Video: Section 1031 Exchanges – Yesterday, Today & Tomorrow
At the most recent ADISA annual conference, The DI Wire sat down with Inland Private Capital Corporation president Keith Lampi to discuss the long-running history and evolution of 1031 exchanges and provide an in-depth look at this growing investment strategy.
Video Transcript
Damon Elder 00:08
Welcome to another edition of Focus on Alternatives hosted by ADISA. My name’s Damon Elder, I’m the publisher of The DI Wire.com and I’m joined today by Keith Lampi, president of Inland Private Capital Corporation the nation’s largest sponsor of securitized 1031 exchanges. Surprisingly enough today we’re going to be discussing section 1031 exchanges, Keith thanks for joining us.
Keith Lampi 00:29
Thanks for having me.
Damon Elder 00:30
So, Keith why don’t we start with the basics you know what exactly is section 1031 of the tax code what’s a 1031 exchange what are the benefits to investors and participating in them?
Keith Lampi 00:40
Sure, Section 1031 very powerful section of the tax code, it’s actually not new it’s about 100 years old it was added to the code in 1921 so we really are getting close to 100 years…
Damon Elder 00:52
For farmers, right?
Keith Lampi 00:53
Typically, farmers were buying and selling trading land, you know sell one piece at one parcel and exchange into another parcel. So, what a 1031 exchange is is it’s a section in the tax code that gives investors of or property owners an opportunity to sell their current holding and rather than pay capital gains tax on that sale. If they reinvest into real estate like kind real estate meaning investment property for investment property, they’re able to defer the gain that was that would normally been triggered on sale and roll their proceeds into real estate. So like kind exchanges also sometimes considered are sometimes referred to as you know property… property trades buying one selling selling one buying another, that’s typically how 1031’s work.
Now the securitized 1031 exchange in the industry really kind of was born in the the late 90s early 2000s. And this was an opportunity where rather than selling one parcel and buying another the securitized structure gave investors an opportunity to buy into larger properties larger holdings own a fractional interest in that particular larger holding, and that was a a new nuance that really gave investors a chance to sell properties that they were actively managing and buying the properties that they could own in a more passive type ownership…
Damon Elder 02:17
Professional management they call it what’s the mailbox money where you invest your proceeds let the asset manager manage and hopefully, they are able to send you a steady flow of cash distributions.
Keith Lampi 02:27
That’s right that’s right. So typically, these are sponsored by firms that are in the investment management business, so firms will identify properties that they think have a a viable long-term strategy. They’ll package them in such a way where they qualify as like kind real estate for section under section 1031, and then investors can buy into those programs with varying dollars. You know some investors may come to the table with $100,000 – $200,000 and they’ll own a smaller percentage of the total in addition larger investors with you know seven figure sums can also invest in the same pieces of property and everybody has kind of a different ownership percentage at that point.
Damon Elder 03:09
It’s not one and done right. I mean there’s actually a perpetual nature to 1031 exchanges, if the investor chooses, they can invest and then when that investment goes full cycle, they could actually reinvest into another 1031 exchange is that correct?
Keith Lampi 03:22
That’s correct so that’s that’s really what is so powerful about this section of the tax code. It’s not it’s not a forgiveness of tax right, you’re you’re selling property you’re investing in real estate and you’re deferring your taxes. But that is perpetual so that can occur in a series of transactions if you think about an investor that’s actively buying and selling real estate, they may have done four or five six different 1031 exchanges and it’s a perpetuating deferral mechanism as long as they reinvest in like kind of real estate, they continue to defer that tax. And many investors use it as in the state planning tool, the way the code is currently written upon death an investors heirs will inherit their real estate at a step up in cost basis. So, a lot of investors over time have very low basis and very substantial gain they continue to defer that gain and and and are active in investing in real estate. Later in life when you get closer to that that point in time where you know you’re your heirs would consider owning owning the real estate they’ve received that step up in basis and that’s it that’s a huge component.
