In 2025, more than half of the $8 billion equity raise for Delaware statutory trust programs was contributed to DSTs that have granted fair market value (FMV) options to the operating partnership of a real estate investment trust. Many hundreds of millions more of equity were raised for DSTs that effectively provide the same optionality to an unknown entity of their managers’ election. How much scrutiny should be placed on these FMV options? In short, more than you might think. This blog post will inspect key FMV option characteristics that are material to the suitability assessment of a DST program.
The 721 exchange: one among many potential exits
DST investors may not always be aware that a DST’s manager (often known as the signatory trustee) generally has significant discretion in how to wind down a trust’s investment. To list four common allowances, the manager may 1) sell the trust’s assets to a third party; 2) sell the trust’s assets to an affiliate (hopefully, governed by an independent valuation); 3) convert the trust into an LLC (typically referred to as a “springing LLC”); or 4) allow a partnership entity to acquire the investors’ DST interests in exchange for partnership units. This final option is intended to qualify as a tax-deferred exchange colloquially known as a “721 exchange” (in reference to Internal Revenue Code Section 721) or an “UPREIT” (due to the proclivity of such exchanges with the operating partnership, or OP, of a REIT).
721 exchanges with DST interests may be appropriate for numerous reasons, and the optionality has been commonplace in trust agreements for some time. For example, if the oft-threatened legislative proposal of limiting 1031 exchanges to $500,000 in gains were implemented, many investors may prefer a 721-exchange exit from an existing DST investment to avoid an otherwise taxable gain.
In recent years, 721-exchange exits from DST programs have been marketed as providing diversification benefits, enhanced liquidity (especially for estate planning purposes), and perpetual, passive income without needing to bother over future 1031 exchanges. Investors should be aware that the sale of partnership units (or a conversion of those units into common shares of the REIT) after such an exchange will likely trigger tax liabilities as future 1031 exchanges are no longer possible. Investors that might participate in a 721 exchange, and their financial advisors, should also understand risks relating to section 704(c) gain, step transactions, and the potential for long-term, restricted liquidity. (Those topics will not be the focus here.)
Is the DST program you’re reviewing subject to a potential 721-exchange exit? If so, it will be evident in the private placement memorandum, the trust agreement, or, sometimes, in a standalone option agreement. You’ll be looking for sections identifying the FMV option or “exchange right” (another common term) generally near the end of a trust agreement or disclosed in a few locations in a PPM.
Once you identify such an exit potential, there are several aspects to assess.
Does cash-out optionality exist?
The DST industry has adopted imperfect jargon around the cash-out features of FMV options. These features describe whether investors can opt out of a 721-exchange exit and instead receive cash of equal value which may be used for future 1031 exchanges. DST programs that do not provide for cash elections are often referred to as “forced 721” programs. This should not be misconstrued as meaning that an OP is forced to exercise its FMV option. (Note that I’ll generally refer to the holders of these FMV options as OPs from here on out.) Rather, in a “forced 721” program, investors are forced into the exchange if the OP exercises its FMV option.
Cash-out features vary significantly across programs. For example, readers should carefully examine whether a cash election is guaranteed or if the OP will solely endeavor to accommodate it. Further, characteristics such as cash-out limits (i.e., a maximum percentage of DST interests that will be acquired for cash rather than exchanged for partnership units) and cash election fees are present in some programs. Generally, if an OP exercises an FMV option, the default is that DST investors will participate in the 721 exchange. To cash out, investors may need to proactively provide a cash election form to the manager within a certain timeframe of receiving the FMV option exercise notice. Investors that elect to receive cash instead of partnership units may be described as “dissenting investors” in the relevant agreements.
If cash-out optionality does not exist, investors should be aware that they are along for the ride if the FMV option is exercised. Due diligence officers should be wary of DST programs that do not define the exchange vehicle (i.e., the partnership that will acquire the DST interests) in the DST program’s materials while also restricting cash-out optionality. Ideally, DST programs allow investors to opt out of a 721 exchange if they weren’t provided exchange vehicle detail at the time of subscription.
Are the terms that govern valuation fair?
