Webinar: All About UPREITs, 1031 and 721 Exchanges

Interested in the latest ways to build potential wealth with alternative investments? Increasingly, real estate investment trust sponsors are providing tax-deferred 1031-to-721 exchanges that ultimately are converted into REIT shares. The DI Wire recently hosted a panel for financial advisers, investors, and others interested in learning more about 721 exchange UPREIT investment programs. Watch to learn more from leaders in the industry.

 

 

 

 

Video Transcript

Damon Elder 00:10

Hello and welcome to The DI Wire webinar. Today we’re going to be talking all about UPREITs, 1031 and 721 Exchanges. I’m Damon Elder, publisher of TheDIWire.com, and today we’re joined by a supersized panel of heavyweights from throughout the alternative investing universe to discuss one of the growing investment options in the industry, 721 Exchange UPREITs. At the recent ADISA conference in Las Vegas, I was wandering around and going in several of the breakout sessions, and one that I walked into was on this very topic and it was literally standing room only. So, I know there’s a ton of interest out there about these 721 UPREITs. And so, we’ve recompiled the panel and we’ve brought them here today for this webinar. And that panel’s comprised of Jay Frank, who’s the president of Cantor Fitzgerald Asset Management. Matt Fries, head of investment products at Cetera Financial Group, Nati Kiferbaum with Inland Private Capital, Mark Kosanke, one of the founders of Concord Investment Services, and he has also been a long-term member of the Board of ADISA. And then finally, Louis Rogers, who’s the founder and Co-CEO of Capital Square. Also, Louis… for those of you who know your 1031 Exchanges history know Louis was among one of the first attorneys, if not the first, to package a 1031 Exchange into a securitized investment product. So, you know it’s fair to say that he’s one of the founders of this multi-billion-dollar industry. So why don’t we start with you, Louis. You know, why don’t you walk us through the basics. You know, what is a 721 Exchange UPREIT?

Louis Rogers 01:35

Thank you, Damon, thank you other panelists. Let’s first talk about the structure and lay the groundwork here. UPREITs have been around for a long time. Sam Zell has best been known for the structure. In an UPREIT transaction the owners of real estate contribute their property to the operating partnership of a REIT. The contributor becomes a partner in the REIT’s operating partnership. And it’s important to understand the structure, REITs typically own their real estate and an operating partnership, and the operating partnership owns many properties. So, the owner of a single property becomes a partner in a multi-asset partnership that’s operated by the REIT. That’s a typical UPREIT. And you ask, what are the tax ramifications? Well, section 721 of the Internal Revenue Code, that’s the provision that governs, it’s a very common provision dealing with entities taxed as tax partnerships. It provides that when the owner contributes property to a partnership in return for interest in a partnership, there’s no taxable gain to the contributor or to the partnership, very simple. Put property in, take out partnership interest, no tax.

Now for the DST variety of UPREIT, DST owners have previously acquired their DST interests as replacement property in section 1031 exchanges. DST owners contribute their DST interests to the operating partnership of a REIT, same as the typical transaction, except DST interests are being contributed instead of a whole property. It’s pretty simple, it’s very similar, 721 and 1031 are very similar. 721 deals with partnership contributions, 1031 with tax deferred exchanges. They could not be more different in their purpose, but they operate in a very similar manner. You ask how so? So well both involve tax deferral and carryover basis. There is no immediate taxation on partnership contributions under 721. Just like there’s no immediate taxation with a complete 1031 exchange. In both cases, the tax basis carries over the contributor or the exchanger, their tax basis carries over to the partnership interest or the replacement property. The tax is deferred until the partnership interest, or the replacement property is sold in a taxable transaction. But note under 1031, you can exchange over and over and over again deferring taxes for a very long time. The DST contribution is not a taxable sale, it’s a 721 that defers the tax. So, important to note that DST UPREITs must be done in two steps. You say why two steps? Well, first, a section 1031 exchange into a qualifying replacement property. DSTs qualify as like kind replacement property under a revenue ruling, but interest in a partnership are not like kind to real estate. They do not qualify for 1031 treatment. I think it was back in 84 when Congress amended 1031 to eliminate partnership interests from 1031 exchange treatment. So, we do what’s called the two step, we 1031 Exchange into a DST. And then later, typically two years or so, the DST owners contribute their DST interests to the operating partnership in exchange for the REITs operating partnership interests, so-called OP units. This is done under section 721. And then regarding the timing, Damon, you ask about the timing, section 1031 is all about timing. It has a number of timelines, 45 days to identify, 180 days to close. But 721 does not have any statutory timelines. There’s no qualified intermediary or exchange agreement. Section 721 operates simply and easily.

Damon Elder 05:42

Thanks Louis. So, Jay, I want you to jump in there, but, you know, we’ve seen a lot of non-listed REITs introduced 1031 Exchange programs that include an option for the REIT to then acquire the DST asset after a couple of years or so and move it into the REIT via 721 UPREIT process. Many of these non-listed REITs are raising significant investor equity through these programs. So, kind of walk us through that. What are the benefits to the investors and, and similarly, what are the benefits to the sponsors?

