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Equity Pouring into 1031 DST Programs

The securitized 1031 exchange sector is in the midst of a revival, having surpassed $1 billion in equity raised during 2015 for the first time in six years. While investments are still nowhere near the heady days of 2006, the industry is definitely booming.

Mountain Dell Consulting, a market research and analytics firm focused on the securitized 1031 exchange marketplace, recently issued a report detailing the increased demand for securitized 1031 products.

Back in 2006, driven by the popularity of tenant-in-common/1031 exchanges and a thriving real estate market, there were 71 active sponsors that raised $3.65 billion in investor equity from 341 different programs.

In 2009, sales barely reach $229 million, and following a 5-year lull, sales started to tick back up in 2014. By 2015, the industry had raised $1.07 billion through 78 programs sponsored by 25 companies.

The DI Wire asked industry experts Keith Lampi, president and chief operating officer at Inland Private Capital Corporation, and Louis Rogers, president and chief executive officer of Capital Square 1031, what was driving the increased demand.

Both agreed that there are two significant drivers increasing demand for these products: aging baby boomers selling their rental properties, and investors who engaged in securitized 1031 offerings a decade ago that have now gone full cycle.

“Many of these property owners are part of the aging baby boomer cohort who no longer wish to have the burden of hands-on property management, which make the securitized 1031 exchange structure a great investment solution,” Lampi explains. “In addition, during the peak of the last market cycle (2005-2007), many of the securitized 1031 vehicles offered in the market place were transacted with 10-year CMBS debt which has very onerous pre-payment restrictions.”

Rogers explained further, “There is strong demand for two products in particular—highly leveraged and all cash DSTs. First, highly leveraged DSTs are sought by investors who originally exchanged into a TIC or DST many years ago and now are having their investment go ‘full cycle.’ They have to structure another Section 1031 exchange to continue to defer federal and state taxes. The second trend—all cash DSTs. All cash investors tend to be aging baby boomers – many on the West Coast – who owned rental property for decades. They paid off all of their mortgage debts and therefore have no debt replacement requirement under Section 1031, so they aim to acquire replacement property outright – without debt. They don’t want the risk of mortgages in their golden years. These are the trends over the last 12 to 18 months.”

Section 1031 of the Internal Revenue Code, which was adopted in the 1920s, 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.

Delaware statutory trusts use the 1031 exchange guidelines, but instead of an investor attempting to identify a replacement property on their own, a sponsor acquires the replacement property and sells DST shares to a number of investors – up to 499 different investors are eligible to purchase interests in a single DST. These programs differ from tenant-in-common 1031 exchanges, where up to 35 different investors own the property, each with separate deeds and LLC interests, who must vote unanimously on all decisions pertaining to the property.

In 2015, the overwhelming majority of 1031 offerings were structured as DSTs – roughly 89.5 percent – while TICs took approximately 10.5 percent of the market share.

John Harrison, the executive director and chief executive officer at ADISA, explained why he believes DSTs are preferable to TICs. “ADISA was originally founded as TICA—the Tenant-in-Common Association – so we have lived through this development. DSTs typically have the ability to secure financing more easily and attract more investors with lower investment minimums.”

He added, “A major advantage and the reason it is easier and less expensive to obtain financing is because the lender views the trustee as one borrower, instead of a TIC with up to 35 borrowers. Another preferable characteristic is that a trustee is making the decisions. Previously, up to 35 TIC investors were required to unanimously make a decision before moving forward, which made it cumbersome.”

Rogers, who structured his first TIC as outside legal counsel in 1999, added, “Helping investors diversify is my favorite part of being a DST sponsor. The minimums are very low, sometimes as little as $25,000, which means that an investor can diversify into two, three, four – maybe more DSTs. DSTs provide much better diversification than TICs, where the minimums were large, commonly $500,000 to $1 million. Many TIC investors acquired a single property and put all their eggs in one basket, while DST investors can diversify into a larger number of replacement properties. Diversification is one the best things an investor can do to reduce risk.”

According to the Mountain Dell report, the most popular asset types for 1031 exchanges in 2015 were multifamily and retail, with 56.2 percent and 30.8 percent of market share, respectively.

Rogers explained, “DST properties come in two flavors—the prototypical DST is a single tenant net leased property – commonly a retail property, medical office building, or corporate headquarters on a long term triple net lease. With a net leased property, there are fewer moving parts, fewer decisions to be made, and fewer things can go wrong that would require a difficult decision. The second flavor is a multifamily apartment community, which to qualify for exchange treatment must be master leased, typically by an affiliate of the sponsor. With multifamily properties, sponsors are acquiring new or newer properties – buying the best assets available in a given market with no obsolescence or capital needs.”

