Pure DST vs. DST-721 UPREITs
Most Popular Reply
Pasadena, CA · Member since 2019 · 136 posts · 148 votes
4yInputs: Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.
Benefits:
REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.
The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.
It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).
You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.
Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).
Gotchas:
The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.
The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.
There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.
Summary:
If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.
I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.
Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.
If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.
35 Replies
- 4yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
@Lan Bak, That's the trade off. And you lose depreciation and deducting expenses against income.
The 1031 Investor5137 Reviews - 4yDave FosterBusiness MemberQualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
@Lan Bak, the REIT does have distribution requirements (one of the reasons they start strong in a market and fade as a market matures). They can be classified as ordinary income/loss or capital gain. Its a little different than regular straight line asset depreciation
The 1031 Investor5137 Reviews - 4yBrandon BruckmanPro MemberFinancial Advisor · Milwaukee, WI · Member since 2018 · 110 posts · 96 votes
Dig into the investing rules for the REIT. You can find this in the prospectus / PPM / offering document. I struggle with very non-specific rules about what the REIT can invest in. The "blind-pool" nature allows some REITs to invest in whatever they want whenever they want. I would prefer a more focused investing objective.
- Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
Inputs: Section 721 of the Internal Revenue Code allows an investor to exchange property held for investment or business purposes for shares in a Real Estate Investment Trust (REIT) without triggering a taxable event. The transaction allows investors to increase the liquidity and diversification of their real estate investments while deferring costly capital gains and depreciation recapture taxes that may result from the sale of a property.
Benefits:
REITs also can provide the same ongoing benefits of real estate ownership including income, depreciation tax shelter, principal pay down, and appreciation. Many REITs continue to make acquisitions on an ongoing basis. This allows the investor to benefit from future buying opportunities in the REIT without triggering any capital gains or depreciation recapture tax events. *Please note: As Dave mentioned, not all REITs allow for ongoing depreciation, but some do. It's important to understand the difference, and I'd recommend sticking with the REIT with depreciation advantages.
The Tax Cut and Jobs Act (TCJA) includes a 199A deduction and applies to certain income from pass-through entities (including REIT dividends) and allows individuals to take the 20% deduction against REIT dividend distributions that yields an effective tax rate of 29.6% or 37% (80% for upper bracket filers). But the 199A is scheduled to sunset in 2025 under the TCJA unless made permanent.
It wouldn't be uncommon for some investors to only realize taxable income on 40-50% of their dividend distributions in today's current environment (I have seen this personally).
You asked about fees, so one quick comment. Often times the transaction between the DST and the REIT involve a significantly lower commission for the brokers. As such, many aren't incentivized to advise you along that path (sad but true). Instead, the commission is passed along to the investor in the form of increased equity.
Most of the time, the REIT has liquidity as an option. This is great of your accountant who may choose to advise that you liquidate shares during a tax year where you realize some loss elsewhere. It's also a great way to pass buildings down to your kids who want nothing to do with the active management business. Instead of saddling them with a $5M commercial property (for instance), you can turn that into 166k shares and divide them amongst your kids (who are in line to get a full step-up in basis when you pass away).
Gotchas:
The UPREIT is sometimes an option, and sometimes a mandate. It's really important to understand the difference. There are examples of DSTs that included an exit into a REIT that DID NOT ALLOW the investor to do a 1031 exchange. The investor was unaware of this previously. Horrible.
The REIT is essentially a "blind pool" investment. The Trustee of the REIT can buy and sell properties within the REIT without triggering a capital gain event to you as the investor, however, this flexibility also allows the operators to potentially add properties to your investment portfolio that may expose you to risks or asset classes you were previously unaware of.
There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.
Summary:
If you are making an investment into a DST with a REIT exit, you are aligning yourself with the sponsor in a long-term way. It's more important than ever to understand what you are getting yourself into. I'd encourage you to evaluate the REIT first, then the DST second. And in some ways, the DST becomes less (*slightly less*) important in that scenario. It's a gateway into the investment you actually want to make.