Jay Frank 06:13

Couple things, well said Lewis. Let’s go back a little history. Section 1031, 1921, a hundred three-year-old legislation. Section 721, 1954. We’re talking 70 years for section 721, even though this might be a new thing for people here, and remember this is IRC section 721, IRC, section 1031. So, this isn’t some aggressive tax stance or some gray area of the tax code. This is part of the tax code. Number two, let me, let me simplify this. 1031 Exchange, you’re selling real property, you exchange in a real property, you follow the rules laid out in the code and you defer your taxes indefinitely. Section 721, you’re doing the exact same thing except you’re exchanging real property into the OP of the REIT tax deferred the whole way. So that what we’re talking about here and the two step to get there, Louis, right? So, what is the benefit, the benefit of both of those? It’s tax deferral, right? So, whether we’re talking about a 721 or 1031, it’s about tax deferral. It’s about generating income off that larger amount of money, because you didn’t have to pay taxes on it. And it’s about what that asset you invest in, how it can appreciate over time. Why is 721 and the two-step gained in popularity? Cause you take those three ideas, right, which are you know, exist in both parts of the code and you add on some additional diversification in a much larger REIT. You add on more liquidity depending on the type of REIT that you’re in. But most of these non-trade REITs have a monthly share repurchase program, right? So, you have a lot more liquidity, and you add in a lot more flexibility. And so, imagine, you know, would you rather own a single asset in a single market? Or would you rather be diversified in a, say a multi-billion-dollar REIT with, I don’t know, several dozen assets in several dozen different markets that’s institutionally managed. All right? So that’s interesting. So right, that’s just risk management, diversification 101.

Number two, let’s say that there’s five siblings or five friends that were selling that property. When you come up into the REIT through the 721, those interests can be divisible between the owners. You can’t necessarily do that when you’re in a 1031 exchange. So, there’s some interesting applications there. And then last, it’s about the future potential liquidity when you’re in the REITs partnership. Let’s say it’s a married couple and one of them pass away, there’s a partial step up in basis. You could redeem half of your investment to get liquidity on that stepped-up basis. Let’s say it’s a million-dollar exchange and your advisor, your CPA can generate $50,000 a year and carry forward losses from elsewhere in your portfolio. You could redeem $50,000 a year from the share of purchase program and offset that taxable event by those carry forward losses. Or let’s just say you pass away, and you have a full step up in basis you can get out. So those are some of the reasons why it’s good for an investor, right?

You also asked why is it good for the sponsor? The sponsor can raise capital in these programs, right? So, whether you’re raising a DST wrapper or a REIT wrapper or some partnership wrapper you’re trying to raise capital and grow your business. So, this is a way to raise capital because people want these for all the reasons that Louis and I just explained. Number two, you raise these things in the DST that ultimately get UPREITed, you’re now growing your larger permanent capital vehicle, you’re growing it, you’re getting a sticky capital, something that has a low or no basis that’s going to be of a very long-term horizon that’s very sticky and permanent capital. It’s very good for the sponsor. And obviously you’re going to make your management fees that the REIT lays out. So, I always think about this DST two step program, It’s kind of like your AAA baseball team for a major league ball club. You got your all stars on the baseball team, but you’re drafting, you’re trading, you’re recruiting, you’re developing players in the minors that are one day going to be part of that big league and contribute at the big-league level. We’re just building AAA players. They’re going to come up to the big-league team and want to be part of that team for a very long time. So, it’s good for the sponsor, it’s good for the investor if it’s the right investor. And it’s, it’s good for the wealth management community because they can help the client solve a problem, grow their assets under management and ultimately grow their practice.

Louis Rogers 10:19

And if you think about it, big picture, we have investors who had a rent house that they exchanged into a DST that owns an investment grade property and then they end up in a diversified operating partnership of investment grade properties. They could have never purchased a hundred-million-dollar property on their own. They could have never in invested in a billion-dollar portfolio of properties. I think this is the ultimate phase in the institutionalization of regular Ma and Pa Real Estate.

Damon Elder 10:49

Let’s go to Mark for a moment because Mark’s a financial advisor and he’s actually working with investors and he utilizes 1031s and I think now 721s in his practice. Obviously one of the major interests in investors in these programs is tax deferral. So, tax is a big part of both 1031s and ultimately these 721s. So, Mark, from a, in the weeds kind of perspective, how does one of your clients or any client’s level of tax sheltering change, when you execute the 721?

Mark Kosanke 11:22

Well, obviously when once you’ve done the 1031 you’ve already completed the sheltering of the capital gain, that’s kind of step one, right? And then by participating in the 721, that tax sheltering continues, I’m still deferring my capital gains tax and that’s the ultimate goal, right? Swap to your drop, you know, pass it on to our beneficiaries with the capital gains tax going away. The 721 from a tax sheltering standpoint still offers the pass through of things like depreciation and certain expenses that the client would be incurring on an ongoing basis. So, from a tax sheltering standpoint, I still get to deduct the things I normally would deduct even on the DST or on a property that I own for myself. Sheltering might be a little bit different because of the combined basic calculations, the tax basis calculations inside of the UPREIT as opposed to one-on-one, but generally, it’s going to be fairly insignificant for most clients. So, the real key is, I continue my deferring of the capital gains, and I continue to shelter the income using the depreciation either directly in a DST or in a combined basis when I’m in the UPREIT.

Damon Elder 12:46

And is there any change to the tax reporting for those investors?

Mark Kosanke 12:49

The 721 is going to issue a K1, and so that’s going to be a different reporting than a client who either on his DST is either doing the reporting on a Schedule C or on an 8825. So, there’s a different type of reporting, a different form that is provided to the client for the information to show on their tax return and a different place on the tax return where that information’s going to show up. But for the most part, the level of the sheltering should stay the same.

Damon Elder 13:28

Well let’s turn back to the real estate then, because I want to bring Nati in. Nati, what is an ideal type of property for a 721 Exchange? What’s the appropriate real estate that you would do this for?

