Many sponsors of DST programs are including section 721 UPREIT options in their potential exit strategies. Several factors are likely contributing to this evolution.
- The UPREIT represents an opportunity to gather 1031 capital to grow assets under management and eventually backdoor the investment into an affiliated REIT program.
- The uncertain future of section 1031 exchanges—if the ability to enter into these exchanges is reduced or eliminated, the UREIT option may still provide investors who have already entered into the affiliated DSTs with the ability to continue to defer taxes while diversifying their holdings into OP units of the REIT.
- As cap rates for commercial real estate are near historic lows, sponsors are unlikely to be able to rely on cap rate compression to increase asset values. Aggregating DST properties into a large portfolio might result in an aggregation premium that could create value for investors regardless of where cap rates head.
A couple months ago, Gail Schneck wrote a blog post about how and when investment in a DST program with an UPREIT exit option may be appropriate for a client. In this post, we’ll consider how to evaluate the mechanics of an UPREIT exit strategy from a due diligence perspective. As we’ll see, UPREIT structures can present various opportunities and risks, and it’s important to understand how different features may affect the investment outcome for your client.
First and foremost, this is an affiliated transaction
The exit strategy may provide a great diversification opportunity for your client and even an optimal return, but a roll-up must also be appreciated for what it is: an affiliated transaction, subject to conflicts of interest for the sponsor. Thus, you should evaluate it as you would any affiliated or related party transaction to make sure your DST client will be treated fairly.
Typically, a DST’s trust agreement will limit fiduciary duties owed to investors as much as possible under Delaware law. However, it’s likely the REIT’s decision-makers—its advisor and members of its board of directors—some of whom are often the same executives controlling the DST, owe more substantial fiduciary duties to the REIT and its shareholders.
Because of the mismatch of interests and duties, it is imperative to closely examine how the transaction will be structured and priced. Is the trustee required to get a third-party appraisal to support the transaction? How close in time to the transaction must that appraisal be obtained? Can investors object to the valuation and provide a second appraisal for consideration? While we wouldn’t expect to see minority or lack of liquidity discounts for the valuation of individual investor interests after the trust property itself is valued, note that some programs provide explicit assurance that no such discounts will be taken, while others do not.
In some programs, an affiliated entity may hold a purchase option to acquire the property at a specific strike price in the future. This price might be based on prospective property appreciation that your investor may think they would be thrilled to realize in the future. However, what this structure really presents is a return ceiling for your investor—if the sponsor affiliate is acting rationally, it will only exercise if the property later becomes “in the money,” which may mean your investor may not receive full fair market value if that exceeds the option price. On the other hand, if the property does not ultimately attain the appreciation upon which the option price is based, the affiliate will simply not exercise the option, and the trust will eventually dispose of the property to a third party at a lower price.
Last, note whether the sponsor might earn a disposition fee on the roll-up (whether or not the affiliated REIT will be paying them an acquisition fee). Some DST sponsors are not entitled to transaction fees for an affiliated exit, which may help to mitigate conflicts of interest, while others are.
Transactional mechanics matter
The requirements and mechanics of a DST exit transaction vary from program to program. So can the level of detail contained in trust agreements regarding these transactions. There are several transactional aspects you must get clear on to confidentially understand how a roll-up transaction could affect your client.
The most fundamental question to ask in evaluating a 721 exit strategy is whether the investors will have the option to receive cash for their interests (to pursue a subsequent 1031 exchange), or whether they will be required to accept units in the REIT’s operating partnership. Some programs will even provide for a combination of both, with limits on the total amount of cash provided by the program.
Related but more subtle considerations deal with the length of time investors have to elect their form of consideration received (if they do have the ability to choose), and what the program will presume if it does not hear from an investor within that timeframe. A DST program that gives its investors 10 days to object to receiving OP units may not be suitable for investors who wish to take cash and continue deferring capital gains under section 1031; a notice of exercise of the option may be easily missed, or objection may not feasibly be obtained by the advisor, within a short timeframe.
Another wrinkle to be aware of is the possibility of a partial exit through a 721 if the DST program owns several properties. Many options we evaluate provide the REIT or its operating partnership the option to acquire some but not all of the properties within a DST’s portfolio. This flexibility may be within the REIT’s best interests but not necessarily the DST program’s. And it also must be evaluated in light of loan provisions. How does the loan agreement provide for partial sale of the portfolio and prepayment of the loan, if at all? (Other items to check related to the financing, regardless of a partial or full exit, is whether the loan requires an assumption fee or prepayment penalty if the REIT exercises its purchase option before the end of the loan term.)
Last, another feature that may give the REIT flexibility, but not necessarily benefit the DST, is how quickly the REIT’s option period opens after the close of the DST offering. We’ve seen these timeframes compress in the DST market recently, and 1-2 years is now becoming common. These timeframes may not give the DST property enough time to meaningfully appreciate in value to overcome the upfront load. As Gail’s post points out, this is less important if the objective was to eventually invest in the REIT, which ordinarily may also be subject to an upfront load that is waived for the DST investor. But if the investor’s objectives are to pursue another 1031 exchange, a sale after the second year of the hold period may not facilitate a full return of capital, and the investor’s returns may be materially limited.
Evaluate the future investment, now and in the future
Gail’s post discussed this, but it bears repeating: you really have to consider the nature of the program that holds the purchase option on the DST interests or the property. Not only can these programs vary in the level of diversification offered, risk/return profile, quality of the portfolio, and fee structure, but the type of REIT—private, public non-traded, or publicly traded—can have bearing on liquidity and tax consequences down the road.
For instance, the eventual liquidity offered by a private REIT is materially different than that inherent in a publicly traded REIT. Regardless of the type of REIT program, to qualify for a tax deferred section 721 transaction, investors will likely receive illiquid units in the REIT’s operating partnership in exchange for their DST interests as an intermediate step to liquidity. In assessing a path to eventual liquidity, consider:
- How quickly these OP units can be converted into (potentially liquid) REIT common shares.
- Conversion from units in the OP to common shares in the REIT is a taxable event. Determine whether investors can hold their OP units indefinitely to avoid this, or whether the REIT can compel conversion at its option at some point.
- Whether conversion is exclusively at the investor’s option or not, understand the prospects for liquidity at the time of conversion. Can the investor easily sell some shares (if desired) to pay the tax liability? A public, non-traded REIT may offer a limited liquidity option to investors, but the share redemption program may be suspended or oversubscribed at any given time. A publicly traded REIT ought to provide the best prospects for liquidity, although ultimate returns will be subject to the market.
Of course, there are other nuances to consider when assessing the eventual REIT investment, including whether the operating partnership will provide tax protection agreements to investors to cover the prospect that subsequent sale of the properties purchased from the DST triggers adverse tax consequences. Thankfully, much of this assessment can be done in advance when you are evaluating the DST investment itself. In fact, you should vet the REIT as you would for general inclusion on your platform, if you haven’t already done so.
But placing a client into a DST program with an UPREIT option will also require an evaluation of the REIT program in the future, if and when it exercises its purchase option, to best advise your client. Of course, this all underscores the importance of staying on top of the REIT through ongoing due diligence.
Chief Operating Officer