721 Exchange UPREITs and Delaware Statutory Trust Offerings – Essential Items to Consider before Investing

Over the years, the use of the 721 Exchange as a Delaware Statutory Trust exit strategy has become increasingly popular among investors for a number of reasons, including the ability to provide tax deferral benefits, the potential for portfolio diversification, the potential for portfolio income and appreciation, and enhanced liquidity.

However, real estate professionals will often cite the words, "Caveat Emptor," a Latin phrase meaning "Buyer Beware." This concept, originating from Roman law, emphasizes the buyer's responsibility to thoroughly assess the quality and suitability of a purchase.

This article is designed to provide valuable information for investors in order to adopt the "Caveat Emptor" mindset when considering 721 Exchange UPREITs as part of a 1031 exchange strategy.

• First, this article will provide an overview for how investors can use the 721 Exchange UPREIT as an exit strategy for Delaware Statutory Trust investments.
• Second, this composition will also provide a detailed review of some of the most important items to consider when evaluating various Delaware Statutory Trust offerings and their 721 Exchange UPREIT counterparts. These items are often overlooked by investors and their financial firms pitching these products however we have found they are of utmost importance.

When considering a 721 exchange UPREIT, understanding the DST investment is crucial; however, it is equally, if not more important, to thoroughly understand the REIT in which an investor will ultimately be invested through the 721 Exchange.

1. Tax Advantages:
Investors are able to 1031 exchange on a tax deferred basis into the Delaware Statutory Trust and then are able to 721 Exchange on a tax deferred basis into the Operating Partnership of the 721 Exchange program. Investors also will potentially enjoy tax advantages via depreciation and write offs to help shelter potential distributions.


2. Diversification:
Many investors incur concentration risk by owning one property in a single market. 721 vehicles tend to own many assets diversified through different markets. The 721 Exchange transaction can provide greater diversification for an individual’s portfolio, which may reduce concentration risk. As always, Diversification does not guarantee profits or guarantee protection against losses however it is considered a prudent strategy for investors to consider.


3. Income Potential:
Investors can potentially receive income generated through distributions to the holders of the OP units. The 721 Exchange vehicle will have the goal of increasing income potential to investors over time through new acquisitions and portfolio optimization.


4. Appreciation Potential:
Investors have the ability to participate in potential appreciation that is realized both at the individual asset level as well as at the enterprise value level. The 721 Exchange vehicle can be positioned to take advantage of market opportunities via new acquisitions designed to potentially enhance shareholder value.


5. Liquidity Potential:
The 721 Exchange vehicle can provide investors with the option of liquidity on a partial or full basis. Investors will potentially have the option to liquidate a portion of their shares in combination with their tax planning strategies. Liquidity may not be a necessity or even a priority for all investors but having it available offers peace of mind and option for investors. It is important to note that liquidity is not guaranteed and may be limited or discontinued in certain circumstances. Investors are encouraged to read the offering material in full for a complete discussion on the 721 vehicles liquidity program.


6. No Further 1031 Exchange Decisions:
Many investors are at a point in their lives where they do not want to have to make another 1031 exchange decision in 3-5 years as you would typically have to if you invested in DST offerings without a 721 Exchange exit strategy. By participating in a DST with the 721 Exchange as a planned exit strategy, investors have peace of mind that as they are further along in years, they and their family members will not be required to make further investment decisions as they will be in the 721 Exchange vehicle indefinitely. On the flipside, many investors want to have options as to if they will participate in the 721 exchange or if they will want to do a 1031 exchange at exit. Certain 721 UPREIT DSTs provide this optionality while others do not. This is another factor that Kay Properties encourages investors to consider as things do change for investors over time therefore having optionality to 1031 or 721 is believed to be vitally important.


7. Estate Planning:
Upon death, OP units can be equally split and either held or liquidated by the beneficiaries of the trust. Beneficiaries receive a step-up in basis and can avoid capital gains taxes and depreciation recapture tax. This strategy helps investors plan for the future with the opportunity to transfer wealth to heirs in a tax efficient manner and allows for individual flexibility when liquidating. Again, Liquidity is not guaranteed and may be limited or discontinued in certain circumstances. Investors must read the offering material in full for a detailed discussion on the 721 vehicles liquidity program.

Due to the increased popularity amongst investors to participate in a 1031 exchange into a DST that has a 721 Exchange exit strategy there has been a greater number of new entrants into the space. This increased level of options makes it even more difficult for investors to decide which of the DST and resulting 721 Exchange UPREIT offerings is the most appropriate for their particular situation.

At Kay Properties, we have been helping 1031 exchange investors evaluate DST, UPREIT and 721 Exchange offerings for nearly two decades and have helped thousands of investors nationwide through this process into over 9,000 separate DST and 721 exchange investments. Here are some of our top items for investors to consider when evaluating a DST with a 721 Exchange exit strategy:

1. Evaluate the REITs Debt Levels:
Some REITS have the ability to leverage their properties up to a 300% debt to equity level. This high level of debt greatly increases the REITS volatility and could prove disastrous to the DST investors who end up inside of the REIT via a 721 Exchange.

While it is true that many REITS hover around a 50% Loan to Value (LTV) ratio which seems conservative to many investors (and the REIT employees and investment advisors/financial planners that are selling them will emphatically declare that this is a very conservative leverage amount), it is also true that leverage of any kind has a multiplying effect on investor equity.

