DST to UPREIT: Unlocking Greater Value & Optionality for Investors
In this webinar, Louis Rogers, co-chief executive officer of Capital Square focuses on 721 UPREIT transactions, where real estate owners can contribute their property to the operating partnership of a REIT in a tax favored manner under Section 721 of the Internal Revenue Code.
While being interviewed by The DI Wire’s publisher, Damon Elder, Rogers explains the tax-favorable structure, “Section 721 provides a favorable tax rule where property has contributed to a tax partnership in exchange for interest in the partnership. Now, in an UPREIT transaction, it’s important to analyze and focus on the parties. We have the owner of real estate, that owner contributes their property to the operating partnership of the REIT. Remember, that’s the entity, on top UPREIT, and that contribution is in exchange for interest in the operating partnership, so-called OP units. And section 721 provides that there’s no gain to the contributor, the property owner or the recipient, the operating partnership. So, you put property in, to a partnership, you can receive property in a partnership with no tax under section 721.”
Rogers also explains a few nuances in the transaction, which include the property meeting all the requirements for REIT specific investment criteria and also explains the similarities and differences between Section 1031 and Section 721, including how Section 721 is much more focused and typically used more in an institutional background.
The founder and co-CEO of Capital Square addresses structural issues with DST’s that encourage investors to look into UPREITs.
“There’s no way to add capital, there’s no way to refinance,” said Rogers. “There’s a workaround for a distressed property where you can drop into an LLC, but there’s really no ability to refinance.”
Rogers also provides insights on why there has been a rise in UPREIT’s, “It combines a number of features, favorable tax treatment, the partnership tax treatment that we’ve talked about, increased cash flow, greater diversification, and many REIT benefits.”
Video Transcript
Damon Elder 00:05
Hello, and thank you for joining The DI Wire webinar. I’m Damon Elder publisher of TheDIWire.com, and today I’m joined by Louis Rogers, founder, and Co-CEO of Capital Square, one of the nation’s leading sponsors of tax advantage real estate investment. He has a background as a leading tax and securities attorney, and he’s an authority on tax advantage real estate. So today we’re going to talk about 721 UPRETs and specifically how they relate to DST, and DST owners, and what the process is to transfer from a DST to a 721, the benefits that may accrue from those things. 721s have certainly grown in popularity among retail investors in recent years, particularly among those who’ve completed 1031 exchanges via DST offerings in the recent, past. So why don’t we jump right in, Louis, and why don’t you explain to us, you know, what is a 721 UPREIT?
Louis Rogers 00:54
That’s great. Thank you, Damon. Thanks to The DI Wire. Let’s have a little introduction to 721 UPREIT transactions, and here we go. A 721 upbeat is a transaction where owners of real estate contribute their property to the operating partnership of a REIT, and they do that in a tax favored manner under Section 721 of the Internal Revenue Code. Now, I don’t want to put people to sleep on the first sentence. That’s quite a lot to unpack.
Damon Elder 01:23
Well, why don’t we pause for a second then, Louis, and kind of drill down a little bit into the structure of the 721.
Louis Rogers 01:29
Yes, the structure’s very important. We start with two parties. We have the owner of real estate, let’s call, call them the property owner, and then we have a real estate investment trust or a REIT that would like to own the real estate. Now let’s use that as a backdrop to discuss the structure of the transaction. So here we go buckle up. The property owner, and that’s typically an LLC or other legal entity. In, in modern times, the property owner contributes their real estate to the operating partnership of the REIT in exchange for what are called OP units. That sounds like a lot of mumbo jumbo, but it’s not. Once you understand the legal structure of a REIT and the rationale for the structure. So here we go. REITs typically adopt an UPREIT structure where the REITs real estate is owned in an operating partnership.
I know operating partnership is not that familiar of a term. If you look at the organization chart, the org chart for a REIT, the operating partnership sits on the top of the REIT, hence the name UPREIT. Magical Fancy that, on the top of the REIT is an UPREIT. The REIT is the general partner of the operating partnership and makes all the decisions for the operating partnership. All the real estate goes in the operating partnership. Now, it’s important to understand the structures because REITs are tax is corporations and corporations typically have two levels of tax. At the corporate and stockholder level, REITs must comply with many requirements to qualify for favorable taxation, essentially one level of tax on a portion of the dividends. On the other hand, entities taxed as partnerships, we call them tax partnerships, have extremely favorable tax treatment for real estate ownership. And this UPREIT structure where you have an operating partnership on top of the REIT, is used to obtain favorable partnership tax treatment. There are a number of things that come with partnership tax treatment, including basis for debt and most importantly for today’s discussion, section 721 of the Internal Revenue Code.
Damon Elder 03:49
Well, let’s stop there for a second, Louis, because obviously tax is super important. Why don’t we talk about, you know, how Section 721, and 721 exchanges work, you know, from that tax perspective?
