FactRight is seeing a trend in non-traded real estate investment trusts (REITs) that are seeking to diversify their funding sources by offering 1031 exchange investment opportunities with the potential to be UPREITed into the sponsoring REIT at some later date. The UPREIT transaction would be done under section 721 of the Internal Revenue Code, which provides for continued tax deferral of the original capital gains. These investment opportunities provide a significant opportunity to the right investors, and long as they understand the ramifications of such investments. Let’s look at the main considerations for determining whether investing in a DST program with an UPREIT option is appropriate for your client.
When does it make sense for investors?
This arrangement offers investors the opportunity to continue to defer capital gains while diversifying their holdings. They are most advantageous to investors seeking diversification and easier liquidity for their heirs. However, such investors must also be suitable for a subsequent 1031 exchange since the sponsoring entity (typically a subsidiary of the REIT) is not required to exercise its option.
What are you UPREITING into?
My father once told me that it is unwise to make investment decisions based on tax consequences alone. And he was a tax lawyer. It is one thing to diversify a portfolio. It is another to assess what you are diversifying into. Before investing in a DST program with an UPREIT option, you and your client should step back and ask whether an investment in the REIT is sound absent the tax advantages. If the answer is a definitive no, reconsider the investment. If the answer is a maybe, you can then start weighing the pros and cons of the investment in light of the tax advantage.
How do you overcome the upfront DST load?
The answer to this question differs based on whether the REIT exercises the option or not, which you will not know before you make your investment decision.
If the REIT exercises the option, the time period to overcome the load could be as short as two years (the holding period required by the IRS to avoid a taxable step transaction.) Overcoming a 10% or so load in two years is likely to prove challenging. This challenge can be partially mitigated by lowering the underwriting fees associated with this offering; however, this usually involves negotiating a lower selling commission. Rather than “overcoming the load,” another consideration is the front-door cost of investing in the REIT (that an investor wouldn’t pay upon the UPREIT transaction). This will, of course, be dependent upon the share class the investor selects. For the typical T share, the load would be around 3.50% up-front and a total of 8.75% or so over time. This is slightly different for private REITs, especially if the only share class available is class A, which often is subject to approximately 10% up-front underwriting fees. Certain sponsors and/or broker deals have addressed this issue by lowering the negotiated load on the initial purchase of the DST.
What type of liquidity does the REIT provide?
Once an UPREIT transaction occurs, investors are required to hold the OP units for at least a year before they can be converted into REIT shares and liquidated (which would be a taxable event). Upon conversion, the investor can take advantage of the repurchase program included in the REIT structure. FactRight notes that repurchase program features vary among and between public and private REITs. One common feature is that these programs can be suspended or terminated without investor consent.
Safeguards for affiliated transactions
Some programs acquire properties for the DST, which they then intend to UPREIT. Other programs have the REIT’s operating partnership (OP) acquire the property, or they take an existing OP property, and drop them down into the DST. Affiliated transactions, such as the latter scenarios, require additional safeguards surrounding determination of the purchase price such as independent appraisals. Even if the OP provides a master lease with an unconditional guaranty, and a minimum net operating income for determining the liquidation value, the purchase price of the property impacts DST investor returns. If the DST pays more than market value for the property, it will be more difficult to achieve projected returns.
Is there a liquidity option?
A few programs offer a liquidity option upon exercise of an option. This means that investors can chose to receive cash instead of OP units in the REIT for their interests. In this case, the load issues may compound if the REIT’s purchase option period arises early in the DST hold period, since the investor is likely to be required to pay a second load it he/she/it transfers into another syndicated 1031 product in such a short timeframe. A relatively short hold period begs the question of whether the investor is really investing in the underlying property, especially when the underlying property is an investment-grade, long-term net lease program where investors are basically seeking to buy as an annuity.
What happens if the UPREIT doesn’t occur?
The option is exercisable at the discretion of the REIT. Most programs intend to UPREIT the property and therefore expand the capital raise of the REIT by capturing the equity raised from the prior DST syndication. But the REIT is under no obligation to do so if the property deteriorates over the holding period. The REIT may decide to pass on the repurchase of the property. This basically leaves investors in the same shape they would be in if they invested directly in the property, or possibly in better shape if the structure includes a minimum NOI guarantee related to the sales price of the property.
One of the biggest advantages of the UPREIT structure is that investors can create diversification by exchanging DST interests into the OP of the REIT, and if properly done through a section 721 exchange, continue to defer capital gains taxes. However, they no longer will have the ability to enter into another 1031 exchange. On the upside, the capital gains continue to be deferred, and, after a year, investors may exit the REIT by converting OP shares into common shares. This liquidity is, of course, dependent upon the liquidity feature provided by the REIT. This strategy probably makes the most sense for investors who have no need of funds and want to receive a step-up in basis while passing a more liquid, diversified holding to his/her/its heirs.
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