Publications

- January 1, 2019: Vol. 6, Number 1

The 411 on 1031 exchanges

by Steve Bergsman

Real estate’s 1031-exchange industry is partying like its 1999 … well, 2004 maybe, when property markets pulsated in Princely fashion. Unlike yesteryear, the current boom appears to be good news for today’s investors, property brokers, purveyors of 1031 investment vehicles, the wider real estate market and, ultimately, the national economy. Today, the question is not so much where will the next 1031 exchange investors come from — because they are coming from everywhere — but what should the next investment be?

“Our concern is not finding investors; our concern is finding properties that will meet the expectations of our investors and broker/dealers,” says William Passo, CEO and founder of Passco Cos. “If there was a year when we were not able to exceed the preceding year, it would be because we couldn’t find the properties we felt were suitable for our investors.”

As of November 2017, Passco, a leading sponsor of syndicated 1031 exchanges, was on track to pass a bountiful 2017 in terms of investment volume and transactions. Indeed, for every year since 2015, Passco’s 1031-exchange business has shown an incremental increase over the preceding year.

Other sponsors of 1031-exchange programs are also reporting strong year-over-year growth. Through early November, Inland Private Capital Corp.’s 1031 business had already exceeded 2017’s total sales by more than 10 percent, says Keith Lampi, president and COO of Inland.

Under Section 1031 of the Internal Revenue Code, an investor can defer paying capital gains (or losses) on the sale of property if the proceeds are used to purchase “like kind” real estate. The time frame is 45 days to identify the target property to be purchased and 180 days to complete the transaction.

Traditionally, an individual investor might buy something like a four-plex residential, net-lease retail property or self-storage facility, and then at some point sell the property and buy another piece of like-kind real estate of equal or greater value. The term “like kind” is very broad, so it covers most types of investment in land or buildings.

In the early 2000s, the Internal Revenue Service established Revenue Procedure 2002-22 to allow the tenant-in-common co-ownership structure to qualify for the 1031 exchange. The result was the first boom in syndicated 1031 exchanges. According to the Alternative & Direct Investment Securities Association (ADISA), the equity numbers jumped from $356 million in equity raised for syndicated 1031 exchanges in 2002, to $1.8 billion in 2004 and to a record $3.7 billion in 2006. Then came the global financial crisis. So many 1031 exchanges failed that by 2010 the amount of equity raised dropped to a modern low of $170 million.

What the heck happened?

Of course, the global financial crisis pounded real estate markets, so properties of all kinds quickly lost value. On a general level, however, notes Adriana Olsen, senior vice president of marketing for Passco, “the economy plays a big role in the growth of 1031 exchanges, as the 1031 makes a lot of sense when there is appreciation.”

More than that, structural issues with the tenant-in-common structure (TIC) proved problematic. First, the TIC could only purchase one investment property. If the TIC bought, for example, an apartment complex in Phoenix or another area hard-hit during the recession, it was probably under water by 2008, so there was no larger portfolio effect to diminish the problems with the one property.

Secondly, the TIC, which could have as many as 35 investors, could make decisions only if all 35 investors agreed. Each investor had his or her own individual agenda or reason for the investment, so achieving unanimity was like herding cats.

“If you bought in the wrong market and used too much leverage, then your cash flow went away, and it is hard to get two people, much less 35, to agree on anything,” notes William Rance (Randy) King, founder and president of RK Properties.

RK Properties does not do TICs anymore, having switched its syndicated business to a structure called Delaware statutory trust investments, or DSTs. However, King says, it has only been a little over a year since it made the switch, the last major sponsor of syndicated 1031 exchanges to do so.

“There are still some small companies doing TICs, but now the market is about 90 percent DSTs,” he says, “and it is an absolutely growing business.”

In 2004, the IRS gave the same benefit to DSTs in terms of 1031 exchanges as it did TICs two years before, but it was not until after the recession that this market started to take off.

“Coming out of the financial downturn, with the marketplace sorting through the challenges that occurred with the tenant-in-common structure, the Delaware statutory trust structure quickly became the preferred vehicle for securitized 1031-exchange products,” says Lampi.

Lenders realized the DST was a more flexible product than the TIC. Lampi lists three main reasons the DST proved a better investment: the ability to pool multiple assets into one vehicle, thus more diversification; a larger number of investors allowed in each offering, which lowers the minimum investment threshold, also encouraging investor diversification; and the asset-management-related decision making is firmly guided by the sponsor, as signatory trustee of the trust.

The syndicated 1031-exchange format, dominated by the DST, has been on a tear for almost a decade now. According to ADISA, from the low point in 2010 of $170 million of equity raised, the numbers have climbed every year, reaching $1.9 billion in 2017 and a forecast $2.4 billion for 2018.