The exercise of an FMV option is generally an affiliated transaction. To reduce conflicts that arise from such transactions, the exchange should be governed by two types of independent valuations. On the OP’s side of the transaction, partnership units will be valued by a net asset value (NAV) that is generally determined monthly or quarterly and based on the valuation procedures of the underlying REIT to which it is tied. DST interests are generally valued based on one or more independent appraisals of the trust’s real estate. Such valuation(s), in turn, will be used to value the proportional interest of each investor. Here is a basic valuation illustration with an all-cash DST program:
At the time of the FMV option’s exercise, the real estate owned by the trust is valued at $10 million. A DST investor owns 10% of the trust, resulting in a valuation of their DST interests at $1 million. The partnership units of the OP have a per-unit NAV of $10 at the time of the exchange, so the investor would receive 100,000 partnership units in exchange for their DST interests.
This simplicity can be muddied in several ways. For instance, the timing of the DST’s real estate valuation is critical. Typically, these valuations are bound by a defined timeframe relative to the FMV option’s exercise. To avoid conflict, best practice is that the timing aligns with the valuation practices of the REIT, which is typically within 30 or 90 days. If the FMV option allows for valuations earlier than that window, the resulting exchange can be misaligned. We can demonstrate this conflict with an extreme scenario:
Throughout 2021, cap rates compressed by around 100 basis points. A DST owning a multifamily property could have experienced an increase in value of around 20% in that year on an unlevered basis (represented by an approximate shift from a 5.5% cap rate to a 4.5% cap rate). On a levered basis, that shift could be closer to 40% in terms of equity value. Let’s say an OP held an FMV option for DST interests that dictated that the value of the trust’s real estate would be derived by an independent appraisal obtained within one year of the option’s exercise. The OP receives an appraisal on January 1 and sits on it until December 31. Seeing that values have gone up immensely in the interim, it exercises the FMV option utilizing the January 1 appraisal. The DST interests are then exchanged somewhere between 20% to 40% below market value (depending on leverage) for partnership units that are no more than 90 days lagging from the REIT’s most recent valuation. This mismatch in valuation timings between the DST and the REIT results in a significant conflict.
In addition to the valuation process and timing, determine whether the FMV option’s valuation considers all the trust’s assets or solely the real estate. If only the real estate is considered, there are two potential outcomes: either the trust will distribute all reserves and available cash to investors prior to the exchange, or the reserves and cash will be absorbed by the OP via its acquisition of DST interests (a nice gift from investors). Vague or ill-considered language can result in numerous conflicts.
FMV options can work in different ways for property portfolios
If a DST owns a portfolio of assets, an FMV option may require that the OP acquires all DST interests, thereby acquiring the full property portfolio, or it may allow for partial acquisitions. This latter potential is often structured through a series of operating trusts (that the parent trust will own) that have each granted a separate FMV option to the OP.
Under such an arrangement, there are a few things to consider. If a single property in a portfolio is underperforming (e.g., the tenant has declared bankruptcy), and the OP must acquire all properties per the terms of the FMV option, then it may refrain from exercising it. Conversely, if the OP has the option to acquire only some of the properties, it may acquire all the properties apart from the underperforming asset. Partial acquisitions could be pursued for many reasons relating to the OP’s investment objectives, including performance, geography, and tenant concentration, among other factors.
But partial acquisitions can also create complexities with future 1031 exchanges. If 19 assets in a portfolio of 20 assets were acquired via an FMV option, the trust would likely sell the final property to a third party or convert into a springing LLC to resolve an issue before selling the property to a third party. In short, portfolio programs are not immune to unanticipated or complicated scenarios.
Pros and cons of valuations considering the master lease
Typically, a DST program that has granted an FMV option will have master-leased the property to an affiliated master tenant, resulting in less volatile cashflows than the underlying real estate, or in many cases, fully fixed master lease cashflows resulting in no volatility. (For those unfamiliar with master leases, check out the blog post that Brandon Raatikka and I published in 2024.) A recently popularized methodology of valuing real estate in an FMV option is to base the exit valuation of the real estate taking into account an in-place master lease (I’ll call these master-lease valuations, which are distinct from the more traditional property valuations).
