The securitized 1031 exchange sector is in the midst of what could be its best year since 2007 — and industry leaders see even more room to grow in the years to come.
In the give-and-take that characterizes the legislative process, the industry was wary that the new law would eliminate 1031 like-kind exchanges in order to raise revenue to offset other tax reductions. But industry efforts to educate lawmakers paid dividends, as Congress elected to preserve 1031 real estate exchanges in the final law — a testament to the important role the sector plays in the U.S. economy.
This optimism is more meaningful because of where the industry was just a year ago: Facing possible extinction as part of the hotly debated tax reform legislation. The Tax Cuts and Jobs Act was eventually passed by the U.S. Congress and signed into law by the President in December.
Previously known as Section 112(b)(1), Section 1031 of the Internal Revenue Code was adopted in 1954 and allows investors to defer capital gains taxes by reinvesting proceeds into a similar, like-kind investment within a specified 180-day time frame.
The Institute for Portfolio Alternatives (IPA) was an integral player in preserving the nearly 100-year-old provision and assembling a dedicated team of tax and 1031 like-kind exchange experts that held a series of meetings with the leadership of both the House Ways and Means and Senate Finance committees.
One of the key efforts: At the request of Ways and Means lead counsel, the IPA submitted a white paper explaining the importance of retaining Section 1031 like-kind exchanges in any comprehensive tax reform legislation.
The countless meetings that IPA members held with Congressional offices helped to effectively demonstrate the role of Section 1031 — and specifically the securitized 1031 exchange space — in encouraging continued investments in America’s real assets, which ultimately creates jobs and grows the economy.
“The securitized 1031 market has evolved tremendously since its inception almost 20 years ago,” says Keith Lampi, president, director and chief operating officer of Inland Private Capital Corporation. “Coming off tax reform, the industry continues to grow as a dynamic marketplace with a bright future.”
Louis J. Rogers, founder and chief executive officer of Capital Square 1031, was one of several industry leaders who worked to defend Section 1031 directly with members of Congress, alongside Dan Cullen of Baker McKenzie, Dan Wagner of The Inland Real Estate Group, and David Fisher, co-founder and managing member of ExchangeRight.
Fisher, who oversees the acquisition of ExchangeRight’s net lease and multifamily portfolio properties, received IPA’s 2017 Outstanding Service Award for his work in representing the industry in tax lobbying efforts in Washington, D.C.
“Last year, we all worked hard to convince Congress that Section 1031 is a good provision that makes sense for our economy,” Rogers says. “Following enactment of the tax reform bill, business has been increasing every quarter.”
At Capital Square, Rogers oversees the firm’s Delaware Statutory Trust — or DST — programs for investors seeking qualifying replacement property for Section 1031 tax-deferred exchanges, as well as other regular, non-exchange investors.
Even in the face of last year’s uncertainty, the industry raised $1.9 billion in equity for the year, according to new data from Mountain Dell Consulting. In fact, sales growth has increased steadily since 2010.
The growth is in large part thanks to large sponsors who have helped evolve the securitized 1031 space based on lessons learned from the financial crisis.
“After the financial crisis, our previously growing industry took several steps backward,” relates Lampi. “This business is one that has long-term viability, with a very clear-cut demographic trend that will continue to propel us forward.”
According to Mountain Dell Consulting’s latest quarterly market report, the industry’s total equity raise in 2018 is on track to be up to $2.4 billion. The continued growth of this market illustrates both the latent demand for these securities and the desirability of real property investment.
THE SALES ROLLER COASTER
Mountain Dell, an affiliate of Orchard Securities, began tracking data for the industry after tenant-in-common properties became popular thanks to the U.S. Treasury Department issuing Revenue Procedure 2002-22 in March of 2002.
This revenue procedure — which provided written guidance on the circumstances that the Internal Revenue Service will recognize tenant-in-common ownership as eligible for tax-free exchanges under Section 1031 — allowed investors to use the structure as qualifying “replacement property” to defer gains on real estate transactions involving the exchange of properties.
