Asset managers know there’s more than one way to invest in real estate, and many of them manage multiple funds with different strategies and structures to give investors options. Those choices might include either a Delaware Statutory Trust (DST) or a Real Estate Investment Trust (REIT)—tax-advantaged alternative investment products that grew in popularity after the economic crisis of 2007-09.
More recently, sponsors have begun equipping their DSTs with an exit strategy that lets investors keep their investment in play without taxation by bridging it from a less-liquid DST to the operating partnership (OP) of a REIT, while staying with the same sponsor.
These special property-to-OP unit conversions are known as UPREITs, or umbrella partnership real estate investment trust transactions. UPREITs have emerged as the latest evolution in the DST space, which last year raised a record $9 billion, according to data from Mountain Dell Consulting.
Sponsors employ UPREIT transactions because they create a more stable investment compared to the DST structure, which for tax purposes has many restrictions that limit the ability to hold investments long-term, add capital, and maximize a property’s value. Advisors recommend them because they offer their clients more liquid investment options, tax planning flexibility, and portfolio diversification. And investors prize their ability to increase access to economies of scale—exposing them to the larger, diversified, better-capitalized portfolios of properties that REITs manage through the operating partnership, which can potentially reduce their exposure to risk.
“Three years ago, 100% of our exit planning practice with respect to 1031 exchanges was concentrated in traditional DSTs,” said Carl Sera, President of Sera Capital Management, a registered investment advisor and real estate consultant. “Now it is about 30% with the UPREIT solution at 70%. Once people analyze the differences, it becomes obvious which way they should go.”
Why the upward trend in UPREITs? In short: DSTs are maturing and the UPREIT reflects adoption of the structure commonly used by institutions for decades. As more financial professionals and individual investors learn about this exit option, and their potential benefits, the more word spreads about them. UPREITs were pioneered by Sam Zell in the 1980’s and, over the last five years, by sponsors Dividend Capital (now Ares Management), JLL, and others who broke into the wirehouses with this type of DST structure and where, to date, the most volume in UPREIT transactions has occurred. DSTs typically consist of a single property, have a holding period of about 5-7 years, and are largely illiquid.
Selling a DST investment to another accredited investor can be logistically difficult, and 1031 exchanges—"like-kind" exchanges that let investors roll proceeds from one property into another—while also tax-advantaged, are typically less flexible than UPREITs.
The Last Stop
Every UPREIT transaction will be structured differently, but they allow investors to break out of repetitive cycles of 1031 exchanges and avoid cashing out early and face tax consequences.
“An UPREIT is your last stop,” said Jay Frank, President of Cantor Fitzgerald Asset Management. “But it potentially allows investors to get partial liquidity over time from a REIT’s OP. While it can cause a taxable event, it may provide investors additional flexibility and liquidity which you wouldn’t have in a DST. There are also ways to manage any tax liability created.”
Carl Sera says UPREIT transactions are popular with many older first-time DST investors. “These are investors who have made the decision to move from active ownership to passive ownership. Once an investor decides to move to passive ownership, they don’t revert to active.”
Taxation and Administration
An UPREIT transaction allows investors to exchange property for OP ownership in a standard REIT. UPREITs are subject to Title 26, Section 721 of the Internal Revenue Code, which specifies that property-to-share conversions are not generally considered taxable events. Otherwise, UPREIT structures are taxed similarly to that of standard REITs, which are not taxed on most of their earnings, as the taxes are paid by investors when they claim dividends as income.
Following completion of the 721 exchange, the UPREIT sponsor owns the newly acquired property and manages its administration. In return, the seller gains operating partnership units that can be converted into REIT shares (a taxable event) or put toward other investment strategies. REITs have the potential to generate risk-adjusted returns through rental and other related income. They are required to return 90 percent of earnings to investors in the form of dividends. While some REITs are traded on public exchanges like NYSE and NASDAQ, non-traded REITs are sold by individual broker-dealers.
Investors that UPREIT into a publicly registered non-traded REIT can potentially benefit from the various investor protections inherent in a public company including the transparency that comes with financial record keeping and reporting.
Asset managers have sole discretion over how UPREIT transactions are administered, and typically dictate in the private placement memorandum whether or not the option is included. These types of exchanges cannot be guaranteed to happen—they’re strictly optional—and a minimum of two years must go by before an investor can elect to make the exchange. The sponsor then dictates when the elected exchange occurs, not the investor.
Perhaps another reason 721 exchanges are on the rise is due to persistent bipartisan scrutiny that 1031 exchanges have garnered from the last three presidential administrations, all of which have sought to scale back 1031 exchange tax benefits.
“1031 has been attacked in the past. Under the Tax Cuts and Jobs Act, 1031 was limited to real property and no longer applies to personal property,” said Cantor’s Jay Frank. “Real estate survived, but it could be looked at again. Getting into a REIT structure mitigates the legislative risk of Section 1031—or Section 721—being materially altered.”
Increased interest in UPREITs also comes as rising interest rates and recession worries have put downward pressure on real estate and reduced demand for DSTs. While this has forced some sponsors to scale back property purchases, other firms like Capital Square started 2023 off by completing the acquisition of multiple multifamily properties for both DST and Opportunity Zone Fund offerings. The industry is currently in a process of “price discovery” as buyers and sellers come to terms with the new reality around debt terms.
“At Capital Square, we view the UPREIT as a method of adding value to quality multifamily investments that otherwise have to be sold to comply with DST tax rules,” said Louis Rogers, founder and Co-CEO of Capital Square. “The IRS revenue ruling requires sale of DST properties when the mortgage matures, and it is not possible to refinance or recapitalize even when it would be in the best interests of the investors. This means that quality real estate that should be held long-term must be sold, with the funds returned to DST investors who will likely structure another 1031 exchange to continue the tax deferral.”
As with any real estate investment, especially alternative investments like DSTs and REITs, there are a number of risk factors that should be considered, such as declines in market value, local economic conditions, operating costs, and more. Current economic conditions around real estate underscores the importance of educating investors on the long-term nature of alts.