Nati Kiferbaum 13:43

It’s a good question. Really in practice, all real estate would work for a 721 exchange, no different than a 1031 exchange, despite the IRS being very stringent, they’re very liberal when it comes to what’s considered like kind. But specific to sort of the DST structure, if we’re sort of characterizing it as a mandatory 721 Exchange, when you think about that in comparison to traditional 1031s, most 1031 Exchanges are typically held in the DST wrapper for 7 to 10 years. And a lot of that is driven by financing, long-term fixed rate financing, long-term leases if you’re doing net lease real estate. And so, you have a longer period of time to sort of overcome the load, grow your NOI and exit hopefully fruitfully. When you think about the 721 Exchange, typically most of the sponsors in the space are holding that real estate and the DST for two years. And then bringing it into the REIT. So, a much shorter period of time. So, when you think about that through the lens of NOI growth, typically net lease assets don’t exactly provide you necessarily as much in the way of NOI growth as maybe operating assets potentially could when they’re being repriced on a monthly basis in the case of self-storage or on an annual basis, in the case of many rental housing asset classes. So, because 721 DSTs provide price discovery on a more frequent basis, you typically see the potential benefit for operating assets being contributed to the REITs as being a little bit more elegant than net lease assets. Again, all asset classes work here, but given the amount of price discovery you see the likelihood of the REIT being able to actually acquire that asset for at least, if not more than what the DST initially acquired the asset for is highly likely.

Jay Frank 15:36

I’d add Nati, that what we’ve found is there’s assets that you probably wouldn’t consider for a regular way DST, because of the binary nature, you buy managed sell, you need to exit before the debt comes due for the most part. There are things you can’t do in a DST, refinance the debt, capital call, renegotiate a major lease, etc. So, you tend to avoid multi-tenant type properties, multi-tenant office or multi-tenant retailer, multi-tenant industrial, some of the or shorter duration type lease stuff like industrial property with five years on the lease. Some of that stuff actually works in the 721, because you plan a call up into the REIT within two or three years. And when that conversion from DST to the OP and the REIT happens, the DST structure wrapper is collapsed, and all those restrictions of the DST wrapper go away. So, you could use shorter debt, shorter term debt. You could do assets, you know, like I said with shorter duration leases. So, I will say that the 721 2-step opens up to a wider segment of real estate.

Nati Kiferbaum 16:41

My only counter to that is it doesn’t remove the risk that’s inherent. So as long as the REIT obviously is able to sort of absorb that level of risk with lease renewals, etc, I Totally agree. So, it does open it up quite a bit, but it can certainly mask bringing in certain assets and certain property types that may not make sense for the REIT either, but I totally agree with you.

Damon Elder 17:06

One of the things that you brought up Jay there is the refinance issue. A lot of these DSTs, again, you can’t refinance them. So, if it’s a really attractive asset, you want to retain ownership, you don’t necessarily want to swap out of it. Is that one of the things that’s kind of driving the popularity of these 721 UPREITs then? You can still maintain some level of ownership of that attractive asset while like you said earlier, diversifying into a larger pool of assets.

Jay Frank 17:29

Certainly, for the REIT sponsor, like, just like I talked about with the baseball minor league system. You’re drafting a guy out of college or out of high school because you’re going to develop that guy, and you think he’s going to contribute to the ball club for years down the line. Same thing here, any sponsor that buys the asset for DST execution with the 721-upgrade option, they’re doing so because that asset fits that REIT and where that REIT wants to be in two, three, four years down the line. So absolutely the REIT’s life will transcend the length of the debt. And obviously you can refinance that debt inside the REIT.

Nati Kiferbaum 18:02

This is certainly a sponsor benefit of the REIT; is you’re seeing a lot of sponsors structure their 721 DSTs on an unlevered basis. So, when you sort of think about that as you transcend that asset or multiple assets into the REIT, now the REIT actually has the opportunity to recapitalize the asset and in many instances that now gets utilized to buy more real estate or in part provide liquidity needs or paying down debt at the REIT level. So, a lot of elegant enhancements for the REIT sponsors, it relates to syndicating on an unlevered basis at the DST level.

Damon Elder 18:38

Louis, I know you wanted to add something there. Why don’t we turn to you real quick?

Louis Rogers 18:41

Well, the DST is the greatest structure for 1031, so much better than what we used to use. But it is a very restrictive structure. It’s a fixed investment trust, you can’t refinance or add debt. And so, for a lot of properties where you could add value, you don’t have the capital, you can’t refinance, it becomes very problematic where the REIT doesn’t have those issues at all.

Jay Frank 19:08

Well said, I didn’t get there. And that’s right, value-add assets that you don’t want to reserve upfront could, it’s, you can do light value add in DST-land, but not real value add and there’s great investment opportunities there, right? And this 721 actually opens that play up.

Damon Elder 19:24

Yeah, and managing properties within the REIT is much less restrictive.

Matt Fries 19:27

So, one thing I would add, right? So, it’s clear that this is a different structure and potentially different real estate investments make sense. I think the part that needs to get discussed a little bit more here, and I know we’re going too soon, is what about the client, right? Because just like different investment properties fit in here, I would argue, and I think based on the nodding of heads, the panelists would agree, this is going to be marketed to a different client, right? So, I want to make sure as we’re kind of going through this, there are some amazing benefits to this structure, but it’s not going to be right for every investor. From our perspective at Cetera, we believe that there are strong benefits that make us comfortable offering this, but we also offer the traditional 1031 as well because they’re really going to appeal to two different sets of investors. And giving the investor that choice, educating them as to kind of the potential risks of both strategies, because they both have risks. and then letting them make the right decision for them, I think is vital in terms of kind of running a platform.

Damon Elder 20:28

Matt let’s stick with you because I was getting right to that question. What is the type of investor that’s going to benefit most from a 721?

