We have previously written two blog posts on 721 UPREIT options which discuss basic concepts which I encourage readers to review prior to reading this blog:
All About the 721 Exchange - Part 1
All About the 721 Exchange - Part 2
In this blog post we will take a deeper dive into due diligence that investors should consider before investing in DSTs with 721 UPREIT option including potential sponsor conflicts, liquidity options, likelihood of a conversion option, and REIT quality.
What is a 721 Exchange?
To recap: for DST investors a 721 exchange is the term often used when DST investors exchange their DST interests for operating partnership units, commonly called OP units, in a REIT operating partnership. This is often called an UPREIT transaction because the investor moves from owning an interest in a specific DST property or portfolio into an interest in the operating partnership of a broader REIT platform.
For the right investor, this can be attractive. It may allow continued tax deferral, more diversification, centralized management, and a potential path to future liquidity. But it is not the same as simply selling a DST and completing another 1031 exchange. Once an investor moves into OP units, future liquidity, tax treatment, and control are governed by the partnership and REIT documents, not by the investor’s ability to pick a new replacement property.
Why investors should look beyond the marketing headline
A growing number of DST offering materials now describe a possible 721 or UPREIT exit. The key word is possible. A 721 option in a DST PPM offering materials does not necessarily mean the option will be offered, that it will be offered on favorable terms, or that investors will have a meaningful choice between either accepting OP units or receiving cash proceeds that may be available for subsequent 1031 exchange.
This is why the first due-diligence question should be: Has the sponsor actually completed prior DST-to-UPREIT transactions? Prior history matters. A sponsor with a demonstrated record of completing 721 exits on transparent, investor-friendly terms deserves more credit than a sponsor that merely reserves the right to pursue a 721 exit someday. Investors should ask how many prior 721 exits were completed, how values were determined, whether cash out elections were honored, whether investors received timely notice, and whether the exchange vehicle was clearly identified in advance.
The central conflict: who controls the exit?
A DST investor may assume that the property will eventually be sold to the highest third-party buyer. That is not always the only path. Depending on the DST trust agreement, the DST manager or signatory trustee may have discretion to sell the property to a third party, sell to an affiliate, or allow a partnership entity to acquire investors’ DST interests in exchange for OP units. Each path can create different economics for investors.
The conflict arises because the REIT or operating partnership may be affiliated with the DST sponsor. In that case, the platform may be both the party influencing the exit and the party acquiring the asset or investor interests. That does not make the structure improper, but it does mean the fairness of the valuation process becomes critical.
Fairness of conversion price: the most important question
The best investor-friendly 721 structures use a transparent and current valuation process on both sides of the exchange. The DST interests should be valued using a recent independent appraisal or other clearly defined fair-market-value methodology. The OP units should be valued using an objective process and not a made-up figure to suit the sponsor’s objectives. The timing of those valuations should be reasonably aligned so that investors are not exchanging a recently valued OP unit for a stale valuation of the DST property.
This timing issue can be material. If real estate values rise after a property appraisal but before the 721 option is exercised, a stale appraisal could cause investors to exchange at a value below current market value. The reverse could also happen, but the concern is that an affiliated OP may have an economic incentive to exercise the option only when the terms are favorable to the acquiring platform. Investors should ask whether the appraisal must be obtained within 30, 60, or 90 days of the exercise date, whether multiple appraisals are required, and whether an independent fairness review is used.
A second fairness issue is whether the valuation includes all trust assets. If the formula values only the real estate, what happens to cash, reserves, prepaid expenses, or other trust assets? Are they distributed to investors before the exchange, or are they effectively transferred to the OP? This detail may sound technical, but it can affect real dollars.
Forced 721 versus investor choice
Not all 721 options give investors the same level of control. Some programs allow investors to elect cash instead of OP units. Others may require investors to accept OP units if the option is exercised. The industry sometimes refers to the latter as a forced 721 structure. The phrase does not mean the OP is forced to exercise the option. It means the investor may be forced into the 721 exchange if the DST sponsor elects to proceed.
Cash-out rights can also vary. A strong structure gives investors a clear, enforceable right to receive cash of equal value, subject to reasonable procedures. A weaker structure may merely state that the sponsor will endeavor to accommodate cash elections, may impose aggregate cash-out limits, may charge fees, or may require investors to act within a short election window. For investors who want to preserve the ability to do another 1031 exchange, cash-out rights may be critical.
Liquidity after the exchange: read the fine print
One common selling point of 721 programs is potential liquidity. That can be helpful, especially for estate planning or investors who no longer want to manage repeated 1031 exchanges. But liquidity should not be assumed. OP units may be subject to many potential limitations including lockups, redemption caps, board discretion, or other conversion restrictions before they can become cash or REIT shares.
Investors should ask practical questions: When can OP units first be redeemed? Are redemptions monthly, quarterly, annually, or at the discretion of the REIT? Are there limits on the total amount the REIT will redeem? Can redemptions be suspended during market stress? Are redemptions subject to a discount to stated share value, or subject to fees? The phrase potential liquidity is not the same as actual liquidity.
Evaluate the REIT, not just the DST
A 721 exit changes the investment. The investor is no longer evaluating only the original DST property; the investor may become an owner of OP units tied to a broader REIT. That means the REIT’s maturity, diversification, leverage, distribution coverage, NAV process, and redemption history are critical.
A REIT with only a few properties may not provide the diversification or liquidity investors assume they are receiving. Investors should ask how many properties the REIT owns, how long it has operated, how diversified it is by tenant, geography, industry, lease maturity, and lender, and whether it has been tested through market stress. A larger, longer-tenured REIT with many properties, stable covered distributions, audited reporting, and a documented history of fulfilling redemption requests deserves more credit than an immature REIT that has not yet proven its liquidity or distribution model.
Master-lease valuation: a subtle but important issue
Some DST 721 options value the property based on the in-place master lease rather than a traditional property-level valuation. This may reduce volatility because the valuation is tied to more stable master-lease cash flow rather than the underlying property’s variable performance. That can sound investor-friendly.
However, it may also create directional risk. If the property is performing better than the master lease implies, a master-lease valuation could be lower than the value a third-party buyer might pay for the real estate. In that case, the DST sponsor may be incentivized to exercise the option when the exchange price is favorable to them. If the underlying property underperforms, the UPREIT option may be less likely to exercise. This is why investors should ask whether the 721 valuation is based on the real estate’s actual market value, a master-lease valuation, or another methodology.
Investor due-diligence checklist
Before giving meaningful credit to a DST’s 721 option, investors and advisors should consider the following questions:
Bottom line for DST investors
A 721 option should not automatically be viewed as a benefit or a drawback. It is best understood as a potential exit path whose value depends on the sponsor’s prior history, the fairness of the conversion price, the investor’s ability to choose cash, the quality of post-exchange liquidity, and the investor’s desire to preserve or give up future 1031 exchange flexibility.
The right question is not simply, “Does this DST have a 721 option?” The better question is: “If the 721 option is exercised, will investors receive fair value, retain meaningful choice, and obtain practical liquidity, or are they granting an affiliated platform an option to acquire the property or investor interests on terms that may primarily benefit the sponsor?”
For more information, be sure to download a copy of my popular book entitled Real Estate Tax Deferral Strategies Utilizing the Delaware Statutory Trust (DST) – 2nd Edition.
Your Comments :