I'd recommend you put yourself in a position to take advantage of a REIT exit as an OPTION, not an OBLIGATION. Test the waters with the sponsor for 3-5 years as they hold the properties in the DST, then decide if you want to align with them as a part of your long estate plan.
Last (and best) recommendation: Ask your broker what the funds from operations (FFO) ratio is. All REITs are required to show their FFO calculations on their public financial statements. The FFO figure is typically disclosed in the footnotes for the income statement. If the FOO ratio is less than 100%, hard pass. That means they are paying dividends out of investor capital or debt, instead of NOI. That easy question to answer will be a really great litmus test in your due diligence toolbox.
If you are evaluating a REIT, it would be wise and prudent to do your homework and select the appropriate professional to guide you. It can be a wonderful tool.
- 4yLan BakMember since 2022 · 16 posts · 8 votesOP
Thanks @Jon Taylor for the great insights and in depth info. Agree that FFO is a good barometer.
As I dig more deeper, it seems that most of these investments have multiple layers of fees built-in
at key points like upfront, ongoing, redemption/exit etc.
- Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
The fees likely aren’t going to be the deal breaker. In my experience, for the right program, a 3% markup is justifiable.
Sometimes the fees are ridiculous, but that is an outdated argument against syndications, as most brokers & investors are sophisticated enough to avoid a structure that isn’t reasonable.
- Member since 2019 · 7k+ posts · 4k+ votes4y
I'm very interested in this thread, I've seen the performance of a few REITs is really good, better than DST. However, my question is, isn't the bottleneck 1031 to 721 exchange is very high minimum to invest (like half mil. $) ?
- 4yLan BakMember since 2022 · 16 posts · 8 votesOP
@Jon Taylor - Curious to know what the average ongoing and/or exit fees are for DST's and the DST-721's
- 4yBrandon BruckmanPro MemberFinancial Advisor · Milwaukee, WI · Member since 2018 · 110 posts · 96 votes
Quote from @Carlos Ptriawan:
I'm very interested in this thread, I've seen the performance of a few REITs is really good, better than DST. However, my question is, isn't the bottleneck 1031 to 721 exchange is very high minimum to invest (like half mil. $) ?
Carlos - the minimums are usually higher, however working with a financial adviser that does a decent amount of business with DST/REIT sponsor firms you can typically get the minimums down to DST levels (100k). Minimum investment amount are self imposed rules by the sponsor that they are willing to bend all the time.
- Member since 2019 · 7k+ posts · 4k+ votes4y
Quote from @Lan Bak:
@Jon Taylor - Curious to know what the average ongoing and/or exit fees are for DST's and the DST-721's
I think most DST fee costs are 6-10% commission , annual 2-3% and disposition fee of 2-4%. It could be higher if they're selling faster than target. They're not really the best investments due to the fees.
Also Jon mention -->
There are a couple of sponsors I am aware of that carve individual properties out of the REIT, into a DST, then pull them back into the REIT at a significant mark-up to the DST investor. This is important to understand on the front end when you are investing in the DST.
.... I bet, since DST is a legal tax deferral strategy , the investors are really into the hands of the sponsor. There's actually one 1031 SFR scheme that marks up asset like this as well.
Btw,there's also a book that shows the track record of most DST sponsors, and if I remember, 95 percent met their target IRR. - Member since 2019 · 7k+ posts · 4k+ votes4y
I found this. The RIA just wrote it a day ago.
https://seracapital.com/721-ex...Lan, the answer is clear. You will lose money in the long run if you invest at traditional DST if the annual growth rate is less than 4%......
- 4yLan BakMember since 2022 · 16 posts · 8 votesOP
Very interesting article @Carlos Ptriawan
I guess an analogy is, if DST's are mutual funds then 721-DST's are index funds.
Wonder what the ongoing annual fees for both DST's and 721-DST's are ?
- Member since 2019 · 7k+ posts · 4k+ votes4y
What I've been wondering, with 10-15% associated fees inside a DST during the life cycle of investment and an actual cap rate of 3-4%, IRR 10-12%, and targeted CoC of 5-7%. How much is left to the investors?