The fall and rise of 1031-exchange sponsors has mirrored the industry’s health.

“At the height of the market, we were reviewing 52 out of 70 sponsors — this was back around 2007,” says Warren Thomas, founder and managing director of ExchangeRight. “Those numbers narrowed to about 10 active sponsors after the recession.”

Today, there are an estimated 30 active 1031 exchange sponsors.

“We started ExchangeRight in March 2012, and the company has grown by 50 percent or more every year since then,” says Thomas. “A year ago, ExchangeRight would be building a portfolio of $60 million to $70 million of net-lease property, and it would take us three months to sell out; now we are building $100 million portfolios every 60 days. Despite rapid growth, we have been consistent, buying buildings occupied by investment-grade tenants, and achieving aggregated lease terms of 12 to 13.5 years and portfolio cap rates of 6.2 to 6.35 percent.”

Although DST growth has been steady for a long time, the 1031 exchange for real estate got an inadvertent confidence boost from the Tax Cuts and Jobs Act signed in December 2017.

When the bill was in discussion, there was a lot of teeth gnashing in the real estate industry for fear 1031 exchanges for property would be eliminated.

“Various proposals and a draft bill were going to limit the ability of the 1031 as to the maximum gain that could be deferred,” recalls Bryan Mick, president and CEO of Mick Law. “The tax act could have substantially and negatively affected exchanges for commercial properties.”

There were concerns that with comprehensive tax reform “everything was on the table,” says Lampi, who is also the president of ADISA. “As an industry, we wanted to make sure our messaging was clear and fully understood: that section 1031 of the tax code provides liquidity in the real estate marketplace, which contributes tremendously to the broader economy, and if it was repealed or reduced there would be a spillover effect.”

In the end, the 1031 exchange was eliminated for personal property but kept for real estate. That decision was a sound one because without the 1031 exchange, many property owners would hold assets longer, leading to less transaction volume, which would have a muting effect on real estate and adversely affect valuations — and that affects local and state real estate taxes. In addition, (1) any time a property changes hands, taxable income is generated through sale and transfer, and (2) prior to selling, a landlord oftentimes improves the property and after the sale, the new landlord might do the same.

“The 1031 exchange increases business in all related companies,” says King. “In my business, when we buy a new building, we go in and redo all the kitchens, bathrooms, etc. That brings in a lot of contractors, plus we buy carpets, fixtures and appliances. It is good for the economy to complete 1031-exchange transactions, as a lot of money is spent on the acquisition to make it better.”

For the individual, 1031 exchanges work because you can defer 30 percent of the money that you might have spent on taxes and reinvest those dollars into another productive asset, so you will end up with greater yield. And those taxes on real estate transactions have been increasing.

“We have seen a roughly 50 percent increase in taxes since 2012,” says Thomas. “Capital gains rate was a maximum 15 percent in 2012 — now it is 20 percent; the investment income tax that didn’t exist in 2012 is a 3.8 percent tax today; in some states, such as California, taxes affecting property investments jumped 4 percent; and investors could also be subject to an alternative minimum tax. Increasing taxation has been a momentum builder for 1031 exchanges.”

With the 1031 exchange saved, that part of the real estate industry has continued to boom, as did the wider property market. Some are speculating, however, that property markets have peaked — especially in those sectors favored by sponsors of the 1031 exchange.

“The larger issue at this point in time is, what do you exchange into?” says Mick. “Class A multifamily has always been a favorite product type amongst investors and lenders, but there is a lot of new multifamily out there, and we are seeing saturation in certain markets. Rent increases are decelerating, and vacancies are ticking up — both early warning signs of too much supply.”

Mick has been noticing more self-storage and even retail deals. He also suggests farmland could be a cheap investment, and if an investor wants to stick with multifamily, class B apartments or value-add situations might be the way to go, although risk levels tick up considerably.

If multifamily becomes a problematic sector, that is a major issue for 1031 exchanges because the industry is reliant on apartments.

In 2007, multifamily attracted only 19 percent of the monies raised for securitized 1031s, reports ADISA. Through October 2018, multifamily gobbled up almost 60 percent of all equity raised during the year. Office, which took 40 percent of equity raised in 2007, has dropped to 17.2 percent and retail, at 19 percent in 2007, has drifted lower to 14.7 percent in 2018.

Passco is currently looking at self-storage and multifamily opportunities in secondary and tertiary markets.

“If you look back from 1986 to 2017, year over year, apartments have always had a higher return than the other major asset classes,” says Olsen. “Rent growth is coming down and occupancies moving up, but that doesn’t mean you can’t make money in apartments long term. Even with increased vacancy rates, apartments show healthier numbers than other asset classes.”

Olsen concludes, “We are still bullish on apartments.”

Steve Bergsman is a freelance writer based in Mesa, Ariz.

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