Louis Rogers 04:00
Yes. Section 721 provides a favorable tax rule where property has contributed to a tax partnership in exchange for interest in the partnership. Now, in an UPREIT transaction, it’s important to, to analyze and focus on the parties. We have the owner of real estate, that owner contributes their property to the operating partnership of the REIT. Remember, that’s the entity on top UPREIT and that contribution is in exchange for interest in the operating partnership, so-called OP units. And section 721 provides that there’s no gain to the contributor, the property owner or the recipient, the operating partnership. So, you put property in, to a partnership, you can receive property in a partnership no tax under section 721.
Couple of nuances though, in an UPREIT transaction, understand that the target property must satisfy the REITs specific investment criteria. There’s a lot of properties and there are a lot of REITs and each one have their own unique investment criteria. So let, let’s say for example, we have the owner of a class, a multi-family property in the southeast, kind of like the properties that Capital Square acquires. That would be a good candidate for a REIT that invests in class a multi-family property in that region. But the owner of a rental house or a small apartment community probably would not be a suitable candidate because REITs typically buy large investment grade properties, and a net lease or mortgage rate would also not be a suitable candidate for the owner of a multi-family property interested in an UPREIT transaction. But once you match up the specific property to a suitable REIT, the mechanics of the transaction are fairly simple.
Damon Elder 05:59
What do you mean by that? How, how are they simple?
Louis Rogers 06:02
Fairly simple because, we’ll, we start with the target property. The target must be valued to establish a purchase price. And this is typically done by obtaining MAI appraisals. And one of the best aspects of an UPREIT, one of my favorite parts is the purchase price is fair by definition.
Damon Elder 06:21
So, what do you mean by that? How do you determine that it’s fair?
Louis Rogers 06:24
It’s fair because the parties engage two or more MAI, that’s the highest level of appraisers to determine the fair market value of the target property. And if the two appraisals vary in a material way, then the parties may engage a third appraiser. And the average of the median, take your pick of the appraisals is the agreed fair market value. So, two or three high level appraisals by definition, this is a fair price. In addition, the REIT will typically obtain its own valuation in what’s called a fairness opinion from RA Stanger and Company or another firm in the business of providing valuations. So, we start with the fair market value of the real estate is determined by the appraisals. So, we know FMV, then the owner’s equity is determined by taking that fair market value, less any debt, assumed by the operating partnership, the contributors receive the number of OP units that equate to their equity.
Now there’s a nuance. A lot of real estate is owned in legal entities. So, let’s say the owner is an LLC, that entity can distribute. So, so the LLC owns a target property the REIT would like to have it in the UPREIT. The LLC contributes the property and receives OP units. Here’s the nuance. That LLC can distribute the OP units to the members. It can do so in liquidation of their interest in the LLC. Then each of the members can go their separate ways, if they want. This is just an option, but it’s a good option. So going forward, each member of that LLC that just did an UPREIT transaction can decide on their own. Each individual member can decide to hold to use the liquidity option to exchange OP units for REIT stock and sell. Each individual member can do whatever they want, whatever’s in their best interest. This creates a great deal of flexibility for gifting and estate planning. And OP unit holders receive distributions from the operating partnership based on their equity. The distributions are typically computed on OP equity at the same dividend rate paid to REIT stockholders. So, you know, if you, if you have a million dollars of OP units or a million dollars of REIT stock and the REIT pays five and a half percent dividend, you received five and a half percent dividend on your OP units or on your REIT stock. And very important, because we’re supporters of partnership taxation, the OP unit holders will have the benefit of favorable partnership taxation. It’s a whole class in law school and beyond, but basis for debt is a very big feature. Interest deductions help as well. Operating expense deductions and depreciation deductions, all of those things shelter distributions in the OP in the same manner as before the contributions. So that’s why we use the operating partnership in the UPREIT in large part to get that partnership taxation.
As a lawyer, I’ve worked on OP transactions since the 90’s, even earlier, famous Sam Zell used the OP structure to aggregate his assets into one, into multiples of REITs in the most tax efficient matter. And one more, one more goodie, the cherry on top of the sunday, frequently OP holders are given tax protection. What do I mean by that? The operating partnership agrees not to sell their contributed property for a period of time. If it were to sell that property, it could trigger recapture tax to the contributors. And so typically the OP says, we will not sell your property taxable in a manner that would trigger recapture. As an aside, the OP can still do 1031 exchanges without triggering a tax. So, it’s called tax protection. And all of that is the section 721 upright structure.
Damon Elder 10:47
So, Louis, most of our viewers are probably pretty comfortable and understand 1031 exchanges. Obviously, they’ve been going on now for, you know, well over a decade and we’ve seen billions and billions of dollars of investor equity flow into those, less familiar, I think probably with a 721, hence this webinar. So why don’t you kinda walk us through, you know, how a 721 exchange compares with a 1031 exchange?
Louis Rogers 11:08
Sure. That’s a great question. Section 721 and 1031 are very similar, only different, how’s that for an answer?
Damon Elder 11:17
Yeah, perfect.