I have been thinking and simulating all tax rules/investment alternatives related to property sales and 1031 ; nothing beats the IRS tax code that allows $500k tax-free for rental/primary residence conversion. - 4yLan BakMember since 2022 · 16 posts · 8 votesOP
Didn't most of those rental to primary residence conversion loopholes get closed over the years ?
- Member since 2019 · 7k+ posts · 4k+ votes4y
yes, I am taking after the loopholes, basically, if initial home is primary, and then converted to rental, and then move back to primary before selling (after 2 years), the first $500k is still tax-free. After the first 500k, there are LTCG againts nonqualifying use. That's OK.
If the house is initially a 1031 purchase and then converted to primary, then there's *no* 500k tax-free, it's straight up non-qualifying use LTCG. - Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
To reply to some of your questions above:
The standard minimum investment into DSTs has been $100k for quite some time, but I've seen sponsors process transactions as low as $40k.
Each DST program has fee structures that are slightly different. I'm looking at one right now with the following (real, live situation):
3.85% commission, 0% annually (unless you go through an RIA, you shouldn't be paying any fees to participate in a DST along the way; but there are operating expenses that are transparently modeled based on the assets in the Trust), disposition fee of 2% (subordinated to a full return of original investor equity outside of monthly distributions). The program has about 50% debt, so those fees are split half/half between your equity, and the debt on the portfolio.
Regarding track record and performance, I'd look at two things: 1) Did they pay on time, every time, at least the minimum monthly distribution; and 2) Did they return AT least my entire original investment (regardless of upfront fees). If that is your goal (which it should be) then the percentage of DSTs that have met that expectation is far lower than 95%. As has been mentioned, the prior performance of the sponsor is stated in each PPM, so take a hard look at that.
When you are considering fees for any sort of syndication, it's also important to evaluate the alternatives. A traditional sole ownership property will cost you approximately 5% of the total value of the property to sell based on fees we are all used to paying (and you are paying all of that out of your equity, regardless of how much debt is on the property, and without a return of capital clause).
Again, simplify your analysis to a strict understanding of the property level analysis inside the portfolio - something you've likely been doing on your investments to date. But, once you get to the REIT, you need to add a few more sophisticated tools to your toolbelt as you seek to understand the way the REIT operates.
- Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes4y
@Jon Taylor I appreciate your input and perspectives on DSTs. Here is what I’m wondering: historically how have DSTs fared during down markets vs up markets. I’d like to know what percent of DSTs formed and marketed during say 2007-09 (pre Great Recession) made a decent return vs DSTs formed during 2014-18 (boom times). Do you have any sources or info to try and ascertain that? Remember folks, were likely entering some sort of recessionary or contracting economy, so having that data that would be telling!
- Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
@Amit M. -
I actually do have that data, but not in the format that you are likely expecting.
DSTs were established in 2004 with an IRS ruling, but they weren't commonly used until after the mortgage crisis and ensuing recession. Prior, most syndications were structured as a Tenant In Common (TIC) structure for the 1031 exchange investor.
As a result, many of the active DST players are either reinvented from the ashes of that crisis, or entirely new.
There are some inherent (unanimous voting by all members to make any decisions) reasons why the TIC was replaced by DSTs, but I'll save you the history lesson.
The most useful lesson coming out of the last recession (and I share your perspective on the cyclical pattern coming around the corner ahead) is how different asset classes faired.
You can get that data from public filings from REITs, who have to report far more data and intel than OTC private placement investments.
Fast forward to the COVID crisis. We saw many publicly traded REITs lose value quickly. The market is very quick to act and is constantly pricing the future into today’s asking price. We saw the beginnings of similar asset class corrections to 2008, but no one could have predicted an eviction moratorium and unprecedented actions by the FED to soften the blow.
Ever since the quick rebound, institutions are adding stabilized properties to their assets that have tenants that have weathered previous economic turmoil.
One way the big boy institutions are trying to mitigate risk is by buying properties that performed historically well during challenging economic times.