Matt Fries 20:36

Yeah, so you know, I think there are a lot of different variations to this answer based on broker dealers. So, I’ll give you kind of my perspective at Cetera, and certainly, others might feel differently. The benefit to the 1031 structure is that it allows the investor to stay in control. And what I mean by that is they can pick this particular product, let’s say they’re going to hold it that 7-to-10-year timeframe, there’s an exit and then they have the option of determining what they want to do with those dollars. Do they go into another 1031? Do they take the proceeds and pay taxes? It’s really up to them and they can be very specific in terms of controlling where those dollars are. You contrast that to the 721, in my opinion, the biggest benefit of the 721 is the diversification. That to me is the best-selling point. There’s a lot of other things, but you get diversification, which arguably makes your investments safer, but you also lose the ability to control where those dollars are going to be invested in the future because that’s now decisions that are going to be made by the REIT company. You know, certainly if you are a younger investor who has a very long expected life going into a 721, you could end up being in a situation where you feel trapped because you don’t want to liquidate because you don’t want to incur the taxes and maybe there’s, you don’t have a lot of basis to kind of help you get out and you could have a very long-term hold in there. Certainly, I can tell you for any of the REITs on our platform, we feel really good about them right now. I wouldn’t say that five years from now we’re going to feel equally as good, right? So, you are taking some longevity risk by going in there. Certainly, there is liquidity and that is a benefit, but the client has to understand if they sell, that’s going to trigger the capital gain, right? So, kind of making sure they understand that and then really, I mean to me it gets back to how much control does that investor want. A lot of the clients that have traditionally invested in 1031s through Cetera, they love that aspect of it. They love being able to read kind of different offering documents and understanding, okay, now I want to do multifamily in this market and you’re going to lose that, right? So, it’s just a matter of kind of balancing the pluses and minuses.

Mark Kosanke 22:44

I agree with what Matt said because you know, working directly with clients, you have younger clients, some who are much more involved with their properties, so they like that process. You know, I’ve got clients who are now on their fourth full cycle event where they’ve exchange and exchanged again, exchange again and they like that, and they’re more active. Contrasted to somebody who really hasn’t done a lot of real estate, they just ended up owning something for some reason and they don’t want to be bothered with that. And yeah, they want to do this one time and be done and then ride it out until the day you can pass it on with stepped up basis. Certainly, older clients I see in our practice are much more, I mean, I can do this once and I don’t have to worry about doing this again? I’m going to be diversified into an UPREIT, I’m like, yeah, and they feel good about that. Whereas to your point, Matt, some of the younger ones like, well, you know, this looks good, but this is a brand-new property, it’s not going to be brand new seven years now. I like the fact that we are doing something different, and I’ve had, you know, some clients do really well with that flip too. So, it’s you know, you got to read the client, you got to read what they’re looking for and then there’s always a combination you can do with clients as well. I think that makes a lot of sense too.

Louis Rogers 24:02

That’s exactly what we see in the field. When you’re young, you buy a rental house, maybe you exchange it for a duplex or a quad, you wake up one day and you have a bunch of kids and a bustling career as a CPA billing hours and you’re too busy to manage your property, so you exchange into a DST that’s passive. And then as you get older, you’ve done a few exchanges, you’re getting closer to dropping and you’re tired of swapping and you say, this UPREIT thing is perfect, the estate planning and the step up in basis on death, all those things are wonderful. It’s an excellent option for lots of people.

Matt Fries 24:40

Yeah, it’s that optionality, the choice I think is the most important thing to be able to offer both to your clients.

Mark Kosanke 24:48

The other thing I’ve seen in my practice is typically not to be sexist, but the male of the family is running the properties and making these decisions and kind of rolling this along and to them it’s attractive that if something happens to them, the properties in an UPREIT and their spouse or family doesn’t have to make the decision because typically the guy’s been running the thing, making decisions, selling the properties, managing the properties, and the wife or kids haven’t been that involved. And I see the stress sometimes with those gentlemen that, gee, if something happens to me, my wife or kids aren’t going to know boo what to do with all this. And, and the same would go for a DST property. But by going into the 721 again, they’re done. There’s no, there’s no more decision to be made other than liquidity down the road when they’re ready for that. So, I think it’s a, a comfort zone for, for people like that as well.

Damon Elder 25:45

So, is a 721 Exchange just as effective from an estate planning perspective as a 1031? I think a common misconception out there is that you would lose, or the heirs would lose the step up in basis, if it were a 721 Exchange versus a 1031.

Louis Rogers 26:02

It’s a little better because as Jay said, the units are divisible, dividable, you can give them to kids, grandkids, and it’s just easier to do your estate planning. But you get to the same result. The only problem is you have to die to get it.

Matt Fries 26:20

You do get the step up.

Jay Frank 26:22

You do not lose your step up in a partnership. That’s what I was talking about earlier. That’s actually the beauty, so that same young person became a CPA that Lewis was telling the story, or Mark, he’s the guy that makes the decision that in that family, for whatever reason. You might want to work on the political correctness of how you deliver that one there, Mark.

Damon Elder 26:44
One of Mark’s strong suits is political correctness.

Matt Fries 26:47

I did preface it.

Jay Frank 26:49

His example, not my example if he passes away, if you’re in your three years into it, call it an 8-year, 10-year DST hold, that family’s staying in that DST for another seven years. In the REIT, that’s the beauty is either got a partial or full step up in your basis upon death, and that portion can be liquidated or all of it at that time if the REIT’s share repurchase program is open. So, the estate planning and tax planning aspects of the REIT are far more impactful, far more impactful than a DST. So, I’d argue, I’m going to marry that idea with what Matt said earlier, and this could sound counterintuitive to some, certainly to some regulators. The older you are…

Louis Rogers 27:30

The more you should UPREIT.