Louis Rogers 11:19
721 is very similar in the outcome to section 1031, but the way you get there is entirely different, and the structure is a bit different. In a typical 1031 exchange, the taxpayer sells an investment property and via our friends the qualified intermediaries reinvest the net proceeds in a like kind replacement property. This is old stuff for many of you, the gain that would be recognized in a taxable transaction is deferred and it’s deferred until the replacement property is sold in a taxable transaction. That’s section 1031, a hundred and one years old. It’s my friend, my favorite code section. It’s taken me this far in life. Thank you, section 1031. Section 721 is much more, is much simpler. When property is contributed to a partnership in exchange for partnership interests, it operates. It’s much more common. There’s no qualified intermediary. It’s very simple. Frequently when partnerships, tax partnerships typically LLCs, but could be a limited partnership or even a general partnership, typically when they’re capitalized and property is contributed, it’s done under 721. It’s so simple and common and ubiquitous, we don’t even think about it. And in both cases, the taxpayers tax basis carries over to the replacement property under 1031 or the basis carries over to the OP units under 721 in an UPREIT transaction. And any gain is deferred until the replacement property in an exchange or the target property in an UPREIT are sold. So, both provisions are very similar in the outcome, but they get there, uh, through a different manner.
Damon Elder 13:03
Louis, you referenced that section, 1031s been around for over a hundred years, but seven 721s actually been around for decades as well, right? It’s just been utilized more by institutional owners of real estate rather than retail investors in real estate, you know. What’s kind of the historical background on 721?
Louis Rogers 13:19
Yeah, that’s a very good point. 721 is much more institutional, just like REITs are much more institutional than DSTs. The 721 UPREIT structure has been used for decades. Sam Zell is known for using it when he formed his equity, residentials and other REITs. It’s a very productive tool for property owners and REITs to aggregate assets in a tax efficient manner. But 721 is much less common than 1031. Let’s compare a 1031 exchange. The sale of an investment property and the acquisition of a replacement property, that’s very common and we’ve done thousands of them, billions of them, more than you can imagine. And it’s estimated that 20% or more of all commercial real estate transactions involve in exchange on the up leg or the down leg. So, 1031 is ubiquitous, you know, thousands of them may be more. For a 721 UPREIT transaction, you have to have an owner of real estate that’s desirable to a REIT and the target property must satisfy the REITs investment criterion. And that’s a rare combination, since most REITs acquire the best investment grade properties. Damon, how many people do you know who own a hundred-million-dollar investment grade properties? Not that many.
Damon Elder 14:43
My best friend, but those are the only ones really.
Louis Rogers 14:45
He could be my friend too. Does he have a boat?
Damon Elder 14:48
Right. <laugh>, unfortunately, no. I keep telling him to buy a boat.
Louis Rogers 14:51
A jet? That makes 721 UPREIT transactions much less common than 1031 exchanges. 1031 applies, you could almost say generically to the sale of investment properties. 721 is very focused and used typically much in a much more institutional background.
Damon Elder 15:11
So, in the pool we swim in, you know, the alternative investment world of retail investors. In recent years we’ve started to hear more about 721 exchanges, these UPREITs. Why are they becoming more prominent in the retail space?
Louis Rogers 15:25
Another good question. It’s, it’s the advent of a new variation, the DST UPREIT transaction. And here you start with a property owned by a Delaware statutory trust or DST. And again, the, the background and the context is very important. So, let’s, let’s walk through it step by step. The beneficial owners of the DST acquired their interests as replacement property in a 1031 exchange. They had an investment property or another DST that they sold disposed of in a 1031 exchange. The DST interests are their 1031 replacement property. Now, old hat, but we know the exchanger’s tax basis carried over and typically is very low, making them excellent candidates for another exchange under 1031 or a 721 transaction because they’re very tax sensitive. Under section 1031, the gain that would be taxable in a sales transaction is deferred. It’s deferred until the replacement property is sold in a taxable transaction. And this is old hat, but it’s technically tax deferral, but the exchangers can exchange over and over again over years and even decades in a series of transactions. People in my office are cringing. We call it swap till you drop. I know it’s corny, but it’s true. Technically tax deferral, but the taxes may be deferred essentially forever by exchanging over and over again. And when the taxpayer dies, his or her heirs obtain a step up in basis to the fair market value, at which point the taxes are essentially for forgiven, tax deferral becomes tax forgiveness. It’s not something you want to plan on because you have to die to get it. But it is a magical part of the internal revenue code. And keep in mind our 1031 exchangers and we have 6,000 – 7,000 of them at Capital Square. They have a low tax basis. They’re very sensitive to any transaction that would subject them to taxation. And we’ve, we’ve talked about swap till you drop, going back to the TIC days back in the 90’s. And our exchangers are not getting any younger. I’m not getting any younger and our investors are even typically older than I am, and it’s a little bit surprising to me, but many of our DST owners are getting a little tired of the DST pattern. They’re getting tired of what’s been a really good story, a great story. They say, gosh, we acquire a desirable property as our 1031 replacement property. You the sponsor, not just Capital Square. The sponsors in our industry have done a phenomenal job. The returns have been exceptional, stable returns and, and value add. So, you find, find the right property, you add value, and when the property is nearing perfection, you sell it for a very big profit, and you start all over again. And they say, oh my God, we’ve got to get a QI again and do this all over again. Many exchanges have told me personally they would prefer a more permanent solution, and that permanent solution is the DST to UPREIT structure.