The number of offerings and amount of equity raised recorded by Mountain Dell nearly doubled every year from 2002 to 2006 — rocketing from 45 offerings raising $356.6 million in 2002 to 341 offerings raising $3.6 billion in 2006.
But the financial crisis brought hard times across a wide swath of commercial real estate investments. The amount of equity raised fell as low as $169.8 million from 21 offerings in 2010. At the time, there were just eight sponsors who raised equity.
“In 2009 and 2010, which represented the trough of industry sales velocity, we stayed in the space despite low sales volume,” notes Lampi, who, during his career, has been involved in more than $6.9 billion in real estate transactions across retail, office, industrial, student housing, self-storage and multifamily property types.
“We viewed that time period as an opportunity to take an introspective approach to improving the product structure. We evolved everything from how we structured transactions, to broadening the asset classes we offered, while also reducing the cost structure for end investors. The underlying story of today’s growth lies in the down years immediately following the crisis where we made many strategic decisions to modify and improve our product structure in a way that helped catapult industry success today. From an industry perspective, I think the marketplace has now really hit its stride,” Lampi adds.
This optimism appears to be supported by the numbers and persists even in the face of the ongoing policy risks to Section 1031. Those risks stem primarily from potential shifts of power in the House or Senate, as a result of midterm elections, that could sustain new efforts to adjust the tax law.
As of the end of June, the industry has raised $1.2 billion in 78 offerings — surpassing the total equity raised in 2015 when the industry crossed another important milestone in its efforts to rebuild after the financial crisis: The $1 billion mark.
“At the pace we’ve seen equity raised in the first half of 2018, we’re back to just slightly under 2007 levels,” says Warren Thomas, a founder and managing director at ExchangeRight based in Pasadena, Calif., and a top retail producer in the early 2000s. “We’re not quite back to 2005 and 2006 levels when we hit more than $3 billion in equity raised each year, but there is optimism we’ll get there again.”
Thomas, who has more than 30 years of experience as a CPA and has been an active commercial real estate investor for the past 20 years, has seen consistent 40 percent to 50 percent annual growth at his firm, which holds about 10 percent of the market share, according to the Mountain Dell report covering the period January through June 2018.
EVOLVING STRUCTURES SUPPORT SALES GROWTH
Behind the numbers, the securitized 1031 industry itself has transformed drastically since 2002. Back in 2006, Mountain Dell reports there were 71 active sponsors that raised $3.65 billion in investor equity driven by the popularity of the tenant-in-common structure.
In the first half of 2018’s 78 deals, just one tenant-in-common offering was brought to market. The space now is occupied largely by DSTs.
“Essentially, the tenant-in-common structure went away in the recession and is not in common use today,” says Rogers of Capital Square 1031. “At a high level, a DST operates much better for investors.”
Inland was a pioneer in the DST corner of the securitized 1031 market.
Experts believe the market is healthier than in the early 2000s, when the tenant-in-common structure prevailed. One of the key benefits is the ability to have more investors in a DST than in the tenant-in-common arrangement.
“For one, DSTs typically allow up to 499 investors. It may be limited by the specific arrangement a sponsor has with the bank, but the law will allow many more investors to participate in one offering than in the tenant-in-common structure,” says Thomas.
In the tenant-in-common era, each offering was limited to only 35 investors.
“Increasing the number of investors in an offering also allows the industry to lower minimum investments,” adds Rogers. “The minimum investment in the tenant-in-common days could easily be $1 million. That meant, people might invest in one offering.”
That was problematic. The 35-investor limit not only led to the high minimum investments, but it also didn’t allow sponsors or investors to diversify.
“The tenant-in-common was a single-asset offering as you could only raise capital from 35 investors,” comments Thomas. “The DSTs allow for the advent of multiple property portfolios — you can have multiple apartments in one offering to create balance.”
