In the past three to four decades, many successful real estate developers, sponsors, syndicators and operators have built substantial portfolios of commercial real estate using high-net-worth investor capital.
Through careful acquisitions, development expertise, market appreciation and operational oversight, these sponsors have amassed portfolios worth tens or even hundreds of millions of dollars.
While this success story is one that many real estate entrepreneurs aspire to achieve, it often creates an entirely new set of challenges later in life.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more – straight to your e-mail.
Profit and prosper with the best of expert advice – straight to your e-mail.
Ironically, some of the industry’s most successful real estate developers, syndicators and operators eventually find themselves facing one of the most difficult decisions of their careers: How to transition out of highly appreciated real estate without creating significant tax consequences for themselves and their investors.
The hidden challenge of success
For many sponsors, years of success have resulted in a substantial portion of both their personal net worth and their investors’ net worth becoming concentrated in a relatively small number of assets. What began as a strategy for creating wealth can eventually become a concentration risk.
A real estate developer might find that the majority of their wealth is tied up in a handful of apartment communities, retail centers, industrial properties, hotels or other commercial real estate assets.
Likewise, many of their investors could have significant portions of their investment portfolios tied to the same properties.
This creates a dilemma. On one hand, the assets have performed extremely well and continue to generate income. On the other, the sponsor and investors might have become heavily concentrated in a single asset class, geographic region or investment strategy.
It’s not an easy solution
The obvious solution might seem simple: Sell the properties and diversify. Unfortunately, it’s rarely that easy.
Many assets have appreciated substantially over decades of ownership. In addition, years of depreciation deductions have created significant depreciation recapture liabilities.
For many real estate developers and their investors, an outright sale could trigger capital gains taxes and depreciation recapture taxes that — depending on their tax situation and state of residence — could consume 30% to 40% or more of their equity proceeds.
Faced with that reality, many sponsors begin considering a 1031 exchange. However, this exchange often introduces another challenge.
The aging real estate developer problem
When these properties were originally acquired, the sponsor might have been in their 30s or 40s. Today, many of these same sponsors are in their 60s, 70s or beyond.
The question becomes: Do they really want to continue operating, managing and overseeing large real estate portfolios for another decade or two?
Many no longer desire the day-to-day responsibilities that come with active real estate ownership. Leasing, property management oversight, lender negotiations, capital projects, tenant issues and operational challenges can become increasingly burdensome.
At the same time, selling and paying the taxes might not be an attractive option.
As a result, many sponsors find themselves caught between two undesirable outcomes:
- Continue owning and managing increasingly demanding assets
- Sell and incur substantial tax liabilities
The capital expenditure challenge
Adding to the complexity, many long-held assets eventually require significant capital expenditures — roofs must be replaced, parking lots resurfaced, mechanical systems upgraded, interiors renovated and brand standards maintained.
For aging sponsors, writing large capital expenditure checks while simultaneously managing complex projects can become increasingly less appealing. The assets that once generated wealth might now require substantial reinvestment simply to maintain competitiveness.
A real-world case study
Kay Properties, where I am the CEO, recently worked with a large real estate operator facing this situation. Over several decades, this client had successfully developed and acquired a portfolio of about 20 hotels throughout the Midwest.
The portfolio had been built using high-net-worth investor capital and had generated significant wealth for both the sponsor and his investors.
However, time had changed the equation. The sponsor was well advanced in age, and many of his investors were also nearing retirement or already retired. The portfolio had appreciated significantly, making an outright sale highly unattractive due to the substantial capital gains and depreciation recapture taxes that would result.
At the same time, another major issue was looming. The hotels were approaching the point at which they would need to complete property improvement plans (PIPs) to maintain their national hotel brands and flags.
Depending on the property, these PIPs were estimated to cost from $1 million to $4 million per hotel. Across about 20 hotels, the required capital infusion represented an enormous financial commitment.
The sponsor ultimately tasked his CFO with identifying a solution that would address the following challenges:
- Avoid a substantial tax burden
- Reduce concentration risk
- Eliminate the need for active management
- Address aging ownership concerns
- Avoid massive upcoming capital expenditure requirements
- Continue generating potential income for investors
Exploring the options
After extensive discussions with the Kay Properties team, along with the sponsor’s CFO and legal counsel, the group determined that selling the portfolio to a large institutional buyer and completing a 1031 exchange into a diversified portfolio of Delaware statutory trust (DST) investments offered a compelling solution.
Following the sale, about $65 million of 1031 exchange equity was exchanged into a portfolio of roughly 30 different DST investments sourced from multiple DST sponsor companies.
Rather than remaining concentrated in one asset class — hotels — the sponsor and investors were able to diversify across multiple property sectors, including:
- Multifamily apartments
- Industrial properties
- Medical real estate
- Retail properties
- Student housing
- Other institutional-quality commercial real estate assets
The result was exposure to thousands of underlying units and properties across numerous markets and asset classes.
Solving multiple problems with one strategy
This DST investment strategy addressed several major concerns simultaneously.
First, it significantly reduced concentration risk by moving from a portfolio concentrated entirely in hotels in a limited geographic area to a broadly diversified portfolio spanning multiple property sectors.
Second, it allowed the sponsor and investors to defer a very large amount of capital gains taxes and depreciation recapture through the 1031 exchange process.
Third, it eliminated the burden of active property management that the developer had borne for many years. As passive owners in DST structures, the developer no longer had responsibility for day-to-day operations, leasing, maintenance oversight or capital project management — those responsibilities now rested with the DST sponsor companies.
Fourth, it addressed the looming capital expenditure requirements associated with the hotel portfolio’s Property Improvement Plans.
Finally, the DST portfolio provided the potential for ongoing monthly cash flow distributions from a diversified collection of institutional-quality real estate assets.
The bigger picture
As the real estate industry continues to mature, more real estate developers are likely to face this same exit strategy conundrum.
The challenge is not simply about selling assets. It’s about balancing taxes, diversification, legacy planning, investor relationships, operational responsibilities and lifestyle considerations.
For many aging real estate developers and their investors, the question is no longer how to build wealth through real estate, but how to preserve that wealth, diversify it, simplify ownership and transition into the next chapter of life without unnecessarily sacrificing a significant portion of their equity to taxes.
While every situation is unique and requires careful legal and tax analysis, DST investments have emerged as a viable solution that could help address these competing objectives for certain larger investors pursuing a 1031 exchange strategy.
To view available DST investments through Kay Properties and access due diligence materials on current DST properties, investors can register at www.kpi1031.com. The Kay Properties marketplace is unique in that there are typically 25 or more DST sponsor companies with between 25 and 50 different specific DST investments posted on the platform at any given time.