Damon Elder 18:43
So, let’s talk about the structural issues with DSTs that I think, I suspect are probably leading to, again, a lot more people looking at these UPREITs. But those structural issues with DSTs are, you know, frankly you can’t refinance or recapitalize DST owned properties. So, when a loan matures, the property needs additional funds for improvement. What do you do?
Louis Rogers 19:05
You struggle. There’s no way to add capital, there’s no way to refinance. There’s a workaround for a distressed property where you can drop into an LLC, but there’s really no ability to refinance. There’s no ability to add capital. And it’s very unfortunate, some of the best properties would benefit from refinancing or from new capital. And that’s true even when adding capital would be in the best interest of the investors would increase their return, would make for a better property. Very inflexible in planning for this session and talking to, to people in the industry, you know, I said gee, I didn’t realize DSTs had this flaw. And they said it’s not a flaw, it’s a structural issue, it’s the structure. And so, we’ll just call it the structure. There’s one more, that can create some challenges. Most DSTs are required to have a master lease in place. It has to be a true lease for tax purposes. It must have really economics. And you know what that means, Damon? It means the sponsor’s required to earn a profit on master lease rents. So, as we say in the office, oh darn, we have to make a profit to make the tax rules work. And that’s not the case with a REIT. So, there’s a little bit of extra structure, a master lease, and there’s a little bit of extra cash flow, that’s in the DST that doesn’t have to be there in a REIT.
Damon Elder 20:41
So were a DST investor to perform an up REIT. They would actually be realizing greater cash flow from that property.
Louis Rogers 20:49
Yes, we’ll go through an illustration in a few minutes on Salt Meadow Bay Apartments, and they’re a very substantial amount of excess cash flow will go from your favorite, everyone’s favorite sponsor, I hope to the investors. And we’ll talk about that. The DST structure is a major improvement, those of you who are around, in the TIC days. But these structural issues create challenges. You have to sell the property when the mortgage, when the loan matures. Most investors will structure another exchange. But you’ve heard, you’ve heard my little, what we call shaggy dog story about the investors saying, do I have to keep exchanging? You know, I’m a serial exchanger, but I’m getting tired. It’s really not that much work, but many of them would like something more permanent.
Damon Elder 21:38
And I suppose if your loans maturing at a point in the market when it’s not the best time to sell, again, this UPREIT structure gives you another opportunity to retain ownership and to look for better options, right?
Louis Rogers 21:48
Absolutely. There is a nice little benefit. You know, no capital calls are permitted. So, investors never have to work, worry about getting a call, you know, for more money. And the sponsors are very good about funding reserves. When you’re buying a property with a 10-year loan and a 10-year investment holding period, you figure out what’s needed in terms of capital improvement, reserves, new roofs, landscaping, hardy plank, if it’s apartments, whatever it is, and you build that in either upfront or over time. But once those funds are expended, it’s not possible to fund additional improvements even when adding value would be in the investor’s best interests. So those are structural issues. UPREIT do not have those structural limitations. UPREITs can refinance, they can recapitalize, they can add new capital to maximize the NOI and value of our property. And in this way, a REIT has a number of structural advantages over my favorite entity, the DST. It’s how we make our living. But it’s true the REIT just works better in these in these ways.
Damon Elder 23:00
Well, let’s talk about some of the benefits that an investor can realize. Were they to go from, DST and exchange into a REIT, what does the REIT provide?
Louis Rogers 23:09
It has a number of features that aren’t available and many of them are not possible from a tax standpoint at a DST. So, we have numerous benefits including liquidity. Let’s start with transparency. You know, a DST is sponsored by a firm like Capital Square and the firm runs the show. Investors don’t vote in the DST structure, the sponsor votes in the REIT, you have an, a board of directors and a majority of the board are independent of the sponsor and the board makes all major decisions for the REIT. And get this, has to approve the sponsor’s compensation at least annually. And the REIT has audited financial statements by a top firm like Ernst and Young to name drop one. And so, the REIT has a lot of transparency, more institutional transparency, than in the DST structure.
The second positive feature is liquidity. REITs typically provide a liquidity option that’s not possible under the DST structure. Here’s how it works. Let’s say we’ve done an UPREIT, and each OP holder has an option to exchange some or all of their OP units for REIT stock. And it’s important to say some are all, they could do one, one unit or all the units, and it’s that OP holder who makes that decision individually on their own. Nobody tells them when or what to do. Now the REIT stock can be sold on the market creating liquidity, and that’s not possible in the DST structure. There’s not a market for DST interests. There’s some secondary markets, but not, not to a meaningful extent. Now the exchange of OP units for REIT stock is taxable, but the option is only exercised by investors when they want liquidity, for example, upon a death, they want cash, need liquidity. The investors in control of the decision to cash out in a manner that’s not possible in the DST structure.
Damon Elder 25:24
Okay. So, let’s discuss the OP structure then. You know, how do OP units differ from simply owning common stock and a REIT?
Louis Rogers 25:33
Yeah again, they’re different but very similar. OP units and REIT stock share the same economics of a REIT, but they’re a different legal structure.