Because *some* DSTs align with that strategy, it gives you an opportunity to shift some of your investment equity into institutional asset classes that would be out of reach for the retail investor with a modest amount of equity to invest.
Net out: You don’t want to hold a bad property ever, but especially not during a recession inside of any sort of a syndicated structure. It all starts and ends with the properties. A good starting point is to ask yourself the question, ‘if you had to, what would you have bought in 2006 with unlimited funds?’
- 4yLan BakMember since 2022 · 16 posts · 8 votesOP
@Amit M. This is a great question.
@Jon Taylor - In a similar vein, I am guessing most recent DST's have loaded up/valued their portfolio at the current/recent peak. What are the risks when valuations start coming down ?
Also, this "
Did they return AT least my entire original investment (regardless of
upfront fees). If that is your goal (which it should be) then the
percentage of DSTs that have met that expectation is far lower than 95%."doesn't bode well.
Should the expectation with the DST's then be just capital preservation with guaranteed yield after all fees (even then, most don't deliver) ?
- Member since 2019 · 7k+ posts · 4k+ votes4y
Lot of good commentaries. Want to add few things:
- There're noticeable performance differences in the last 4 months between public REITs and private REIT. Most of private REIT that I tracked, don't experience a downturn since April, while the majority of public REIT experiences an average of 5-10% losses, the loss is more if the underlying asset is in office or hotels sector. In my personal opinion some of the public REIT losses is more buying opportunity (also applicable to CEF too).
- Jon : If that is your goal (which it should be) then the percentage of DSTs that have met that expectation is far lower than 95%-----> thank you, it's worthed to give more deep analysis on this. It seems it's even worse than my own calc.
- Jon: A traditional sole ownership property will cost you approximately 5% of the total value of the property to sell based on fees we are all used to paying----> Good point, however, in my own calculation, it's really not hard to find investment that could beat DST performance. There's no magic in real estate. Unlevered IRR performance for SF in west coast high appreciation asset has gross yield of 18-25% IRR, post-recession maybe giving 8-12% IRR, is okay. It's really not hard to move around money where's the better chance to invest next ( I give a hint, a warehouse/industrial asset will perform better than hotels). The SF IRR can only be beaten by Venture Capitalist private investment in some tech sector (prior 2021). This is why I think even if I have to sell my investment, I can beat the DST performance easily when I buy my next rental.
- One good thing about 721 from my own thinking is that some the private REIT compare to DST : the traditional DST only manage single asset while REITs manage multiple institution-class asset, including even non-US property, where the money manager invests pro-actively and understand the reward/risk more than like an individual like me.
- We could also track the performance per sector from the result of crowdfunding. - Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes4y
@Jon Taylor good point about the history of TIC and DSTs.
So I gather then that TIC failures post 2008 were quite high (notwithstanding their awkward voting structure)? Do you have any idea what that fail percentage was? - Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
It would be anecdotal, as there were quite a few smaller TIC offerings in those days. I can say that it was significantly painful for many.
- Pasadena, CA · Member since 2019 · 136 posts · 148 votes4y
RE: Private vs Public REIT. I've seen the same thing. Many private REITs are less volatile due to the fact that they are valued quarterly by private institutions rather than in real-time (with forward projections and assumptions priced in) by the capitalistic marketplace. They are similar, but different products as a result.
RE: DST vs Sole Ownership. Agreed. If you are going to the trouble of acquiring the property, managing the tenants, taking all the debt risk, and executing your own exit, it had better pay you more!
- Member since 2019 · 7k+ posts · 4k+ votes4y
Quote from @Jon Taylor:
It would be anecdotal, as there were quite a few smaller TIC offerings in those days. I can say that it was significantly painful for many.
Currently, there's still very few MF syndication that could accept 1031 exchange to their syndication, thru TIC mechanism.
The problem from the technical side is only timing, you just need to time it correctly for that 6 months window to close. This is the only DST advantage in my view (and second is mortgage boot replacement) where time is no longer concern with DST.
Join the conversationCreate a free account to reply, vote on answers and follow this thread.