Damon Elder 04:25
Essentially what you’re talking about is pretty much an elimination of the capital gains tax.
Keith Lampi 04:29
At that point in time, right.
Damon Elder 04:30
Wow, that’s very powerful… Interesting. So, Keith for the previous 15 years or so the securitized 1031 exchange industry has focused on some particular asset types. What in the past we’re the most popular and, how have we transitioned what are we seeing today that work best in that structure?
Keith Lampi 04:49
The industry’s come a long way, over the past 15 years. And you know it was a kind of an early day’s kind of a small cottage industry. Really you know throughout the course of the past decade plus, it’s really evolved and grown and and sector expansion has been something that’s really kind of driven that. So, 10, 15 years ago we were seeing a lot of triple net lease long term credit plays mostly in the office and retail sector. And that really kind of dominated the space. Today you know it’s it’s really evolved in a in a way that’s that’s spread and expanded the the menu of options that investors have to participate in.
So, we’re seeing a lot of activity in the residential multifamily space, and that’s kind of anchored our industry if you if you kind of look at where sales are occurring today. But there’s more to it than that, we’re seeing activity in some alternative space alternative sectors such as self storage healthcare related assets some student housing properties some industrial. So so there really has been a a growth trajectory in in that diversification that our industry is bringing investors which I think has been a great trend to be active in participating in.
Damon Elder 06:00
Multifamily seems to be particularly attractive. Is that from an investor perspective. Do they understand apartments? So, they’re more comfortable investing their dollars there. Does multifamily generally have make for a better fit in a 1031 exchange. You know why is multifamily such a popular component of that asset mix.
Keith Lampi 06:20
I think multifamily really does resonate with our our clientele. You know if you think about the the typical securitized 1031 exchange investor, typically it’s an investor that’s coming out of an active ownership role in real estate. They’ve they’ve actively managed their properties for for a number of years, and when they get to considering a a securitized 1031 exchange, they’re ready to relinquish active management they want to get into something more passive. Oftentimes what they were investing in was a residential piece of property, so apartments seem to fit that that mold quite well.
It’s it’s not hard for them to get their mind around it. In addition, I think apartments are really well suited for some of the nuances that Delaware Statutory Trust, which is the structure securitized transactions kind of fit into. Apartments work really well in that structure, so I think for for a lot of those different reasons apartments have been popular. That said, we’ve we have seen the apartment activity expand and now it’s beginning to contract a little bit. I think as an investor investors see different opportunities to diversify and and grow and and and spread their their dollars across different investment strategies that concept of diversification is also really resonated.
Damon Elder 07:35
Keith in the early part of the century in the 2000’s 1031 exchanges were growing in popularity every year leading into the Great Recession, at the height I think it was something like $4 billion had been invested and maybe it was O8, O7. And then obviously the Great Recession came along bad for everything including real estate of course. And for several years we really saw almost no securities 1031 exchange volume. And then in the early part of this decade started slowly growing and I think now we’ve really seen quite an explosion. What are you seeing out there?
Keith Lampi 08:05
It has it’s been a a growing industry right from a from a sales perspective. So oftentimes sales and 1031 exchange markets are going to track with the general growth trajectory of the economy. So in 2010 2011 property owners didn’t have the necessarily the gain on sale to defer or perhaps they just didn’t like their valuation so they weren’t considering selling or monetizing their the previous holding. As recovery took hold as we saw the economy continue to kind of find its foothold and and and you know increase asset values, that’s driven sales velocity between the 2012 and and where we are today era. So, what’s really been interesting is at the peak of the last market cycle we talked about you know what what asset types were being presented to investors. There were some structural tweaks. I I feel like the the quiet years of 2010 and 2011 really was kind of an introspective moment for for industry participants. It gave us a chance to evaluate what was done previously, look at our structure the structure in ways that we felt we put investors in a better long-term position, and I think that phenomenon has really catapulted sales in in this this recent era of this this recent market cycle.