Damon Elder 25:47
And at some point, the op unit holders have the option, the right to transfer their OP units into common stock REIT, is that right?
Louis Rogers 25:56
That’s correct. That’s the exchange option. It’s taxable and so you only exercise it when you want liquidity. And to have liquidity, you have to pay tax. You simply don’t have that option in the DST structure.
Damon Elder 26:11
And how does the tax treatment differ between, you know, these different structures?
Louis Rogers 26:17
Yes, the operating partnership is taxed as a partnership while the REIT is a corporation that has favorable REIT treatment. They’re different legal structures, but they share the same economics. The distributions on OP units typically mirror the dividend rate on REIT stock. So, let’s say you own a million dollars of OP units, and you own a million dollars of REIT stock, and the REIT declares a 5 ½ or 5.5, 6 dividend rate, that’s what you receive on your OP units or on your REIT stock. Same economics, different structure. The investors in the OP have the benefit of owning real estate through the operating partnership. And so, they receive the tax benefits of depreciation, interest deductions, operating expense deductions, and all of those sorts of things like they had before the contribution that will tend to shelter their distributions from taxation.
Damon Elder 27:18
So, you know, we’ve discussed briefly, earlier, but you know, one of the things in the DST 1031 exchange world that we’ve heard forever, it goes back again before DSTs were the preferred exchange method, and it goes back to the TIC days and whatnot. But, you know, we’ve heard forever that one of the great benefits is that investors can swap till they drop, as you said, where they just can come in continually sell an exchange, do another 1031 exchange into another property, continue to do this, essentially permanently defer their cap gains until death, and at that point, their heirs receive a step up in basis and the cap gains is forgiven. So why would someone choose the UPREIT versus simply performing this series of 1031 exchanges? If, you know, estate planning is really their ultimate goal.
Louis Rogers 28:03
To do a couple of things. One is to eliminate the DST structural issues, namely the prohibition on refinancing or recapitalizing in a case where refinancing or adding capital would be beneficial. Also, to retain the best properties, essentially forever. It’s a treadmill, every 10 years you have to sell, sometimes even earlier when there’s a profit to be had and to obtain the REIT benefits that you can’t have in a DST structure. The transparency, an independent board audited financials by a big firm, those sorts of things, are benefits in the REIT structure.
Damon Elder 28:45
So, what types of properties are most appropriate for a 721 UPREIT? Because obviously you could do a 1031 on almost any type of property, complex or something. So, what do the REITs want? What would make it appropriate to make the 721 UPREIT?
Louis Rogers 28:58
Typically, only the best institutional quality properties. We’re talking about 50, 100, or more million dollars properties, and the kind of properties that DST sponsors are buying. The DST sponsors are buying some of the best properties in the country and they would, you know, have a good possibility of fitting a REITs investment criteria.
Damon Elder 29:25
Okay. Well, let’s talk about debt for a second. Obviously, DST holders typically are exchanging into properties that have at least some level of debt and sometimes not, but most commonly. How is the DST debt handled then if they were to exchange the property into an UPREIT?
Louis Rogers 29:41
Sure. Debt’s a big deal, especially in this rising interest rate environment where you have, old loans that were closed even two or three years ago at low interest rates. I think Capital Square has 20-30 loans in the 2’s. Can you believe that in the 2’s in an UPREIT transaction, the debt is either assumed or repaid. With Fannie Mae debt on multi-family properties, there’s even an option for a supplemental loan to increase proceeds. So, if you have an old loan in the 2’s or 3’s or 4’s, it’s beneficial, more than beneficial. It’s profitable to assume that loan. If the loan is not so good, the operating partnership, the REIT can pay it off.
Damon Elder 30:25
And I guess one of the other things is that typically the DST structure, you’re acquiring a single asset, sometimes a small portfolio, but most typically a single asset. Whereas obviously in a REIT, the goal at least is to have an enormous portfolio of properties. So, I guess it therefore provides the benefit of diversification to investors who choose to do an UPREIT.
Louis Rogers 30:45
Exactly. To reduce the risk from being concentrated in a single asset. Caroline in my office will cringe, but we say, don’t put too many eggs in one basket because if you drop the basket, what happens, Damon?
Damon Elder 31:00
Sure. You lost all your eggs.
Louis Rogers 31:02
Yep. So, it’s corny, but it’s true. We learned in 2008 back in the TIC era, that we didn’t want to be overly concentrated. We want to diversify. And one of the best parts about the DST is the minimums are low, and so even a relatively modest investor can diversify into several DSTs to reduce the risk from being overly concentrated.
Damon Elder 31:26
Let’s pivot now to exit strategy. How does exit strategy differ? From a DST to REIT?
Louis Rogers 31:35
Exit is dramatically different. In a DST, the property must be sold no later than when the loan matures, but UPREITs have no mandatory sale date. So, the best properties can be retained long-term, essentially forever. In addition, there’s a liquidity option with the UPREIT that’s just not possible in the DST structure.
Damon Elder 31:57
And how has estate planning changed depending on which type of asset you’re holding?
