Key Takeaways
Tax Deferral Requires Quick Action
DST sales can trigger capital gains taxes and depreciation recapture unless investors execute 1031 exchanges within 45/180-day deadlines
Limited Secondary Market Liquidity
Early DST sales are challenging with no formal market, potential discounts, and sponsor approval requirements
NNN Lease Renewal Critical
Triple net lease properties depend on lease renewals for exit success; re-tenanting can cost 25%+ of asset value
721 UPREIT Alternative Strategy
REIT conversions offer tax deferral and diversification but carry volatility, liquidity, and fee risks
In this section, we'll look at some exit strategies and the potential risks they carry, drawing on the same kind of careful planning used in mission scenarios.
Selling a DST
When a Delaware Statutory Trust (DST) sells the underlying property, the process begins with a decision made by the sponsor, who is responsible for managing the trust and the property. The timing of the sale often depends on market conditions, the property's financial performance, or the scheduled end of the DST's investment period, which typically ranges from five to ten years.
Once the sponsor decides to sell, they notify the investors, providing details about the sale, such as the expected closing date and the next steps in the process. The sponsor will then proceed to list the property, searching for a buyer much like any traditional real estate transaction, often using brokers or agents to facilitate the sale.
After a buyer is found, the due diligence process begins, during which the buyer inspects the property, reviews financial documents, and negotiates terms. This stage can take some time depending on the complexity of the deal.
Once the sale is finalized, the proceeds are distributed among the DST investors based on their percentage ownership in the trust. Unlike other investment vehicles, a DST does not reinvest the proceeds into new properties; instead, the trust is dissolved, and investors receive their share of the sale.
Critical Tax Consideration
At this point, the sale becomes a taxable event, meaning that investors may owe capital gains taxes and face depreciation recapture on their portion of the profits unless they choose to defer these taxes by participating in a 1031 exchange.
To defer taxes, investors can reinvest the sale proceeds into another like-kind property, such as another DST or other qualifying real estate, following the IRS rules for a 1031 exchange. These rules include identifying a replacement property within 45 days and completing the purchase within 180 days. Often, sponsors or 1031 exchange facilitators provide assistance to investors to help them navigate this process.
After the sale and distribution of proceeds, the DST itself is dissolved. The investors will receive any necessary tax documentation, such as a 1099 and closing statement, detailing their share of income, gains, or losses from the sale. The distribution of sale proceeds can take several weeks or months after the property sale, depending on the complexity of the transaction and the administrative process followed by the sponsor.
Upon the sale of the DST, the investor can choose whether to 1031 exchange into another DST, their own property, pay taxes, or do a combination of all three.
Selling Early: Secondary Transactions
DSTs are typically designed to be long-term, passive investments, and there is no formal, centralized secondary market like you might find for stocks or bonds. As a result, selling a DST interest can be more challenging and may take longer than selling other types of investments. Liquidity is limited, meaning you can't easily sell your interest at any time, and finding a buyer may depend on the demand for that specific DST or property type.
When selling a DST interest on the secondary market, the price may be lower than the original purchase price or market value. Secondary market buyers might expect a discount due to the reduced liquidity and because they often have less control over the investment compared to owning direct real estate. The price a seller receives will depend on factors like the DST's remaining holding period, the performance of the property, current market conditions, and the terms of the DST.
Some DSTs may have restrictions or requirements regarding secondary sales, which are often outlined in the offering documents. The sponsor of the DST may need to approve the sale or transfer of interest, and they may provide guidance or assistance with the process. Investors should review the terms of their DST agreement to understand any limitations or procedures for secondary market sales.
Secondary Market Warning
While it is possible to sell your DST shares early, this should not be your primary strategy when entering the investment. Selling DST shares on the secondary market can be time-consuming and may result in a loss. In theory, you can 1031 out of a DST before the sponsors sells the asset. However, it is crucial to consult with your CPA to understand the potential tax implications of an early sale.
NNN Exit Strategy
Unlike other asset classes, such as residential and self-storage, NNN is a bit more difficult to exit. As explained earlier, NNN leases typically go down in value as the lease becomes shorter over time. Therefore, the goal is to renew the lease at the end of the term. Theoretically, this should increase the value of the property and allow the owner to sell for a profit. This exit strategy is typically referred to as a "blend and extend."
