Securitized 1031 exchange offerings raised a total of nearly $3.5 billion in 2019, just shy of the approximately $3.7 billion in peak fundraising in 2006, according to the year-end market report released by Mountain Dell Consulting, a market research and analytics firm focused on the securitized 1031 exchange marketplace.
“The latest Mountain Dell research confirms what to date has simply been the word on the street,” said Tony Chereso, president and chief executive officer of the Institute for Portfolio Alternatives. “The securitized 1031 exchange market continues to see substantial growth driven by continued investor demand. Product innovation, investor centric investments and strong performance over the last decade continue to create more investor interest and drive sales growth.”
Section 1031 of the Internal Revenue Code allows investors to defer paying capital gains taxes on investment property sales by reinvesting the proceeds into a similar investment property within a specified time frame. Securitized 1031 exchange programs are structured as securities and sold to retail investors, with the vast majority (93.6 percent) structured as Delaware statutory trust offerings.
“Prior to the Great Recession, the tenant-in-common structure was widely used for fractionalized Section 1031 exchange replacement property programs,” said Louis Rogers, founder and CEO of Capital Square. “While DSTs were a proven structure going back to 2004, DSTs did not take off at first. Starting around 2012, most sponsors shifted to the more modern DST structure and have enjoyed increasing sales.”
Fundraising in 2019 increased 40 percent or $996 million compared to 2018, and outperformed Mountain Dell’s second quarter projections by $726 million.
“Last year’s market equity raise comes close to the $3.7 billion peak of 2006. It is hard not to draw comparisons and recall the recession that followed not long thereafter,” said Warren Thomas, managing member at ExchangeRight. “With valuations for most asset classes far higher now than they were in 2006 and mounting indicators of excess that normally precede a recession, ExchangeRight is looking to the past for lessons and proceeding with caution.”
“The last recession brought cap rate expansion, decreased occupancies, failing tenants, foreclosures driven by excessive use of mortgage debt, and the offerings of asset types that relied upon discretionary spending were often hit the hardest,” Warren further explained. “Although the next recession hopefully is not as severe as the last, investors and advisors are wise to understand the risks of the times as we celebrate the proper use and growth of 1031 offerings.”
With a total of 38 sponsors raising equity in 2019, the same as the previous year, the number of active programs increased from 139 to 171, which was the largest number of offerings since 2006 when 71 sponsors launched 341 programs.
“Just like the TIC-era, the number of DST sponsors has grown rapidly from just a few in 2012 to 38,” said Rogers. “Being a DST sponsor is a complex business that requires a combination of specialized tax, finance and real estate expertise and access to capital. Just like the last time we were in this movie, caution is warranted.”
The top firms in the space were Inland Private Capital Corp., which maintained its top spot with 25 percent of market share, followed by Passco Companies and ExchangeRight Real Estate each with 10 percent, Capital Square and Black Creek Group each with 7 percent. Cantor Fitzgerald (6 percent), NexPoint Real Estate Advisors (5 percent), and BlueRock Real Estate (5 percent) each raised significant equity in 2019.
Multifamily real estate continued as the most popular asset class for 1031 exchanges with $1.6 billion raised (46.8 percent), with multifamily/student housing properties raising an additional $224.7 million (6.5 percent).
“While apartments carried the day again in 2019 accounting for 47 percent of industry sales, we are beginning to see an uptick in investment activity throughout other sectors, which provides 1031 investors with greater potential for portfolio diversification,” said Keith Lampi, president and chief operations officer of Inland Private Capital Corporation.
Retail properties contributed $487.8 million (14 percent) to the total capital raised. Medical office properties took in nearly $271.1 million (7.8 percent), and traditional office properties totaled $204.6 million (5.9 percent). The equity raise for self-storage and industrial properties totaled $240.8 million (6.9 percent) and $209.3 million (6 percent), respectively.
“Based upon Inland’s internal data, the average number of DST’s per exchange was 3.07,” added Lampi. “This means that on average, a 1031 investor is diversifying into a minimum of three DST’s with Inland, and potentially achieving additional diversification if they are also working with another sponsor. This growing trend in the way of diversification is a positive sign for the industry and its longevity going forward.”
“The Great Recession taught us that long-term net-leased properties backed by investment-grade credit tenants in the necessity retail and healthcare space tended to have the most stable net operating income in times of heightened turmoil,” said Warren.
Properties located in Texas (39) and Florida (21) were the most popular, followed by Illinois (17), Georgia (16), and Tennessee (16).
Out of the 171 total offerings, the vast majority were structured as Delaware statutory trusts (160), followed by direct title (5), tenant-in-common (4), and limited liability companies (2).
There were 127 offerings registered as 506(b), however, 506(c) registered offerings accounted for 26 percent of the marketplace with 44 offerings, as the popularity of crowdfunding and web-based direct investing continues to increase.
“The securitized 1031 market is no longer the small cottage industry it was in the early 2000’s,” said Lampi. “With close to 20 years under its belt, the industry has evolved into an established, mature marketplace which is why we are seeing more and more full cycle activity occur. I believe this is a favorable trend for the industry as a whole, because it provides investors with an opportunity for liquidity, while also establishing a track record and proof of concept for the how the product works from beginning to end.”
Full-cycle DST deals have created significant liquidity from existing investors, with full-cycle activity reaching an estimated $1.1 billion in 2019. The average first-year return was nearly 5.5 percent, and offerings averaged 185 days on market.
Mountain Dell noted that interest in 1031 exchanges remains “very high” in current economy, as more institutional sponsors enter the space, and broker-dealer and RIA involvement continues to grow.
“We have heard for decades about the aging and likely retirement of many registered reps who sell commissioned products,” said Rogers. “Whether from attrition or growth of wealth management platforms, RIAs (wealth managers) are showing interest in DSTs as a solution to their clients’ tax issues.”
“Many RIAs are now distributing DSTs to their wealth management clients without a sales load and more have shown interest for the future,” Rogers added. “While just a trickle back in 2012, sales by RIAs are moving the needle for sponsors across the nation. This is a major trend, with RIAs predicted to distribute approximately one-third of all DSTs to their wealth management clients.”
Industry groups and product sponsors alike lauded the 2019 equity raise, which exceeded industry expectations across the board, while remaining cautiously optimistic about the future of the space.
“2019 was a tremendous year…This is a testament to the overall growth in our sector and, in particular, to the vibrance and value 1031 exchanges deliver to the US economy,” said Larry Sullivan, President of the Alternative and Direct Investment Securities Association (ADISA) and president of Passco Companies.
“Despite some ongoing policy risks to 1031 exchanges, our outlook for the marketplace is extremely optimistic as we enter a new decade,” said Chereso. “A shift of power in Washington at the end of the year has the potential to shake some of this optimism, but strong investor demand and growing product transparency helps the industry remain confident despite political uncertainty.”