets reported the state investigation and subsequent lawsuit on Thursday, stating regulators are seeking $9.7 million on behalf of the investors.

DBSI was developing several Tampa Bay area projects when it closed its St. Petersburg office on Sept. 3 and dismissed employees.

In November, it filed Chapter 11 on behalf of itself and the many limited liability companies it controls. The petitions were filed in Delaware bankruptcy court.

In the Bay area, DBSI left at least two projects unfinished when it shut down. It also had contracts to buy properties that it cancelled.

General contractor RR Simmons Construction Corp. has filed a $2.1 million lien for unpaid work on Park Centre at Telecom Park, an 88,000-square-foot office building it was constructing for DBSI.

DBSI had not yet started construction of One Hernando Center, a 3.2-million-square-foot industrial park slated for State Road 54 in Brooksville, east of Interstate 75.

The company has other projects in Florida under development, some through fractional ownership with investors. DBSI relied on equity funds managed by brokers and financial advisers as well as tenants-in-common funds to buy land and develop projects.

The company, started by accountants about 29 years ago, relied on about 12,000 investors for equity. Many of those investors hold fractional interests through tenants-in-common investments.

A DBSI spokesman said in October the company owned 18.6 million square feet in 34 states, which it valued at about $2.6 billion.

Updated Story - Biz Journal