Understanding Blend and Extend
A "blend and extend" is a lease restructuring strategy commonly used in commercial real estate, particularly with NNN leases, where tenants are responsible not only for rent but also for property taxes, insurance, and maintenance costs. The goal of this strategy is to modify the lease terms in a way that benefits both the landlord and the tenant, offering a solution that addresses immediate market conditions while providing long-term stability.
How Blend and Extend Works
At the heart of a "blend and extend" deal are two key components. The first is the blend, which refers to blending the tenant's current rental rate with a new, typically lower rate that better reflects current market conditions. For instance, if the tenant is paying above-market rent due to an older lease agreement, the landlord may agree to adjust the rent to a rate that is more in line with the current market. This blended rate is essentially an average between the original, higher rate and the new, lower rate, offering relief to the tenant while still maintaining a steady stream of income for the landlord, even if it's slightly reduced.
The second part of the deal is the extended portion, in which the tenant agrees to extend the lease term in exchange for more favorable rent. This extension benefits the landlord by providing long-term security, knowing that the tenant is locked into a longer lease, which minimizes the risk of vacancy. For the tenant, the extension ensures that they can remain in their current location for an extended period at a lower, more manageable rent. This can be especially advantageous for businesses that are looking to cut costs without having to relocate, as moving can be disruptive and costly in its own right.
The blend and extend strategy is particularly attractive during times when market rents have decreased and tenants are seeking relief from higher lease costs. For landlords, it offers a way to maintain occupancy and avoid the costs associated with finding new tenants, such as broker fees and potential renovations or improvements to make the property attractive to prospective tenants. While the landlord might sacrifice some rental income in the short term, the long-term stability and avoidance of vacancy risks are usually worth the concession.
Example of Blend and Extend
To illustrate how this works in practice, consider a tenant who signed a lease a few years ago when the market was strong, agreeing to pay $20 per square foot. Since then, market conditions have shifted, and rents have dropped to $15 per square foot. The tenant, now paying above the market rate, approaches the landlord for relief. Instead of facing a potential vacancy when the tenant's lease expires in two years, the landlord may offer a blend and extend deal, where the rent is immediately reduced to $17 per square foot. In exchange, the tenant agrees to extend the lease for an additional five years, giving the landlord long-term assurance that the property will remain occupied.
In this way, the blend and extend strategy serves as a win-win for both parties. The tenant receives relief in the form of a lower rental rate, while the landlord secures a longer-term tenant, reducing the uncertainty that comes with lease expirations and tenant turnover.
Ultimately, a blend and extended agreement helps both parties manage their respective risks. For tenants, it ensures they can continue operating in a desirable location without overpaying for rent. For landlords, it reduces the likelihood of costly vacancies and turnover, providing peace of mind with a more predictable cash flow. As with any real estate strategy, timing and negotiation play a critical role, but when done right, the blend and extend approach can be an effective tool for managing lease agreements in changing markets.
However, what if the tenant leaves or doesn't renew the lease?
In this case, the owner or sponsor will be required to re-tenant the building. In order to find a new tenant could be very expensive and time-consuming. After paying the leasing broker and tenant improvements, it could potentially cost more than 25% of the price originally paid for the asset. For a Tenant-In-Common, this will almost certainly require a capital call. For a DST, this could require the DST to spring to an LLC. If the sponsor has a REIT, the REIT could potentially step in and save the asset via a 721 UPREIT.
721 UPREIT
A 721 UPREIT (Umbrella Partnership Real Estate Investment Trust) is a tax strategy that lets people who own commercial property delay paying taxes. They give their property to a REIT and get shares called OP Units. As long as they keep these units, they don't have to pay taxes on any profit they make from selling the property. This is helpful for property owners who would otherwise have to pay big tax bills. Plus, they get to own shares in many properties instead of just one, which can spread out the risk.
The 721 UPREIT strategy became more popular in the DST industry when the Biden administration threatened to limit or remove the 1031 exchange in 2020. Sponsors introduced the 721 as a potential exit strategy for their DST investors in case the 1031 was impacted. It was relatively well received by the market.
