An innovative real estate investment structure known as an Umbrella Partnership Real Estate Investment Trust (UPREIT) was designed to provide real estate investors with a tax-free opportunity to exchange their property, such as a DST property interest, for ownership units in a REIT’s umbrella partnership. This unique exchange is made possible through the Internal Revenue Code (IRC) Section 721 exchange, which has been hailed as one of the best-kept secrets in the world of real estate investing.
In a typical UPREIT setup, the REIT consolidates its assets and operations within a single operating partnership subsidiary. The REIT assumes the role of the sole general partner of this operating partnership, granting it exclusive authority to manage the partnership’s operations. However, the rights of limited partnership interest units (OP units) holders, as outlined in the partnership agreement, place certain limitations on the REIT’s management powers.
Furthermore, the REIT also holds a majority stake in the outstanding OP units. These units are acquired by the REIT through the contribution of net cash proceeds from equity capital raises or initial public offerings (IPOs). The remaining OP units are owned by external limited partners (OP unitholders) who have contributed their previously owned real estate assets to the operating partnership. These properties, or the interests in the entities that own them, are exchanged for OP units of equivalent value to the REIT’s common stock through a 721 exchange.
The appeal of UPREIT investments lies in their access to institutional quality assets that are not correlated to the stock market, providing greater diversification on a tax-deferred basis. These investments typically focus on specific asset classes, such as multifamily apartment communities, student housing, industrial properties, net-leased retail stores, and hospitality assets. A diversified portfolio should include REITs with complementary asset classes to balance economic risk. For example, a REIT with net-lease retail stores can provide consistent cash flow even during economic recessions, while a multifamily REIT offers potential rent increases in a growth economy. This diversification strategy allows investors to benefit from stable income and growth potential.
Another advantage of exchanging a DST investment for an UPREIT is the potential for a future initial public offering (IPO). Once an UPREIT reaches a certain size in terms of property value and equity capital, it may consider going public. If the UPREIT is listed publicly, the share price has the potential to increase and outweigh any associated tax liability upon divestment. However, this depends on factors such as acquisition CAP rates, lower DST interest rates, and current cash flow distributions. There is also a risk that market factors could cause the share price to fall below the UPREIT’s value, resulting in unrealized losses.
While UPREITs are not initially available to investors reallocating their portfolios to alternative real estate investments, they should consider the benefits of UPREITs when making decisions about reallocating from stocks and bonds to DST investment properties. Investors holding a DST property interest may have the option to enter into an UPREIT investment at the end of the DST hold period. This allows for greater diversification, higher potential cash flow, and continued deferral of capital gains from the appreciation of the DST investment. The UPREIT option is particularly attractive to long-term investors who may pass on the investment to their estate, as it provides potential liquidity through a shared redemption program or an IPO listing. Overall, UPREITs are a valuable tool for achieving the goals of portfolio reallocation, offering institutional quality real estate investments with tax-sheltered gains, diversification, and reduced exposure to volatility.