“There are diversification undertones that explain just one of the many reasons why the industry adopted DSTs over the tenant-in-common structure. The tenant-in-common structure of the past just didn’t encourage diversification,” muses Lampi. “An investor with exactly $500,000 had to choose one product with one sponsor just to meet the minimum investment threshold, which impeded a financial adviser’s ability to provide a client property diversity — say by choosing a product in the apartment sector or office sector. That was a major limitation.”
“Now, regular folks can diversify and invest in multiple properties,” adds Rogers. “The greatest way to reduce single-asset risk is to diversify, that is, to invest in a number of properties. The DST makes it easy for investors to diversify — the sponsor conducts all the due diligence, closes on the real estate and loan when applicable, manages the property on a turn-key basis, and sells the property at the end of the holding period. It is truly a turn-key investment, making it feasible to diversify and reduce risk by owning a portfolio of DSTs.”
The DST not only provides diversification, but it also addresses one other major flaw in the tenant-in-common structure.
“The biggest limitation of the tenant-in-common structure didn’t rear its head until harder times,” notes Lampi. “As the recession ran its course, the fact that, under the tenant-in-common structure, a sponsor had to obtain unanimous consent for any major decision presented challenges. By example, let’s say you received an attractive bid to purchase a property, the sponsor would have to get unanimous consent among all 35 investors to move forward. Time and time again, this would stymie the value proposition that sponsors aspire to deliver their investor base.”
In many respects, the DST market expanded post-recession thanks to the spotlight that exposed these flaws in the tenant-in-common structure.
“During the recession and afterward, lenders viewed financing real estate differently,” says Lampi. “It became difficult to obtain a loan if structured as tenant-in-common ownership, as lenders realized the impact the unanimous consent provision had on sponsors’ ability to navigate market cycles.”
“ExchangeRight, formed in 2012 as the 1031 market was beginning to rebuild, has been intentional in offering programs that built in structural improvements compared to the earlier tenant-in-common offerings,” Thomas notes. “An ExchangeRight DST portfolio typically includes up to 20 properties.”
ExchangeRight also introduced a lower disposition fee and a model that would entirely waive the fee should a DST program fail to return all of the investors’ capital upon sale.
“Now, the DST business is very strong,” says Rogers. “The industry’s potential is firmly based on a demographic trend. Many real estate investors realize that they do not want to manage their own property, especially as they grow older. Today, many real estate investors can sell their investment property for a record price and defer all taxes by investing in one or more DSTs, where they don’t have to deal with tenants, toilets and trash.”
And opportunities still exist in the market, whether it’s the clear demographic trend in the investor marketplace or the ability to reach new accredited investors.
“This industry is now well-positioned to serve the registered investment adviser market in a significant way,” comments Thomas. “A commitment to that marketplace for two to three years could help sponsor firms achieve substantial gross volume in the marketplace.”
There also remains untapped potential to market to accredited investors under Rule 506(c). The rule, which came to be as part of the Jumpstart Our Business Startups Act in 2012, allows for parties to advertise their private investment opportunities to any interested parties, if the investor can provide proof they are accredited before they invest.
“The prospective market is enormous, and we now have a way to reach a growing number of investors in need of 1031 replacement property,” Rogers adds. “Rule 506(c) of Regulation D changed the world of fundraising by permitting sponsors, broker-dealers and registered reps to advertise and solicit for DST investments. It is now easier to educate investors on the replacement property options available in the market. The Internet is going to drive the next wave of 1031 investors; we started with TICs and now DSTs, with the ability now to reach a larger audience via the Internet. That is truly amazing; I would not have believed it possible a decade ago.”
Yet with significant growth opportunity, there should come significant diligence, and that underscores the importance of the industry coming together to improve and innovate products on behalf of investors.
Thomas cautions, “The challenge with an expanding market is that increased money flow could lead sponsor firms to compromise their program acquisitions or models and for the investment community to compromise their due diligence in an effort to expedite the placement of funds. Being uncompromising in our combined efforts is necessary for our mutual success and for these long-term real estate investments to provide value to our investors.”
By Haley Fry