Jay Frank 27:32

The more attractive to 721 starts to become. And the younger you are, I think the less, because if you’re 30 years old or 40 years old, whatever, and you’ve got 50, 60 years, 70 years you’re going to live, what are the odds that that REIT is still going to be operating and have not caused a taxable event on your situation or just been liquidated altogether by then three times? You know, like you had longevity risk is Matt correctly labeled it? You have to think about that. So, the older you are but the ability to also offset partial liquidity to get partial liquidity from the REIT, you don’t have to sell it all at one time. You can’t do that when you own a piece of property. You can’t do that when you own A DST. It’s all or none when you sell something. So to be able to take some out, even if it’s taxable, someone has a million dollars in this thing, needs $50,000 of liquidity for whatever reason, they can get that and they might be willing to pay taxes or like I said, if they can use some carry forward losses and get out very tax efficiently, you can’t even think about that in regular real estate or a DST, which is also real property.

Nati Kiferbaum 28:34

Well, one thing just to balance, I know we all try to talk about defining age in terms of what’s appropriate, whether it’s a traditional 1031 or 721. One thing we’ve been actually seeing a lot is a lot of younger investors are a lot more acutely focused on fees. So, let’s just assume round trip every 1031 DST takes six, seven years, right? So, you know, if you are 55 years old, you might be doing four or five exchanges and there’s friction associated with each one of those traditional 1031 DST exchanges, right? And so that naturally erodes your what you put in your pocket from wealth creation over that period of time where there’s obviously a lot less friction in the REIT. As you enter, right, you’re not going to be paying transaction costs every single time. So, we’ve seen more and more investors of that younger age start to be more focused on that portion of the actual transaction.

Louis Rogers 29:32

You need the economy to scale, right? As you have billion dollars of property versus a property.

Damon Elder 29:38

Let me go back to Matt and Mark real quick because again, they’re more on the investor side of things and I want to talk a little bit about the actual mechanics of this process. Let’s say for instance that a broker-dealer had a selling agreement for a DST, a 1031 Exchange, that now ultimately has the option, or it may be mandatory to do an UPREIT. How do you handle a situation where perhaps this non-traded REIT where that this 1031 property may be getting UPREITed into what if, what if your broker-dealer doesn’t have a selling agreement for that REIT? What happens there? Can you still give advice to that client? What’s the technical prospects there for those investors when that situation may arise?

Matt Fries 30:26

Once again, I think you’re going to get different answers to that question based on the firm that you’re talking to, right? We believe that if you’re offering a 1031 that has the potential or even the mandatory nature of a 721, that we need to be comfortable with that REIT before we would approve the underlying 1031 offering. So, the first step to the two step, the 1031, if we know there’s the potential for an UPREIT, we would require that we have an agreement to sell the REIT. The reason for that is I don’t think you can really make a determination as to how attractive the initial 1031 is unless you also have an opinion on the landing spot, which is the REIT. So, we would require that we have the REIT before we would approve the 1031. There have been situations where we’ve chosen just not to approve kind of what we consider to be an attractive offering because we’re not comfortable with the REIT. We’ve also had situations where for whatever reason we’re not comfortable with kind of the 721 process. So, we will only work with the REIT, but in order to kind of have that entry point, we would require kind of a comfort level with the underlying product. If it was something that was not affiliated or not planned for, we could look at the REIT at that time and try and make a determination whether we were comfortable with it. If we were comfortable and we could sign an agreement, then we could kind of do that process. If we weren’t, obviously you can’t stop a client from exercising an opportunity that’s in front of them. If they choose to do it, they can do it, but we wouldn’t allow our advisor to be compensated or to be involved in that transaction.

Mark Kosanke 32:02

Right. And I think the real key from a Rep. standpoint is to have the conversation of the 721 with your client day one. And let the client know, you’re almost selling two products now instead of just one. You got to represent both right from the get go, because you don’t want two years later to the client call you and say, Hey, I got this paperwork for 721, what is this? I think it’s imperative that the Rep. have the conversation with the client ahead of time that this may happen, or this is a possibility it could happen. This is possibly an earlier exit from the DST property than they might’ve been used to or might’ve been expecting. And then there’s certain information that you the sponsors are going to need too, in terms of what is their existing cost basis at the time, and that has to be provided to the transfer agent so they can come up with an overall cost basis. So, again, I think it’s imperative that the Rep. have that conversation on both the 721 and the DST upfront so the client is if nothing else expecting that that could happen. So, when it does happen two or three years down the road, the client knows what is going to be expected of them, the Rep’s already prefaced it and you know, because like it or not, the Rep’s probably going to get dragged back into it, you know, I mean that, that client is going to get a letter from one of the sponsors that says, Hey, it’s time to 721 and the first thing that client’s going to do is call the Rep and we’re going to get that call, and if they’re going to say…

Louis Rogers 33:41
What the heck is this?

Mark Kosanke 33:42

Yeah.

Damon Elder 33:43

So, what you’re referencing there, Mark, is the instance where we’re seeing a lot of these non-traded REITs now have these two year holds and mandatory 721s. So, I’m assuming in those instances, both the advisors and the sponsors are making it quite clear what the process is here, right? But there are other instances, and I know certainly, I know Louis at least has done this and perhaps it applies to Inland and Cantor as well, but there are instances where you had a legacy 1031 and that sponsor also has now got a non-traded REIT and they’re choosing to take that legacy 1031 that does not have that mandatory UPREIT provision. And that’s where I think you might get into more of those situations. Is that impacting our sponsors?