Damon Elder 09:27
And I have to assume that we probably I know we’ve been seeing in the DIY has been reporting quite broadly, a lot of 1031 exchange sponsors have been taking programs full cycle that they invested in in the early part of this decade. Obviously, there’s been tremendous valuation increases and they’ve done some nice full cycle events that we’ve seen massive returns to investors very very attractive returns at the very least. And that money is probably be recycled like you said the the cumulative effect of a 1031 exchange can be very powerful.
Keith Lampi 09:55
Yeah, and that’s that’s that’s great I think that’s really important on a on a number of levels. You know first full cycle activity I think is a function of the fact that what once was this new cottage industry and and and now we’re at a point where we’ve got almost two decades under our belt. We’re no longer that that new cottage industry, we’re a we’re a mature industry that has previous investing transactor activity that that is now being you know profits are being harvested and and transactions are going full cycle. And that that of course has helped drive the the sales velocity that we’re seeing today. But in addition, full cycle activity helps to kind of underscore that these programs do work. It improves concept it shows investors that this is a structure that’s viable.
Damon Elder 10:42
Proven.
Keith Lampi 10:43
Proven structure, I think a lot of a lot of the full cycle activity are programs that were put together in 2012 2013 kind of post retooling of some of the the fees and expenses that the new kind of changes within the Delaware Statutory Trusts that that many industry participants had kind of melded into their offering structure. And so, it’s it’s a bit of a vindication moment I think for our industry and I really think positions as well long term.
Damon Elder 11:10
So, the preferred structure for 1031 exchanges in the securitized world in the last decade or so have been Delaware Statutory Trusts. What are the… why has the industry transitioned away from the old tenant in common structure that we saw a decade or more ago to the Delaware statutory trust DST? What’s the benefit there from investors?
Keith Lampi 11:28
Two other benefits which are more prevalent when when investors evaluating a program. The tenant common structure limited the number of investors to 35. So, what that oftentimes led to or presented investors was a very high minimum threshold. It wasn’t uncommon to see a program that had a $400,000, $500,000 minimum investment. The Delaware statutory trust allows sponsors to take in up to 2,000 investors, now we never get anywhere close to that number but what it allows sponsors to do is substantially reduce the minimum investment threshold that that they ask investors to to come in with. So in in effect it’s it’s a structure that encourages diversification. You know if you’ve got an investor that has three or $400,000 in proceeds with the TIC structure, they kind of had to put all their eggs in one basket, with the DST structure they had the opportunity to pick two or three different properties or offerings with you know geographic diversification, sector diversification, and also you know sponsor diversification so…
Damon Elder 12:31
Right, you’d much prefer for them to stick with the one sponsor but.
Keith Lampi 12:33
Absolutely, right.
Damon Elder 12:34
Massive diversification allowances with DST structure.
Keith Lampi 12:37
It’s it’s never a bad thing. I think diversification puts our our industry in a better position. That was one of the the key issues that the TIC structure presented. And and and then the last point is the Delaware Statutory Trust structure the Delaware Statutory Trust structure allows sponsors to pool assets. Now that it’s not a blind pool structure they have to be defined assets, but it’s not uncommon for a sponsor to have two or three different properties within one DST. So again, staying with the diversification theme there’s just a lot more optionality for investors to consider and position themselves long term with a diversified portfolio.
Damon Elder 13:17
So, Keith we’ve really had seen a tremendous rebound in the 1031 securitized marketplace. I mean I think the number I’ve heard most recently is it’s gonna raise something like 3.2 billion this year, which is massive growth over last year, and approaching the record which I think was about four billion before the recession. Where are we going? What changes do you foresee in the industry? What’s going to happen in the next three five years?