Louis Rogers 32:03
Sure. So, another excellent question. OP units are divisible. The owners of OP units can exchange some are all for REIT stock, sell them, gift them, hold them, do whatever the heck they want, and they can break them down. And an individual OP holder can gift a unit or 10 or a 100 or all to kids or family members. There’s a great deal of flexibility and it lends itself to gifting and estate planning for people that are, that are looking for those opportunities.
Damon Elder 32:39
What about the step up and basis? Again, that’s one of the greatest estate planning tools for DSTs. But does it apply if you exchange your DST into an UPREIT?
Louis Rogers 32:48
It does. Step up applies to OP units, it applies to DST interests. It’s a great planning tool, but there’s one big catch. Damon, you have to die to get it.
Damon Elder 33:01
Well, right, of course. Yeah, not a great benefit to me, but for, again, those who are far wealthier I suppose that estate planning’s a key part of and again, like I said, the attractiveness of a DST, but so that’s great then. So, if you take your DST and you UPREIT it, you’re not going to lose that ultimate benefit again. You’re not going to realize it, but your heirs will, right?
Louis Rogers 33:22
That’s correct. And, and you retain partnership taxation for all the benefits, especially depreciation deductions to shelter your cash flow.
Damon Elder 33:31
So, so let’s say, you know, an advisor and investors brought this opportunity, or they’re just looking into, you know, again, managing their portfolio. What are kind of the, what are some of the key factors that investors and advisors really should be considering when it comes to an UPREIT transaction?
Louis Rogers 33:47
Well, it gives you more of an institutional structure. It’s tax favored and it also provides the benefits of capital markets in Wall Street via the REIT. It just gives, it’s just a different flavor of a real estate investment. Perhaps the one of the greatest features is a potential for liquidity. That’s a very big deal in a DST. The investor gets liquidity when the property is sold, the sponsor makes that call. It has to be done by the time the loan matures frequently, sooner when there’s a profit to be had. But the investor can’t say, I want to exercise my exchange option and sell my stock. It just doesn’t work that way. The structure’s not built that way.
Damon Elder 34:38
Well, one of the questions just springs to mind is, you know, if I take my DST interest and I UPREIT it, if the REIT then ultimately sells the property that I contributed in the 721. Do I, am I impacted from a tax perspective?
Louis Rogers 34:54
You could be, you could have recapture tax. That’s why tax protection is frequently given. Like in Salt Meadow, the OP and the REIT agreed not to sell the property taxable. You can always do another 1031. The OP can always do another 1031 exchange and not trigger recapture.
Damon Elder 35:15
I want to dive into Salt Meadow a little bit and talk about that as a case study, but first I have one last question that I just thought about. So, if I’m in the DST and the loans maturing, what happens if a sale falls through or something happens? I mean, does the bank just take the property back?
Louis Rogers 35:32
They could, or you could drop into an LLC while you figure it out. More likely you would drop and resolve your problem in an LLC format.
Damon Elder 35:45
Gotcha. Okay. Well now let’s go back and go from theory to practice. Capital Square just recently completed its first UPREIT transaction, Salt Meadow Bay Apartments in Virginia Beach. That loan was coming due in the short term. So, you provided those investors an option to perform an UPREIT into Capital Square Apartment REIT. Why was Salt Meadow other than the loan maturing, why was this property a good candidate for a 721 UPREIT?
Louis Rogers 36:13
A number of features. Salt Meadow is a class A apartment community in an irreplaceable location, a mile from the ocean front. The communities enjoyed strong rent growth and strong occupancy. Capital Square had substantial capital improvement reserves and used them to add value to the property, and the results have been exceptional. Part of the story here is, this is a DST success story and the, our industry should be proud of it. Lots of sponsors buying excellent properties, managing them to perfection. Salt Meadow was originally acquired for 48,600,000 in 2019, and this April, just in April, it had an appraised value, two MAI appraisals of, drum roll please… 72 million dollars from 48.6 to 72 million since 2019. Salt Meadows an excellent case for the discussion of DST to UPREIT.
Damon Elder 37:19
How did the, what happened to the DST investors or how did they benefit, I guess, from the after tax equivalency when you get to going from your DST distributions to then UPREITing and getting redistributions?
Louis Rogers 37:33
In many ways, starting with the economics, the distributions on the OP units increased 42% over the DST distributions. So, a hypothetical investor receiving a hundred thousand a year in annual distributions in the DST would see an increase to 142,000 in annual distributions. That comes from the REIT having greater efficiencies, greater economies of scale, and the elimination of the master lease where the sponsor had a little bit of profit from the, from the excess rentals, beyond the DST distributions.
Damon Elder 38:15
And so, the value of the property was determined via these two MAI appraisals. But how is that better? Or maybe it’s not, maybe it’s the same. I don’t know, maybe it’s worse. How is that different, I guess, than a competitive sales process?