Jay Frank 34:23

Let me jump in there. What you’re talking about is, I think more aligns with Mark. 95% of the money being raised and DSTs built with a 721 option today are basically mandatory UPREIT options or maybe an option with a small cash provision really for people that have a financial need to get liquidity. The people offering optionality to take cash or OP and it might happen or might not, that is a small fraction, single digit fraction of the market. And it is not what Mark is saying, you should talk to your client, you are literally recommending are two securities at that time. There are two securities in the document they are signing up to buy, they’re making an investment decision at that time on two securities. The broker dealer, if it’s a broker-dealer, most of this businesses being done in the wires and the RIA market. But if it’s a Rep at a broker-dealer or a IAR, with a fiduciary obligation, they’re making that recommendation at that time. If it’s a broker-dealer, they are signing two selling agreements at that time. So, let’s just make sure we’re all on the same page. These things are pre-wired all the way through. When I say pre-wired in a national webinar, not premeditated, not guaranteed to happen, very important part of tax code. This can’t be preset that it’s for sure going to happen. It has to be the 721 option of the REIT has to be an option, not an obligation, otherwise it’d be premeditated when it wouldn’t count as tax deferral. But so just so everyone understands that nuance.

Damon Elder 35:54

Is that why we have these 721 UPREITing options? They’re really not options, they’re mandatory. And is that why because you’ve got to have these documents in place?

Jay Frank 36:04

They’re not mandatory. They have to be an option. Every one of them is a fair market value option where the REIT sponsor has the right but not the obligation to exercise that option. It’s always going to be in the REITs best interest to exercise that option, because you get to call it up, raise free capital at fair market values. You’re not overpaying for the asset and you’re growing your REIT. So, it’s always going to be a pretty good option for them.

Damon Elder 36:24

But isn’t It mandatory for the investor? I mean the investor signs on the dotted line.

Jay Frank 36:28

When the REIT sponsor executes fair market value option, it is typically 95% of the marketplace, mandatory UPREIT certain sponsors have a small cash provision, a few sponsors have a full cash provision. But I would argue, and maybe we get there, I would argue that for the advisors giving advice for the client and the client who’s collectively with their advisor and their CPA decided that the UPREIT is where they want to be and it’s in their best option. They want to go into a DST with that option that has the highest probability of taking place and a DST that offers a cash option, or no option or stock option will give you all of them. The probability of 721 ever occurring dramatically drops. Because if you give a cash option, that REIT now has to account for the fact that a lot of people could elect cash, which might not be in the REIT’s best interest because they don’t have the cash or it’s not the best use of cash. And they have to answer to their shareholders in a fiduciary manner about what’s in the best interest of the REIT. So, the no cash option or small cash provision maximizes the probability that the 721 option does take place. Which is what the advisor and the investor signed up for on day one.

Louis Rogers 37:42

Doesn’t that raise a serious issue for the investor? I’m agreeing today essentially two years hence I’m going to go in the REIT. What if the REIT has terrible performance in two years? What if its properties aren’t doing well, what if its stock price is in the tank, I’m stuck. How do I make an informed business decision today for something that isn’t going to happen for two years?

Matt Fries 38:05

Yes, so I think without question that is a risk. I think you’re taking the same risk by going into any 1031 though, right? I don’t feel that it’s a different risk than if you invest in a 1031 and that particular property does poorly. You know, so I guess that’s how we’ve at least gotten comfortable with the idea of the fact that the client isn’t the one that’s going to make the decision. Its real estate, it’s a long-term investment and you know, usually it works out, but sometimes it doesn’t. To go back just for a moment to the point that Jay was making, right? I think from our perspective once again, it’s getting into a situation where the client can really understand those nuances and where they are. And I know I’ve said this already, but to me it really does kind of go back to the point that these appeal to different clients and making sure that somebody who wants that kind of more hands-off kind of solution can have that recognizing that there will always be risk and certainly there’s no guarantee that the performance of the REIT is going to be better or the same as what a standalone 1031 would be. But at least they get the benefits of having that broader exposure.

Mark Kosanke 39:13

Right? And I would agree, and but again as a Rep I think you’ve got to have a different conversation nowadays than when you were just doing the DST. I think you’ve got to Jay’s point, you are selling two products right up front. You’re selling one today and one semi automatically two years from now. And I think that’s a different conversation you have with the client because again, to my experience as a Rep, when that time happens, whenever it is, say it’s two years out, that client is going to pick up the phone and call you. What is this? What am I doing? Explain this again because they forgot what you told them two years ago, trust me. And so, you are going to basically do the same spiel all over again to that same client. So, you as a Rep, hate to say it as a Rep, you’ve got to be prepared for that because that’s going to happen a lot of the time and that’s okay, there’s nothing wrong with that. But again, I think it’s having that ready maybe documenting that you have that conversation ahead of time too. So, the client understands that and it’s obviously in the PPM and whatnot but just having that prepared so that the client knows it’s coming. You are going to end up talking to the client again two years from now, which you know, is not a bad thing either, but you’re going to have that conversation.

Louis Rogers 40:36

It’s even more intense than that Mark, because it’s taken us 10, 12 years on DSTs to get people familiar with the DST, the UPREITs are fairly new. There’s just not awareness of what in the heck it is. You might have three conversations with your investor, and they’ll ask the same questions every time and then on the fourth conversation they’re still asking the same questions. I mean, it’s taking a while for people to absorb it. It’s relatively new for them and they need a little more time.

Mark Kosanke 41:07

Agreed.