More and more sponsors began creating REITs as a way to attract business, but also keep business. DST sponsors make most of their money at the front end of a DST. They make relatively little profit holding/managing the DST. However, in a REIT, sponsors can cultivate fees throughout, making a much more profitable long-term strategy.
Benefits
- Diversification: They own shares in lots of properties instead of just one.
- No More 1031 Exchanges: Investors don't need to do another 1031 exchange to avoid taxes.
- Potential Liquidity: They might be able to sell their REIT shares more easily.
- Tax Control: They can sell shares and net the losses in their portfolio against the gains in the REIT.
Risks
- Lack of Diversification: Financial advisors working for large wire-houses usually preach ultra-diversification. However, they usually recommend exchangers dump their entire exchange into a single DST… This is odd since 1031 exchanges typically represent an oversized portion of their entire estate.
- Timing Risk: Investors don't know where the REIT will be in a few years or what their own finances will look like.
- Transparency: It can be hard to see what's happening inside a REIT. Properties can be bought, sold, or refinanced, and the paperwork might be hard to follow.
- Volatility: OP Units in a publicly traded REIT can go up or down with the stock market, which means they're less stable than owning property directly.
Additional Risks
Liquidity Risk
REITs can often choose to stop honoring stock redemptions. Therefore, investors may not be able to access their capital like they thought. Diversifying the REITs would help mitigate this risk.
Fee Risk
Sponsors can collect many types of fees over the life of the investment. Make sure to ask your financial advisor about all the fees involved, not just the obvious ones.
Debt Risk
Most REITs have debt, and investors might not know they are being pushed into a REIT with risky loans. This can lower cash flow if interest rates go up.
Capitalizing the REIT with Struggling DSTs
Sometimes, if a DST is struggling to make a profit, sponsors might sell it to a REIT at a higher price to avoid a blemish on their track record. This can help in the short term but might hurt the REITs performance in the long run.
Capitalizing a struggling REIT with strong DSTs
A sponsor with a struggling REIT may offer attractive DSTs to bring in 1031 investors but not tell them about the problems with the REIT. This is a strategy for a REIT sponsor to build their REIT without requiring cash investors.
721 UPREIT "Option" Dilemma
When a DST sponsor is attempting to build or support a REIT, they may present investors with the "option" of a 721 UPREIT. In these situations, the sponsor might emphasize that the 721 UPREIT is only an "option" and assure investors they won't be forced into it. This flexibility is often preferred by investors, as it gives them the choice to decide if they want to exchange their DST interest for shares in a REIT. This contrasts with a mandatory 721 UPREIT exit, which would require all investors to participate in the exchange.
Hidden Pressure Risk
However, there is also a potential risk when a sponsor is struggling to sell the DST property for a profit or is facing challenges with their REIT. In such cases, even though the 721 UPREIT is framed as an option, investors may feel pressured into it to avoid losses. This scenario can occur when the DST property has limited prospects of selling for a profit, effectively leaving investors with little choice but to enter the REIT to protect their investment.
DSTs with Triple Net (NNN) leases are particularly vulnerable to this situation. These leases often come with the challenge of limited cash reserves, which can make it difficult to renew or extend leases when they expire. If a property's lease nears expiration and there aren't enough reserves to cover the cost of tenant improvements or other necessary expenses, the DST faces the risk of either a capital call—where investors are required to contribute additional funds—or being sold at a loss.
Faced with these outcomes, investors may feel compelled to move into the 721 UPREIT to avoid the immediate financial hit. Even if the sponsor is able to renew the lease, NNN appreciation is often limited, and overcoming the fees may be challenging.
In essence, while the 721 UPREIT is positioned as a choice, in some situations—especially in DSTs with NNN leases—the investors may be indirectly pushed into this option to avoid worse financial consequences. It's important for investors to be aware of this potential risk when considering DSTs and to thoroughly evaluate the sponsor's plans for the property and the REIT.
Frequently Asked Questions
Need Help Planning Your DST Exit Strategy?
Schedule a consultation to review your DST investment and explore the best exit options for your situation.
Schedule Exit Planning Session