He explained that many investors believe that multifamily assets have the brightest future, but time will tell if this is the case.

“With a multifamily investment, in a rising tide, you can raise your rents every time a tenant leaves – which can be every 10-12 months. In good times, you can raise the rents dramatically, but multifamily investments are the opposite of net leased properties. They are full-service properties, so if expenses go up, then ownership ultimately pays for it. This differs from a triple net asset, where the tenant pays for virtually everything. The multifamily assets have the brightest upside in good times, but can be problematic in bad times.”

Multifamily assets are thriving because of the demographic shift that has taken place in recent years.

“Millennials are the largest demographic and they are renting, plus seniors are trading down from larger homes into nice apartments, and many Americans can’t afford to buy homes, don’t qualify or don’t want to commit to owning a home,” said Rogers. “So the demographic wave of renters is enormous, but apartments can become challenged very quickly if the economy turn negative.”

Hospitality assets have the lowest market share for 1031 exchanges at 0.06 percent, but maintain a higher first year yield at 8.9 percent compared to other asset classes that hover around 6 percent.

“Hospitality can be very risky for DSTs because hospitality typically rents by the day and, therefore, lacks long-term stability,” said Rogers. “One property can have hundreds of rooms by the airport. What happens if people don’t travel and the rooms are not rented? Hospitality can be volatile. It has the highest profit potential – but it is also has the riskiest profile. High risk, high reward is not a desirable formula for most DST investors who want to protect their hard-earned capital.”

The top four 1031 sponsors for 2015 were Inland Private with 42.2 percent of market share; Passco Companies with 14.5 percent of market share; ExchangeRight Real Estate with 8.1 percent; and Capital Square Realty Advisors with nearly 5 percent.

The industry is also keeping an eye on 506(c) 1031 offerings which allow private placement sponsors to solicit directly to accredited investors, although Rogers and Lampi both agree that these offerings are unlikely to trend in 2016.

Lampi noted, “Selling products through the broker-dealer network without using general solicitation has proven an effective avenue for most of the established sponsors in the industry. Having said that, as new sponsors enter this market, we may see more 506(c) offerings over the longer term.”

“The broker-dealers are doing extensive due diligence, vetting the sponsor, and overseeing the process, so the investor has a firm with FINRA licenses and executives in the firm with credentials protecting them, making sure that investors get a fair deal,” Rogers explained. “This is good for investors and does not exist in the world of “whole” properties where caveat emptor (let the buyer beware) is the predominant theme.”

The demand for 1031 programs in 2016 is expected to increase. As real estate continues to sell for higher prices, with more sponsors entering the market that are structuring a wider variety of asset classes in various geographic locations, according to the report.

“The industry experienced a drastic uptick in the number of sponsors participating in the space in 2015 compared to 2014, increasing to 25 from 15,” said Lampi. “This increased competitive landscape drives enhancements to the product structure that are focused on delivering value to investors, such as more competitive fee structures, with a growing emphasis on total return and exit scenarios.”

He added, “Product diversification will provide a broader range of opportunities for broker-dealers and financial advisors to offer diversification to their investors across their 1031 trade. All in, growing sponsor participation, expansion into new asset classes, and an evolving product structure will be key elements that drive industry evolution for years to come.”

Rogers expects that in the near term, 1031 exchanges will continue to evolve and react to the needs of the all cash and high leverage investors.

“As the older deals cycle out, the demand for high leverage DSTs will follow suit. There won’t be as much need for high leverage DSTs in the future,” he said.

John Harrison noted that there has been background noise in Washington about changing the tax treatment of 1031 exchanges. ADISA and other associations sponsored two key studies focused on the impact of Section 1031 exchanges, and ADISA has been involved in the review of these studies.

“I have personally made several trips to the Hill and met with House Budget Chair Tom Price (R-GA). His tax experts, as well as many in Congress, are realizing the instrumental value of the 1031 like-kind exchange tax code,” said Harrison. “Additionally, ADISA’s legislative and regulatory committee sponsored a website that enables members to quickly craft a message highlighting their concerns about any potential repeal or limitation of IRS Section 1031, which will be immediately sent to their member of Congress. We are strongly encouraging our members to take action.”

Harrison agrees that the market for these programs will continue to flourish in the near-term, saying “I don’t believe changes will be made to the tax code affecting Section 1031. It would be detrimental to the economy. I predict strong, continued growth over the next couple of years.”

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