The DST vs. UPREIT Dilemma: Are 721 Products Being Properly Sold?

A recent trend in the securitized 1031 exchange industry is toward increased equity investment in DST offerings that are likely to be contributed to a REIT within two or three years of the initial offering.  In its June DST Market Equity Update, Mountain Dell Consulting indicates that more than 50% of the current volume falls into that category, a significant change over just the past few years.  With this proliferation of the Umbrella Partnership Real Estate Investment Trust (“UPREIT”), it’s important to examine who is selling these products and, more importantly, whether they are appropriate for such a large percentage of investors.

UPREIT transactions are not new.  They have been around for years but have only recently been widely used by REIT sponsors as a means to raise additional capital. The mechanics are fairly simple: sponsors initially raise equity from investors in a §1031 exchange transaction through the Delaware Statutory Trust (“DST”) structure which is deemed eligible as replacement real estate in a like-kind exchange under IRS Revenue Ruling 2004-86. Subsequently, most commonly between 25 and 36 months after completion of the initial DST, beneficial interests of the DST are converted to Operating Partnership (“OP”) units in the REIT’s umbrella partnership through a §721 contribution.

Perhaps the greatest challenge facing §1031 exchange investors is access to real estate expertise to understand which of these products is appropriate for them.  Traditional DSTs are most appropriate for some investors while 721/UPREITs may be best for others.  Like-kind exchange transactions can involve millions of investor dollars and often comprise a large concentration of investors’ net worth.  Decisions of this magnitude require advice from experienced subject matter experts in order to fully understand the pros and cons of both.

Potential UPREIT Advantages

There are many potential advantages of the 721/UPREIT structure. Once in the UPREIT, the investor’s equity is now part of a diversified portfolio of real estate, not invested solely in the real estate that was owned by the initial DST.  The OP units are easily divided which can be advantageous for estate planning purposes.  Those units can potentially be sold, subject to lock-up timeframes and at the discretion of the UPREIT’s board who may limit or suspend altogether any advertised share repurchase program.

Much of the discussion around the DST vs. UPREIT comparison focuses on the expertise of the professional who presents the opportunities to potential 1031 exchange clients.  Advisors who have spent their entire careers in the traditional equities industry may have little experience in real estate or the intricacies of §1031. Furthermore, the 721/UPREIT opportunity may be the only product available on their company’s approved product menu. Thus, it is critical to understand potential disadvantages that are often overlooked or misunderstood.

Potential UPREIT Disadvantages

Potential disadvantages of the UPREIT structure should be discussed in detail.  These include:

1. Termination of §1031 – once DST beneficial interests are converted to OP units via the §721 contribution, those interests cannot be further exchanged via subsequent 1031 exchange transactions.
   

2. Comingled properties – the property owned by the DST is combined with both legacy (past) and blind pool (future) real estate owned by the UPREIT, and the client’s investment dollars are thus subject to future decisions made exclusively by the REIT board.
   

3. Capital gains on sale – when investors sell their UPREIT shares or the sponsor opts to unilaterally sell contributed DST property without a subsequent 1031 exchange, an unavoidable taxable event occurs.
   

4. Liquidity uncertain – advisors often express the advantage of liquidity in an UPREIT investment, but this can be misleading as there is no assurance of future share repurchase options.
   

5. Discounted conversions – contributions to the UPREIT occur at Fair Market Value (“FMV”) which may be less than the equity initially invested in the DST.
   

6. Affiliated party contributions – the real estate which is owned by the initial DST may be sourced from the sponsor’s REIT itself and then repurchased via the §721 conversion. This gives the sponsor an opportunity to repurchase the real estate at a lower value in the future.
   

7. Unilateral decisions – many times conversions from DST to UPREIT under §721 are at the sole discretion of the sponsor.
   

8. Minimal financing availability – UPREITs have fewer options for debt which can be a challenge for full deferral of capital gains liabilities and will depend on each client’s individual exchange. 
   

9. Higher minimums – higher investment amounts may limit the ability to diversify by property, geography and, importantly, sponsor and strategy.

Key Takeaways

There is a place for 721/UPREIT product, but in our opinion, they may be suitable for only a small percentage of §1031 exchange transactions, not roughly half that the industry is currently experiencing.  It should be used as a tool, but not the only tool. In our experience involving over 2,000 1031 exchanges, 721 UPREITs are rarely appropriate for more than 20% of an investor’s allocation.

Advisors’ understanding of their clients’ investment goals and the important differences between traditional DSTs and UPREITs are critical.  Once clients deploy their equity into a 721-eligible product, there is no turning back.