Louis Rogers 38:31
Well, it, it gets you to fair market value competitive sales price process would as well. We just know it’s fair because two appraisers determined the value, and the REIT obtained its own fairness opinion, and the economics are just staggering that the 72 million valuation represents over 161% return on equity and by participating in the transaction. Here’s the magic, the DST owners realize that appreciation without taxation under 721 and their distributions went up 42% and they’re owning the same property that they originally acquired in 2019. That’s the economics are staggering. But wait, there’s more, like what is it Mr. Popeil who’s selling the pocket fishermen and all those things. But wait, there’s more. We have the safety net, the diversification, because the participating DST owners have the safety net of a more diversified investment. REITs typically owned large portfolios of property. And in the current challenged economic environment, the OP structure provides safety through increased diversification, a large pool of properties. And, and wait, Mr. Popeil says there’s more, the ability to capture future appreciation. Salt Meadow is the kind of property that benefits from additional capital improvements to further increase value beyond the funds held in DST reserves. And plenty of money was there and that value add has been completed. The DST structure doesn’t permit, as we’ve talked about, refinancing or recapitalizing, even if this would add value. And even if it’s in the best interest of the DST owners, the structure doesn’t permit it. While the REIT has capital to upgrade Salt Meadow and add more value to the property. And then they’re the, the so-called REIT benefits, the transparency with the majority of an independent board of directors’ financial statements by top CPA firms, and the liquidity option, that’s not possible under the DST structure.
Those are, those are some of the benefits. And, and wait, there’s more. Salt Meadow is a quality asset that should be held long term, but the revenue ruling mandates a sale when the original Fannie Mae loan matures in the REIT structure Salt Meadow can be held on a long-term basis, essentially forever. In the DST structure, investors tell me they feel like they’re having to sell their best assets as they mature, and there’s still more, in a rising interest rate environment, being able to assume favorable long-term debt is a positive. And all of that is done under section 721 without any taxable gain, federal or state to the investors. And for those various reasons, Capital Square encouraged each investor to work with their representatives, their financial advisors, their tax advisors, to determine what is best for them.
Damon Elder 41:51
So, let’s talk about the, the mechanics then of the 721 exchange in regards to this real world case study. How were the DST investors treated? I understand that the UPREIT was optional, but were investors charged different fees? On the DST disposition, depending on whether or not they chose to perform the UPREIT,
Louis Rogers 42:11
Everyone was treated the same. We focus, focus on optionality and equality. Each DST investor had complete optionality and equality regardless of their individual choice. We’ll talk about it in detail in a minute.
Damon Elder 42:29
Okay. And how many of those DST holders chose to perform the UPREIT?
Louis Rogers 42:35
The results were phenomenal. Over 85% of the investors by value selected the UPREIT option with roughly 10% structuring another DST 1031 exchange and only a small number cashing out. Those are typically deceased investors who, who have had the step up, they have dropped, they swapped till they dropped, and now they can cash out.
Damon Elder 43:00
So why do you think so many, such an overwhelming percentage of the DST owners chose to perform the UPREIT?
Louis Rogers 43:08
Because the UPREIT was an excellent solution for them. It combines a number of features, favorable tax treatment, the partnership tax treatment that we’ve talked about, increased cash flow, 42% is hard to beat, greater diversification, and many reap benefits. Because of all of those things, The Salt Meadow UPREIT transaction was an overwhelming success, and that is in a current challenging economy. We gave each investor a number of options in terms of the disposition. And it’s important to reiterate, every investor made their own decision with the advice from there, Rep, financial advisor, CPA, tax lawyer. And they were, each investor was encouraged to make their own decision. They could do one of three things. They could even combine the three things. They could exchange their DST interests for operating partnership units in the REIT under 721, the UPREIT, they could structure another 1031 exchange by having their share of the proceeds sent to the QI in the normal manner. Or they could cash out and pay tax. And they could even do some of each, they could do some UPREIT, some 1031, some cash. They could mix and match no problem. But regardless of the option selected, all investors were treated equally with the same fee structure. They all received the same fair market value appraised purchase price. And that is what makes this transaction stand out above the rest. We understand in some UPREIT transactions, investors who don’t participate in the UPREIT are treated differently. Maybe they’re charged higher fees. Maybe there’s some other disincentive resulting in a lower total return. We think investors should be treated thus same. They should make their own decisions based on what’s best for them. And the DST to UPREIT transaction is an ideal solution for the best DST properties, the ones that should be kept long term, and properties that would benefit from additional capital.
And so, DST owners are able to defer taxes just like they’ve been doing with this serial exchanging, you know, that’s not people who eat Cheerios, that’s people who exchange over and over again, that’s a joke. Serial exchangers, without the restrictions of a DST and without the need for regular reinvestment of gains. And so, for the right properties, the DST to UPREIT is an excellent solution. And in my opinion, this represents the next stage of the institutionalization of Tax Advantage real estate. Just a little history for those of you who weren’t around back in the day, we talk about a whole property where an investor owned the whole property, frequently a rental house that was your typical 1031 replacement property, and then those of you with some gray hair or no hair, you remember the TIC industry developed to provide fractionalized institutional quality real estate to regular folks.
