721 UPREIT DSTs: Real Estate Investing Expert Explores the Hidden Risks

In today’s complex real estate market, understanding the nuances of 721 UPREIT DST structures is essential for any investor.

One of the critical features of these arrangements is that the REIT holds the option — but not the obligation — to purchase the DST’s property through the UPREIT strategy. This subtle distinction can have profound implications for investors, making due diligence not just advisable, but critical.

The anatomy of a 721 UPREIT DST structure

In a typical 721 UPREIT DST transaction, a property is initially transferred into a Delaware statutory trust (DST), allowing investors to acquire a beneficial interest in real estate without directly managing the asset via a 1031 exchange.

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The Kiplinger Building Wealth program handpicks financial advisers and business owners from around the world to share retirement, estate planning and tax strategies to preserve and grow your wealth. These experts, who never pay for inclusion on the site, include professional wealth managers, fiduciary financial planners, CPAs and lawyers. Most of them have certifications including CFP®, ChFC®, IAR, AIF®, CDFA® and more, and their stellar records can be checked through the SEC or FINRA.

Later, the REIT may choose to acquire the property from the DST. However, because the REIT only has the option to execute this purchase and is not obligated or compelled to do so, the decision rests entirely in the hands of the REIT.

This arrangement means that while investors might be enticed by the benefits of 721 UPREIT DST investments — such as tax advantages and a passive income stream potential — they also bear certain risks.

One key risk could be that the REIT may decide to mark up the purchase price of the property when transferring it from the DST to its own portfolio, regardless of changing market conditions.

The importance of market timing and due diligence on 721 UPREIT investments

Imagine a scenario where a REIT acquires a property for $100 million in 2022. Over the next couple of years, macroeconomic factors — particularly rising interest rates — cause the property’s market value to decline by 20%.

By 2024, the property is realistically worth only $80 million. Despite this downturn, some REITs may opt to mark up the property’s price by 20% based on their original 2022 acquisition cost.

This maneuver results in DST investors being charged $120 million for an asset that, in current market conditions, is worth significantly less at just $80 million.

This example underscores a critical point: Since the REIT is not obligated to acquire the property in a 721 exchange from the DST investors, it can delay or even forgo the transaction if market conditions deteriorate further.

In such cases, investors could find themselves locked into a DST investment with inflated valuations and misaligned expectations.

Understanding valuation and markups: Crucial items for 721 UPREIT investors to consider

One of the first questions an investor should ask is whether the DST they’re considering has been subject to a markup by the REIT — and if so, by what percentage.

Often, these REITs, already in possession of the property, sell it to the DST at a marked-up price that can sometimes exceed 20% (this is often referred to as a “non-arm’s length transaction”).

A significant markup can be a red flag, suggesting that the underlying asset may be overvalued and that hidden fees could be eroding potential returns. While such markups are disclosed in the fine print of the private placement memorandum, they are often omitted from the estimated use of proceeds table.

This omission makes it challenging for investors to track the true cost basis and understand the complete financial picture, thereby increasing the risk of misaligned expectations over time.

The critical role of expertise in navigating 721 exchange UPREITs

Given these complexities, investors must exercise caution and thoroughly assess both the acquisition price that the REIT purchased the property for and the subsequent markups that they are passing along to DST investors.

Market conditions are dynamic, and properties that were once market value can quickly depreciate due to economic shifts, such as changes in interest rates.

With the REIT’s ability to exercise or not exercise its option at a time of its choosing, the risks associated with overvaluation become even more pronounced for 721 UPREIT DST investors.

Conclusion

The flexibility inherent in 721 UPREIT DSTs, while offering significant benefits, also introduces a layer of risk that must not be underestimated. Investors need to be acutely aware that a REIT’s option but not obligation to acquire a property could lead to situations where market values and marked-up prices could truly impact an investor.

This divergence underscores the necessity of due diligence on 721 UPREIT DSTs and investments — ensuring that investors are informed about the markups, the timing of market changes and the underlying financial risks.

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Ultimately, due diligence never guarantees a profitable investment, and all 721 UPREIT and DST investments could result in a full loss of principal invested. This is the reason that trying to understand exactly what is going on at the 721 UPREIT DST and the final REIT destination is crucial.

I spend a great amount of time understanding these intricate details in order to share the implications of them with our investors. After nearly two decades of experience in the 1031 exchange and 721 UPREIT DST space, I have learned that thorough due diligence is the key to making informed investment decisions.

Unlike many financial advisers, wealth managers, RIAs and even DST brokers, I make it an imperative to delve into the fine print and scrutinize the markups and valuation methodologies that can often be overlooked.

Understanding the option but not the obligation — and knowing when and how that option might be exercised — can be the difference between a profitable investment and a costly misstep.

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