Damon Elder 41:08

So, in discussion of these 1031s, so you’re initially entering as from an investor’s perspective into a 1031, you’re doing it like kind exchange and then ultimately it UPREITs you do the 721 and transfer into the REIT. How do the distributions change from the one aspect when you’re doing the 1031 to ultimately getting into the UPREIT? Because REITs typically pay different distribution ranges than DSTs, although there’s certainly a wide range there as well. I’m throwing that up Nati don’t we go with you first on that?

Nati Kiferbaum 41:38

Yeah, I mean they certainly can change from DST to REITs and REITs are living and breathing, so distributions change, they evolve as they price on a monthly basis. So, they absolutely do move. I would say generally speaking, DST returns and the returns that are being driven by the REIT assuming you sort of parody in terms of what type of real estate that they’re obviously targeting, which should always be the case returns are pretty equal, right? Where things do sort of change is you do have the ability to be a little bit more creative with the different share classes. So, there’s no consistency here, but you know, typically in an operating partnership you could provide a share class that might benefit the OP unit holders that is different. And typically, that comes in the form of maybe a different performance fee, maybe a different advisor fee. And that sort of, you know, maintains some of that parody associated with what returns you were used to seeing on the DST side and what you might see when you get into the REIT. But even after that, even if you do create that parody through a share class that’s unique to the UPREIT exchangers, again, you still have volatility, right? As it relates to a monthly repricing and price discovery associated with that particular REIT.

Jay Frank 42:59

And Damon, when you buy a DST as an investor, you’re buying it at a moment in time that sponsor Nati at Inland, they diligence the property, they bought it at 5.7 cap rate yesterday at that moment in time. The REIT is also being valued in real time based on that same exact market condition on an appraisal basis, typically is how they’re valued. And so, which means you’re living in the same real estate environment the day you buy the DST and you’re kind of living at the same moment in time from real estate point of view, two years, three years later when the UPREIT takes place. So, you’d expect the distribution yield that you’re earning on a DST and on a REIT to actually kind of be in the same ballpark because it’s still all US core income producing moderately to no leveraged US real estate. Could you have some divergent? Sure, but you’re going to earn, I mean what are yields in DSTs right now? Probably four to five, I’ll think low to mid fours with where rates and everything are at. And then in the average public non-traded REITs yield right now is probably 5%. There’s some a little higher, some that are lower, but you are going to have parity because it’s both real estate valued at today’s current same market conditions, if that makes sense.

Mark Kosanke 44:08

So, I hear that Jay, but at the same time I’d like to ask Louis and Nati, I’ve had some full cycle events this year where the client has gotten back a hundred twenty-three, a hundred thirty two, they’re getting back a lot more of their principal 5, 6, 7 years later than what they put in. And so, my question then would be, how do you see that happening in an UPREIT? Because generally you don’t see that kind of big-time appreciation. Obviously, you pick the right properties on the DST, they perform, they’re now going full cycle, the client’s getting back a hundred percent plus, you know, some nice profit in the back end. Do you expect to see that in the REIT? I think we have to have the expectation that you’re not going to.

Nati Kiferbaum 44:54

It’s a great question.

Jay Frank 44:55

Absolutely. And so, what you just said the thing was up 125% in seven years, that’s like 3% – 4% a year. That’s not huge appreciation. And if you look at the public non-traded REIT index, they’re actually have all outperformed that. The REIT should be able to deliver better returns in a larger diversified portfolio than a single asset DST.

Mark Kosanke 45:13

Okay.

Jay Frank 45:14

The REIT’s going to have more ongoing fees that would hurt the REIT’s performance relative to the DST. The DST is going to have much bigger up front and backend fees, which will hurt the DST, but the REIT’s going to have access to cheaper capital, more flexible financing, more liquidity. So, the REIT should be able to deliver better returns. 

Nati Kiferbaum 45:30

Yeah. But Mark, I think to your question, right? You have to, and this goes back to your point on how you position this all on the front end. You don’t look at the UPREIT transaction as a judgment day, right? What that fair market value is shouldn’t be treated as that judgment day. Like it would be through a traditional DST where it’s sold in seven years. What was the outcome, right? And I think that’s a very important point to how we sort of manage investor expectations as they get the UPREITed.

Jay Frank 45:59

Yeah, what matters is during that DST hold period, not how did the DST do, it’s how it do relative to the REIT, because if have 10% in the DST and the REIT’s at 10, you got the same number of units of the REIT. Your DST is down 10, which is more likely, which what’s happened in real estate the last three years and the REIT’s down 10, it actually hasn’t hurt you or helped you either. You can, because you own one asset in one market can have different returns in that DST than the REIT. That’s where you could do better or worse. But that’s just the idiosyncratic nature of a single asset in a single market. But that idiosyncratic binary risk is kind of what the investor’s trying to avoid by getting into the DST and getting that more diversified portfolio. Nati, I like how you said it, I’ve never thought about it that way.

Mark Kosanke 46:41

Yeah, good.

Damon Elder 46:43

What about liquidity though? We’re talking real estate, so these are long-term holds anyway and liquidity can be uncertain, right? But if you’re doing a 721 into an illiquid non-traded REIT, is it just through redemptions that you get your liquidity then? I mean what’s the point? I mean these REITs are now designed to be perpetual. So, what is the liquidity?