But TICs were challenged in the 2008 recession. Since 2012, the DST structure has been working exceptionally well. All the major sponsors used the DST structure, and many successes are recorded every morning on The DI Wire. I can’t wait to wake up every morning and read about it in The DI Wire, but there are structural issues that make DSTs a relatively short-term solution. While the REIT is a long-term solution, and there are many benefits in the REIT that you just can’t have in the DST structure. And so being the old geezer on this panel, from my perspective, and that’s almost 40 years, the Salt Meadow UPREIT transaction is the fourth, and it’s the ultimate phase in the progression and institutionalization of tax advantage real estate.
Damon Elder 47:26
Well, Louis, let’s stop for a second. What do you mean there when you’re talking about the next phase in the institutionalization of tax advantage real estate? You know, what does that mean?
Louis Rogers 47:36
Yes. I mean, think back to the 80’s. Back in the 80’s, the typical investor would own a whole property or rental house, not very institutionalized. And then over time, the tenant in common industry developed and provided fractionalized institutional quality real estate to regular folks. And now, since 2012 or so, we’ve used the DST structure from a rental house that is not at all institutional to the TIC and now the DST structure, the properties have become more investment grade, the structure has become more institutional. But still the DST structure is a relatively short-term solution, where the REIT is a long-term solution. And that’s, that’s why I’m seeing this process, this evolution from an investor owning a rental house to owning an interest in an investment grade property, to now owning an interest in an operating partnership that owns many investment grade properties. That is a progression in the institutionalization of tax advantage real estate.
Damon Elder 48:52
I want to go back just a bit. We’ve talked a little bit about liquidity being one of the benefits for those who UPREIT into a REIT structure. But is liquidity a real benefit for those who perform an UPREIT into a non-traded REIT, you know, what are those options?
Louis Rogers 49:06
Yes. Well, non-traded REITs have stock redemption features that provide a measure of liquidity for the OP investors who exchange OP for stock. The traded REITs have more complete liquidity. It varies from non-trad to traded.
Damon Elder 49:22
Sure. And obviously a DST.
Louis Rogers 49:26
Has none.
Damon Elder 49:27
Doesn’t have any liquidity.
Louis Rogers 49:29
Doesn’t have any. So, you know, the non-traded have a redemption feature. They have a, what they call a death put, which sounds morbid talk a lot about death, death or disability.
Damon Elder 49:38
Benefit in all this real estate is if you die.
Louis Rogers 49:41
That is true. It’s a shame that, that, you know, the best text shelter is to die. So, we don’t want to do that. But the non-traded REITs have a redemption feature. Death or disability is usually very, very common. And also, a redemption feature over time. There are some restrictions, but it’s, it’s more than you will receive in a DST.
Damon Elder 50:07
Gotcha. And then obviously, ultimately, if a non-traded REIT were to list, you retain, you obtain full liquidity at that point, of course.
Louis Rogers 50:15
Absolutely.
Damon Elder 50:17
Okay. So, let’s go back. So, you know, Capital Square has been operating now for over a decade, and you’ve been one of the nation’s most successful sponsors of 1031 exchanges. Are you viewing the UPREIT? I’m assuming so but let me get it from your own mouth. You know, is the upbeat option going to be offered to other Capital Square DSTs? I know I’ll, there’s probably got to be a large number of them that are starting to mature.
Louis Rogers 50:39
Yes. Capital Square intends to offer the UPREIT option to many DST owners. Several years ago, Capital Square added optional under bold and underlying optional 721 language to the private placement memoranda for multifamily DSTs. And it’s very important to note this is optional and the investor makes the call to UPREIT or structure another exchange or cash out. By comparison other sponsors have what’s called a mandatory 721 feature, and that’s where the sponsor makes the, the determination that the DST property is going into the REIT. We believe the investors after consulting with their financial advisors should decide what’s best for them, whether to UPREIT exchange or cash out. And yes, Capital Square has many properties that are excellent candidates for future optional UPREIT transactions. The portfolio is large and growing of those candidates over 14,000 units and 56, 56 large number, residential communities class A and B apartments built for rent communities throughout the southeast in Texas and 3,800 lots across 14 manufactured housing communities in Florida.
Many will be excellent UPREIT candidates. And it’s important, to see the context here. There the returns on full cycle DST properties have been exceptional. On the last 12 multi-family properties sold, the average total return exceeded 186%. The IRR was over 17% and the holding period was only 4.6 years, and those are audited numbers. There are many similar properties similar to those that have been sold, that dozen that were sold that are candidates for a profitable sale in the future. Those candidates, will be potential properties for future optional UPREIT transactions. And thanks to Damon Elder, the publisher and The DI Wire for allowing me to describe the DST to UPREIT story. In conclusion, this is the most exciting time in my almost 40 years in the real estate investment business. Stay tuned the best is yet to come.
Damon Elder 53:08
Well, Louis, I want to thank you for your time and your insights. Certainly, I think we’re all learning quite a bit more about the 721, and that’s a very interesting story. So again, thank you so much.
And thank you to all of those who tuned in to watch this webinar today. Obviously for additional viewing, it’ll be available on The DI Wire pretty much in perpetuity. And thanks again so much, Louis. Thank you. Have a great day, and I’m sure we’ll be talking again soon.
Louis Rogers 53:33
Thanks everyone. Have a great day.
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