In theory, this practice reduces the volatility of future valuation ranges. Commercial real estate is broadly valued on two components: net operating income and a cap rate or discount rate (depending on the valuation approach). If you swap a volatile set of cashflows from something like a multi-tenant office building for a fixed set of cashflows from a master lease, the valuation is less dependent on underlying property performance and mostly reliant on just the rate environment. Ongoing master-lease valuations of DST interests may parallel the NAV movements of a well-diversified REIT, which fluctuate more on rate movements than the performance of any one of its assets.
Master-lease valuations are generally touted as a favorable FMV option feature to investors. Why not limit the volatility factors on your DST interests for valuation purposes? Indeed, this style of FMV option in a DST program is extremely prominent, and wealth advisory firms and investors alike appear to have a significant appetite for it.
While this structure can reduce valuation volatility, conflicts can arise from the trust’s, and therefore the investors’, granting a call option with a strike price that can (and will likely) differ from market value. With an FMV option that is based on a property valuation, the OP only has the option of indirectly acquiring the real estate at its market value (i.e., the value that will be realized by the OP post-exchange and would be realized by the trust if sold to a third party). Conversely, if the OP has the option to acquire the real estate based on any other kind of value, the trust is exposed to directional risk, and the OP may only be incentivized to acquire the real estate when the master-lease valuation is lower than the property valuation.
Consider the overly simplified, rate-neutral graph below that plots the value appreciation of a DST’s real estate under a master lease in blue. The green lines represent a range of potential underlying property values based on property performance. There is some level of property performance that will result in the relative alignment of the two valuation methodologies after three years (which is a common timing assumption for an FMV option exercise).
Under any scenario in which the underlying property outperforms this breakeven point, the FMV option will be in the money, and the OP will be incentivized to exercise it. Under any scenario in which the underlying property underperforms this breakeven point, the FMV option will be out of the money, and the OP will not be incentivized to exercise it, at least on that basis. (It should be noted that the OP will likely have a reputational incentive to exercise the FMV option anyway, in order to preserve its ability to raise capital for current and future DST programs.)
Valuation parity and methodology
If an FMV option is governed by a master-lease valuation, many sponsors will illustrate, upon the trust’s real estate acquisition and master lease commencement, that the property valuation and master-lease valuation are in parity. This is shown by either providing a combined appraisal, two separate appraisals, or, in the event of a third-party, arms-length property acquisition, by solely providing a master-lease valuation that aligns with the consummated market transaction.
One benefit from this illustration is that it provides precedent for how the master lease may be valued in a 721-exchange exit. In recent years, we have observed that appraisers will contemplate the valuation of a property as encumbered by a master lease with varying degrees of emphasis on reversion values, credit ratings, and master lease duration. Without this precedent, the ultimate valuation process utilized in the FMV option is speculative, and it is unknown whether the master-lease valuation has the propensity of concluding values higher or lower than the property valuation.
Envision a scenario in which an investor acquires interests in a DST that has granted an FMV option that will be based on a master-lease valuation, but this valuation methodology is not provided at the time of subscription. If the master-lease valuation has the propensity of concluding higher values than the property valuation, the OP may exercise an out-of-the-money option, resulting in higher investor returns, or the OP may be wholly disincentivized from exercising the option. If the master-lease valuation has the propensity of concluding lower values than the property valuation, then the investors will have a higher likelihood of incurring a loss upon exercise as the OP will be more incentivized to exercise the option when it is in the money.
Demonstrated parity between the two valuation methodologies does not eliminate directional risk as detailed in the prior section, but it does provide useful tools for analysis and will reduce conflicts of interest.
What’s next?
The DST marketplace is currently in a unique position. Most of the growth in DST fundraising over the past few years is attributable to DST programs that explicitly grant FMV options to the OP of a REIT; however, most of these programs have yet to hit sufficient maturity for the FMV options to be exercised. It is difficult to predict how exits for these programs will play out in the coming few years. More likely than not, most of these programs will not result in alarming outcomes to investors or the broader industry, but as sample sizes increase and the varying features of FMV options are tested, FactRight is interested in providing thorough analysis so that the full breadth of outcomes can always be understood by its clients.