For example, in a 50% LTV REIT, if property values were to increase by 10%; the equity in the REIT has increased by 20%, However, on the flip side, if property values were to decrease by 10% the investor equity in the REIT has decreased by 20%, moving the investors from a 50% LTV to a 70% LTV.

I think you can see my point how debt magnifies gains and conversely magnifies losses.

To find out how much debt the DSTs “final destination” (the 721 UPREIT exchange into the REIT) can take on, one only has to review the REITS prospectus or private placement memorandum and complete a search in the PDF for “leverage, financing or debt”.

For investors who prefer to avoid the risks associated with leveraged REITs, there are alternative 721 vehicles available that are predominantly debt-free, with a 0% loan-to-value (LTV) ratio.

With these DSTs and their debt free (all equity) 721 Exchange vehicle exit strategies, investors are able to “SWAN” - Sleep Well At Night - knowing they do not have exposure to large amounts of debt and that the vast majority of the properties in the 721 REIT are unleveraged. Yes, the upside may not be as high as those that are highly leveraged however, conversely the downside is not nearly as impactful as those REITS that are leveraged.


2. Evaluate the REITs Exposure to Floating Rate (Variable Interest) Debt:
Another important factor for investors to consider in a 721 REIT transaction is whether the REIT they are transferring into carries debt, and if so, the proportion of that debt that is fixed-rate versus floating-rate.

Many of the DSTs that include a 721 Exchange REIT strategy have a large amount of their debt outstanding that is floating rate. This floating rate debt creates an increased layer of heightened risk as interest rates increase. Many large real estate firms, institutional sponsors and REITs have lost their buildings to foreclosure due to floating rate debt over the years.

Therefore, each investor should review the REITS 10k and 10Q (annual and quarterly) reports to review just how much outstanding debt of the REIT is floating rate debt.

Our analysts at Kay Properties recently reviewed four different REITS available to DST investors via the 721 Exchange, and noted that each one had large amounts of floating rate debt on their buildings from between 26.60% of debt outstanding to all the way to 83.20% of the debt outstanding that had a variable interest rate. As rates have risen the cost to service this floating rate debt drastically increases and creates pressure on the REIT and its ability to service that debt and deliver a healthy distribution to investors.

Many investors remember the ARMs that got so many homeowners into trouble in the Great Financial Crisis of 2008 and 2009. These ARMs (adjustable rate mortgages) are very similar to floating rate loans used by many of the 721 exchange REITs. As interest rates rise so does the interest rate on the outstanding loan which increases the risk and volatility to the investor whether it be a homeowner or a REIT.


3. Evaluate the REITS Dividend Health Percentage - Adjusted Funds From Operations (AFFO) to Distribution Ratios:
Adjusted Funds From Operations measures the financial performance of a REIT specifically in its capacity to potentially support the issuance of a dividend to its shareholders. If a REIT has a dividend health percentage of less than 100% it means that they are not covering their dividend from operating activities (i.e. rent from the buildings). Rather they are paying a portion of their dividend through borrowings (increasing the level of debt that the REIT owes) and/or their distribution reinvestment proceeds.

When a REIT's Adjusted Funds from Operations (AFFO) to distribution ratio exceeds 100%, it indicates that the REIT is generating more AFFO than it is distributing in dividends. This suggests that the REIT is potentially maintaining or increasing its dividend payments without relying on borrowing or selling assets to fund them. In other words, the REIT is in a strong position to support its dividend payments, which can be a positive sign of financial health and sustainability.

Again, investors need to evaluate and consider each DSTs 721 REIT vehicles most recent 10k and 10q reports. A number of the DST and 721 REITS in the market are not fully covering their dividend and have dividend health percentages from roughly 40% to 90%. The closer a REIT is to 100% signals to investors that the REITS management team is focused on delivering a predictable, durable income stream in the form of dividends to its investors.

When a REIT pays a dividend out of borrowings it signals to investors that the REITs management team is kicking the can down the road and relying on the potential for future rent growth in the portfolio to achieve a sustainable dividend coverage. This is a plan that may or may not work out in the end depending on the economy and property level performance. Investors that are particularly focused on will my DST and resulting 721 REIT be able to pay me a regular and consistent monthly dividend are advised to strongly consider the REITs AFFO and dividend health ratio.

The above items are just a few of the important factors to consider when deciding which DST with a 721 Exchange exit strategy to invest in. Our experience of working with investors and these types of DSTS, REITS, 1031 Exchanges and 721 Exchanges for nearly two decades (as well as having been personally invested in these strategies for nearly as long) places the Kay Properties team in a unique position to provide guidance to investors throughout the country.

As always, we encourage investors to read each of the DSTs Private Placement Memorandums (PPMs) for a full discussion of the business plan and risk factors and then beyond that to read the final REITs prospectus (the program they will eventually 721 exchange into) as well as its quarterly and annual reports to understand debt levels, debt structure (variable/floating vs fixed rate) and dividend health percentages. For those investors needing help we have team members across the country and have helped thousands of investors participate in over 9,000 of these DST, REIT, 1031 exchange and 721 Exchange investments, and if appropriate we would love to share what we have learned with you.