Keith Lampi 13:40
I think the industry is poised for continued growth, this year is is absolutely a big growth year for the industry I think to your point that if we do hit or achieve that $3.2 billion figure that’s about a 30% growth rate from where sales velocity was last year. So, growth has been consistent it’s been steady, and I do see that trend continuing. Now real estate I think across numerous sectors most would consider real estate being fully fully priced, the low hanging fruits been picked a lot of investors are selling their properties because they’re highly appreciated and they’re harvesting gains. So, it’s very important for investors to have an opportunity to invest in sectors and strategies that they think makes sense long-term given where we are in this market cycle. I think industry participants are thinking about that, they’re they’re bringing strategies in sectors to market that are mindful of kind of where we are today and where where we’re going that’s good that’s a good thing long term.
The the phenomenon of the aging baby boomer cohort getting to that point in their lives where they want to take an active actively managed property sell it but they’re looking for a a strategy to deal with the capital gains, that’s that’s a mainstay that’s not going away so. I think just that that fundamental concept will continue to drive sales velocity for years to come. And then finally as a mature industry and and continuing to mature I think full cycle activity is going to continue to occur. So, you know the three to five year projection in my mind I don’t see any major upswing or downswing. I think it’s it’s steady growth from here on out, and you know barring barring a major correction in in the financial markets I think the the industry is really well positioned for the future.
Damon Elder 15:35
So, Keith you mentioned that you know real estate valuations have really come back to even above now I think posts are prerecession highs. So does the 1031 structure continue to make real estate investment attractive, because the tax advantages even if you were to evaluate and say look these properties are pretty highly priced why would you still want to investment in real estate?
Keith Lampi 15:58
It really does depend on the the investor and their their basis and kind of where they are in their investing life cycle. But I think there’s a as a general rule of thumb, the tax benefits are pretty substantial and are substantial enough to to make it make sense to stay with real estate. Psychologically a lot of these these investors are property owners they’ve been property owners for a long time that’s kind of embedded in their their DNA, so there’s there’s that desire to stay with real estate. So, the the phenomenon within 1031 exchanges is you’re you’re buying and selling in the same market. So, if we believe we’re in kind of the the late the late point of the cycle you’re selling high you’re also buying it at a higher valuation, that’s why it’s so important to evaluate what makes sense given where we are today.
You know I think a lot of strategies that will probably grow in in the way of sectors that are that gain popularity are those late cycle sectors that have performed well at a point in time where a correction occurred. So, there’s a heavy focal point on properties like self-storage, student housing, healthcare related assets. These are all late cycle strategies that investors have evaluated performed well and at the peak of the last market cycle should should perform well long term. And yes, I’m coming in at a fully priced valuation but overtime you know real estate will continue to appreciate if it’s managed well and and the investment management strategy is appropriately implemented.
Damon Elder 17:32
And I would imagine a lot of 1031 investors or folks who are more interested in steady cash flow from the the proceeds of the properties you know management and being run the distributions. And then also the tax benefit so maybe they’re not necessarily looking for a big appreciation pop again they’re really looking for that steady income flow and the 1031 benefit.
Keith Lampi 17:52
That that’s a great point. I I think you know generally speaking when an investor gets to the point where they’re considering a securitized vehicle, they’re very cash flow oriented. I used the baseball analogy, they’ve they’ve swung for the fences, and they’ve hit their home runs and now they’re looking for preservation of capital stable income and and and modest appreciation. So, kind of the the back of the napkin after tax analysis. If an investor were to cash out pay their taxes and you know let’s say they had 65 – 70% of the dollars that they normally would have had to reinvest into something else, and you kind of compare and contrast the two. Doing a deferral into it another 1031 putting the 100% of those dollars to work generating income on 100% of those dollars makes a lot of sense on a on a risk adjusted basis.
Damon Elder 18:42
Well Keith, thanks so much for sharing your wisdom and your insights. It sounds to me like the 1031 exchange industries and the great point and skies the limit. So that’s great a lot of investors and Americans taking advantage of this very powerful section of the tax code. So, thanks so much.
Thanks for joining us and thank you for watching. For more information on 1031 exchanges Delaware Statutory Trusts and all things regarding alternative investing please visit adisa.org
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