Jay Frank 47:05

Yeah, I wouldn’t call them illiquid non-traded REITs. I mean the new era REITs that were all born related starting 9, 10 years ago after FINRA 1502, the quality of product is exceptional. There’s some poor performing REITs and whatever, but for the most part really high-quality sponsors bringing no load product with real transparency through independent third-party pricing. And last I checked; the entire industry’s done an exceptional job man meeting their monthly share repurchase program. I mean I can think of one big REIT that’s limited beyond their 2% a month, 5% a quarter, I won’t say names, but for the most part the industry’s shown up and performed both through covid, which was a tough environment, really tough for a short period of time. And then I think a tougher time has been the real estate recession we’ve been in. Cap rates have grown 25% in the last three years and the billions and billions of dollars. Matt, do you remember the numbers? Anyone remembers the number like non-trad REITs in the last three years have generated like $50 billion dollars of liquidity through the SRP and not a single non-traded REIT has shut down their SRP that at least I am aware of so…

Damon Elder 48:07

The big boys, yeah.

Jay Frank 48:08

I’m not calling these liquid products Damon, they’re not daily traded, right, obviously.

Damon Elder 48:12

Limited liquidity, let’s say,

Jay Frank 48:13

These are not illiquid products either. There’s significant liquidity built into these.

Damon Elder 48:17

But that is how the investor ultimately gets their option for liquidity at that point, right? Is they’ve got to go through the redemption process.

Jay Frank 48:22

Yeah, there’s some secondary markets but yeah, it’s exactly right. And that’s the most efficient way.

Damon Elder 48:27

So, we’re not going to see the traditional full cycle events like Mark was referencing. We’re going to see them go through this UPREIT.

Jay Frank 48:34

There are still some REITs out there that are built for an exit. It’s just that I think that’s 0.1% of all fundraising right now in non-traded REIT land.

Damon Elder 48:40

Right.

Jay Frank 48:41

They still exist but it’s just not the norm. The norm is these perpetual offerings that are built to perform in perpetuity.

Damon Elder 48:48

Okay.

Matt Fries 48:49

To me the more interesting comparison is the liquidity features of the 1031 to the 721, right? And I think everybody would agree there are far more liquidity options if you’re in a 721 product than if you’re in a 1031. So, if the lens that the client is looking at is I need to have access to this recognizing that neither is a hundred percent, the 721 is going to be above report.

Damon Elder 49:11

Well, I think we need to wrap up. There’s been a lot to take in here and I think there’s further discussion obviously that’ll be going on. And like Louis you referenced, the industry’s just really starting to really learn about these things, investors certainly. So, I think there’ll be a lot more discussion on these UPREITs, but it sounds to me like the 721 is really adding a lot of variability and a lot of options to investors who are seeking tax advantaged real estate investments.

Last question, I’m going to throw it out there and then we’ll conclude. Are we going to see the traditional standalone DST market really evolve almost entirely or be consumed from a percentage perspective by the 721 planned UPREITing? Or are we going to see options for both continue to grow?

Jay Frank 49:51

I think the regular way, like Matt said it best earlier, there’s a need for both because for one client, one’s not always right. And there’s other options too, like not selling the property or paying taxes because you have a small taxable situation, you’re dealing with all this complexity for no reason. Or the opportunity zone program or you know, getting elected to the cabinet like our chairman just did as Secretary of Commerce where you get a tax holiday when you sell a step up in assets. So, there’s different ways to avoid taxes. The last one’s probably the hardest one, you know, all without having to pass away. But I’d also like to say on behalf of the group, you know, this is obviously not tax legal investment securities advice or recommendations. So, I think the biggest takeaway, is there’s complexity here. So, make sure you’re working with the right professionals, the Mark Kosanke’s of the world with the right firms like the Cetera financials of the world, to make sure you’re getting the right advice, who do make these types of recommendations.

Nati Kiferbaum 50:42

Yeah, my only other point, just to kind of put some numbers to it you know, real time when you kind of look at the market surveys that are out there, right? You know, today roughly 40% of the capital that’s been raised year to date has been from pure play, 721 DST providers. We’ve also have seen over the last 60 days, two new market entrants, institutional market entrants. We’ve also seen nine figures in new equity get brought into the marketplace. And if you look at that today in terms of available equity, over 55% of the available product that’s out there minus what’s been sitting out there for more than 365 days is 721 DST product. So, it’s expanding rapidly. From our house view, it wouldn’t be crazy if you were sitting here in 2025, end of 2025 if one in every $2 was being raised by 721, DST providers. On the 1031 side, the traditional business, one of the things we think about a lot is we’ve seen hockey stick growth, and it’s not just in the traditional business, but also in the 721, the RIA space, right? And you the RIAs have actually adopted and in many instances prefer the 721, DST vehicle. And when you think about that, they’re very much focused on what does that investor experience look like? And it looks very different between 1031 DSTs and 721s. And there are many things we could unpack, but certainly price discovery is one of them. And that’s very beneficial to the RIA business. So, as we think about what might be the evolution of DSTs going forward, I certainly could see that price discovery on a more frequent basis becomes something that might be required in order to have that parity between the investor experience. That’s our house view maybe two, three years from now. But as that RIA business continues to grow, we think that’s going to be something of focus.

Jay Frank 52:29

And Nati, you know, one-to-one parody next year, but of a bigger and growing pie, right?

Nati Kiferbaum 52:34

A hundred percent, a hundred percent.

Damon Elder 52:37

Alright, well that’s definitely one thing we’ve seen accelerate in recent years in this space is just change, right? And so, I think we’re clearly seeing that in the 1031 now with the 721 optionality. So, I guess we’ll keep an eye on it. There’s a lot to come, lot to change. That’s lots of change that’s happening in this industry. We’ll keep watching it. Thanks to you guys for sharing so much of your knowledge. I think our readers and our viewers are certainly going to learn a lot from this webinar, and we’ll check in with you guys down the road and we’ll keep an eye on this process. So, thanks so much everyone.

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