Recently, several DST property sponsors from the multifamily, self-storage, and industrial sectors have asked me if they should consider offering UPREITs, or umbrella partnership real estate investment trusts. This acronym is popping up everywhere as sponsors and investment advisors alike have been touting this option as a tax-deferred alternative to 1031 exchanges. 

We have been involved in UPREIT transactions in the past and have had a few investors who have chosen this route, so we know a good deal about them. 

My take: UPREITs are not the way to go.

 

What is an UPREIT?

An UPREIT, umbrella partnership real estate investment trust, or section 721 exchange, is a type of structure generally offered to investors when a net-leased DST property sponsor is selling an existing property or portfolio and rolling it into their own REIT. Investors are presented with the UPREIT as an alternative to exchanging into another DST or cashing out and paying capital gains taxes. 

Investors who choose the UPREIT option contribute their proceeds from the sale in return for an investment and operating units via a 26 U.S. Code Sect 721 (nonrecognition of gain or loss on contribution). 

In my twenty-three years of experience with management-free real estate investing, I have yet to see REITs perform as well as individual properties or DSTs. As such, my analysis as a long-term real estate investor is that you are far better off skipping UPREITs and, instead, exchange into DST properties.

 

The Facts & Fiction of UPREITs

Let’s go through the facts about UPREITs, including comparisons to DSTs, so we can show you why DSTs are your best option.

Sponsors of UPREITs pitch the following benefits:

1. Management

You no longer have to worry about property management because you gain ownership in the operating partnership (OP), which provides the management. 

2. Diversification

By being an investor in the UPREIT, you gain access to a much larger portfolio of properties within the REIT, which provides a greater diversity of real estate investments.

3. Liquidity

Typically, OP units are transferable 1-to-1 with shares of the REIT, which would be exercised when investors are ready to cash out all or part of their OP shares. 

 

These benefits sound great, but to what degree are they true? Here is the reality of UPREITs:

1. Management

DSTs are already management-free, so this point is moot.

2. Diversification

DSTs already allows us to cherry-pick the best properties and diversify at the same time. With an UPREIT, you are stuck with whatever the REIT owns. 

3. Liquidity

This can be an issue with a DST because there is no liquid secondary market like there is for publicly-traded REITs, but that is just about the only downside. Most REITs are not publicly traded, and this benefit of liquidity will often be limited as well. If you own the right property, DST or sole owned, in the right market, and price it right, you can mitigate enough of the liquidity concerns to outweigh this one, minor benefit of liquidity in an UPREIT.

It is important to understand the facts when it comes to these kinds of investment types. What one sponsor tells you will generally be what works in their favor, and not usually what will benefit you the most. 

 

Additional Disadvantages of UPREITs

Beyond these general comparisons, there are several additional issues when participating in an UPREIT, which include:

  1. Because you can no longer complete a 1031 exchange after contributing to an UPREIT, you forfeit your tax advantages moving forward. 
  2. Upon conversion of operating partnership units to stock (not when you sell the stock), investors must recognize their capital gains, recapture depreciation, and pay state taxes if applicable.
  3. Fees and expenses can often be higher for REITs than individual properties and DSTs. 
  4. Investment options are then limited to just ONE. Out of the approximate 1,225 REITs that exist (According to Nareit, 220 Publicly Traded REITs and 1,100 Private REITs), you only have one REIT to choose from: the REIT offering Operating Partnership units in exchange for your property. This lack of choice is a major con.

These are just some of the UPREIT disadvantages. Ultimately, contributing your DST property into an UPREIT is a case of letting the tax tail wag the dog. 

 

Evaluating the REIT

Investors who choose the UPREIT option do so to defer their taxes, receive income and potential growth, and sell their units/shares easily in the future. However, the single-most-important factor here is the REIT itself. Questions to ask include: 

  • Is the REIT being offered as an UPREIT option a good investment? 
  • Is it really the best REIT available out of the approximate 1,225 REITs that exist?
  • Does it really have the potential to outperform the real estate you already own?

With the DST option, we choose specific properties because we have reviewed the due diligence, analyzed the sponsor and area, and see that they are best for their return profile. In doing so, we believe they will outperform other properties. But with an UPREIT, we are getting the good, the bad, and the ugly including whatever properties the REIT owns.

This just leads me to wonder: Why trade a well-chosen DST property for a collection of properties that averages out to mediocre?

 

Conclusions

Now that you know the comparatives and disadvantages of UPREITs, DSTs may be the better choice for you.

To further discuss the differences between the UPREIT and DSTs, contact us today.