Three Key Items to Evaluate When Choosing a 721 Exchange

Editor’s note: This is part two of a two-part series about how to evaluate 721 exchange UPREITs when considering them as part of a 1031 exchange strategy. Part one is Considering a 721 Exchange? Adopt a Buyer Beware Mindset.

Due to the increased popularity among investors to participate in a 1031 exchange into a Delaware statutory trust (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 (umbrella partnership real estate investment trust) 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.

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Here are some of our top items for investors to consider about the REIT (real estate investment trust) they’ll ultimately be invested in when evaluating a DST with a 721 exchange exit strategy:

1. Evaluate the REIT’s 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 REIT’s 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 advisers/financial planners who 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 rise by 10%, the equity in the REIT has increased by 20%. However, on the flip side, if property values were to fall 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 on how debt magnifies gains and conversely magnifies losses.

To find out how much debt the DST’s “final destination” (the 721 UPREIT exchange into the REIT) can take on, one only has to review the REIT’s prospectus or private placement memorandum and 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 for those REITS that are leveraged.

2. Evaluate the REIT’s 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 floating-rate debt (as opposed to fixed-rate debt).

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 REIT’s 10-K and 10-Q (annual and quarterly) reports to see just how much of the REIT’s outstanding debt is floating rate.

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 26.6% of debt outstanding all the way to 83.2%. 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 adjustable-rate mortgages (ARMs) that got so many homeowners into trouble in the Great Financial Crisis of 2008 and 2009. These ARMs 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 REIT’s dividend health percentage.

Adjusted funds from operations (AFFO) measures a REIT’s financial performance, specifically in its capacity to potentially issue dividends to its shareholders. If a REIT has a dividend health percentage of less than 100%, it means that the managers are not covering their dividend from operating activities (i.e., rent from the buildings). Rather, they are paying a portion of their dividend through borrowing (increasing the debt level that the REIT owes) and/or their distribution reinvestment proceeds.

When a REIT's adjusted funds from operations 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 DST’s 721 REIT vehicle’s most recent 10-K and 10-Q reports. A number of the DST and 721 REITs in the market are not fully covering their dividend — with dividend health percentages from roughly 40% to 90%. The closer a REIT is to 100% signals to investors that the REIT’s 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 REIT’s management team is kicking the can down the road and relying on the potential for future rent growth in the portfolio to achieve 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 who 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 REIT’s AFFO and dividend health ratio.

Professional guidance can help

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 DST’s 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.

Past performance does not guarantee or indicate the likelihood of future results. Diversification does not guarantee profits or protect against losses. All real estate investments provide no guarantees for cash flow, distributions or appreciation as well as could result in a full loss of invested principal. Please read the entire Private Placement Memorandum (PPM) prior to making an investment. This case study may not be representative of the outcome of past or future offerings. Please speak with your attorney and CPA before considering an investment.

Annualized return is defined as a total return including profit on sale and monthly distributions earned on an annualized basis.

Total return consists of initial return of investor principal, monthly distributions, and profit upon sale.

All return calculations are calculated as if the investor closed on the DST investment at the same time the property was purchased.

Diversification does not guarantee profits or protect against losses. All real estate investments provide no guarantees for cash flow, distributions or appreciation as well as could result in a full loss of invested principal. Please read the entire Private Placement Memorandum (PPM) prior to making an investment.

Please speak with your attorney and CPA before considering an investment. There are material risks associated with investing in real estate, Delaware Statutory Trust (DST) properties and real estate securities including illiquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multifamily properties, financing risks, potential adverse tax consequences, general economic risks, development risks and long hold periods.

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