1031 Exchange Rules and Regulations

Chapters:

00:00 – 00:13: Bumper

00:13 – 04:06: Spotlight: Jeff Hertz and Cantor Fitzgerald

04:06 – 05:15: Introduction Episode 27

05:15 –  10:10: Introducing the 1031 Exchange

10:10 – 13:37: LLC Partnerships and the 1031 Exchange

13:37 – 16:40: Why do a 1031 Exchange?

16:40 – 19:43: What is a 1033 Exchange, Rules, and How it compares to a 1031 Exchange.

19:43 – 24:50: The Kinds of Tenant in Common Structures and their Advantages

24:50 – 25:58: What Does a Delaware Statutory Trust Have to Do with Delaware?

25:58 – 26:48: 1 Advantage of a DST for a Real Estate Investor

26:48 – 28:30: Finding the Right DST Sponsor

28:30 – 29:57: What is the Financial Time Commitment on a DST?

29:57 – 35:27: What to Expect in Returns When Your DST Goes Full Cycle

35:27 – 37:29: Institutional Grade DSTs vs. Privately-Owned DST Investments: Pros and Cons

37:29 – 45:36: Does a 721 UpREIT Help Me with Liquidity

45:36 – 46:50: I’m a Young Real Estate Investor and I Don’t Want to Manage My Own Rental Properties.. Is a DST for Me?

46:50 – 54:26: How Does a Qualified Opportunity Zone Work, and Can I Benefit From It?

54:26 – 58:16: How a Master Lease Can Benefit You in an Inflationary Environment

58:16 – 1:02:12: How Different Investments Perform in an Inflationary Environment.

1:02:12 – 1:04:13: Master Leases in the Single Family Rental Space

1:04:13 – 1:10:56: Don’t Fall For This Typical DST Sales Trick.

1:10:56 – 1:14:19: The Future of Interest Rates… Will they Go Back Down?

1:14:19 – 1:14:31: Goodbye

1:14:31 – 1:15:04: Disclosures

Show Transcript:

Wally Smith:
Jeff Hertz podcast with Cantor Fitzgerald. Jeff, welcome to the 1031 Show.

Jeff Hertz:
Thank you very much. It’s a pleasure to be here.

Wally Smith:
You bet. So you’re Senior Vice President with Cantor?

Jeff Hertz:
Yep. I head up national sales and advanced planning with our sales team.

Wally Smith:
Okay. And you’ve been with Cantor for how long now?

Jeff Hertz:
A little over six years.

Wally Smith:
Okay. And gone through several roles during that time?

Jeff Hertz:
Yeah. I started out as really more of a product specialist in a couple different strategies that we employ and now in more of a high level management role. But I’m involved with everything from acquisitions and dispositions to some asset management, to marketing, investor relations. Cantor is a large firm, but we’re a small component within a very large company. Always a lot to do.

Wally Smith:
Is most of your focus on DST specifically or just property packaged in a number of different ways?

Jeff Hertz:
To an extent I’m involved in all of our strategies, but in a way DSTs were my first love. They were my foot in the door to get into Cantor. I guess I’m the go-to person on the team when it comes to our DST solutions.

Wally Smith:
Very good. Well, before Cantor, let’s go back a couple of companies, before that you were with Inland, I think.

Jeff Hertz:
Yep. I was with Inland Real Estate for a dozen years, wholesaling in the Upper Midwest.

Wally Smith:
Okay. And then before that, another small company, right? Nuveen?

Jeff Hertz:
Yeah. In another startup, I think Nuveen was founded in the late 1800s. So when I was there, we’d been around for 120, 130 years or something like that.

Wally Smith:
Big company. Where did you go to school? What did you study?

Jeff Hertz:
Went to University of Oregon, studied psychology. I thought I was going to be the guy sitting with the person on the couch. But as it turns out, being in sales and management you tend to apply a lot of the things that you learn about the human brain and how people function.

Wally Smith:
Absolutely. We talk about that a lot here, really coming alongside the clients and figuring out what really do they need. Because there are a ton of products out, there are a ton of registered reps presenting products, but fortunately we’ve been pretty blessed, having a lot of people just feel like they have that connection with us. There must be a deep psychological aspect to that. So now for Cantor, you said you do a lot of different things, acquisitions, dispositions. Is there any one specific area that’s a focus?

Jeff Hertz:
Really just providing training and providing guidance with our sales team. But that extends into working with financial advisors. That extends even in some cases, into working with, not directly obviously, but working with individual clients. I might give a presentation with an advisor, with one of our salespeople, but we’re also talking to a family, in some cases even multi-generational. There’s a lot of attributes to it. What I really enjoy is actually getting into the real estate side of the business, understanding what we’re buying, why, how it’s going to be managed, all that. I think that makes me maybe a little bit better at my job in terms of then relaying that message to advisors and their clients. I like to go see our properties either before or after we’ve purchased them if feasible. I guess I enjoy the real estate side of the business as much as anything.

Wally Smith:
Are you on the road a lot?

Jeff Hertz:
Leaving for Boston tomorrow.

Wally Smith:
Oh boy. All right. That’s a pretty city. That’s nice. Just don’t try to drive there.

Jeff Hertz:
And the weather’s, thankfully compared to a couple weeks ago, is going to be very, very warm. Nice.

Wally Smith:
I have a friend who just took his middle school kids back there for the history tour and they hit all the must have spots there. And also just for the record today we’re now talking about any specific deals, any specific offerings, products, funds of Cantor. Really just talking about the industry and trends and what we feel going on. Many of our viewers are individuals, they’re small businesses who may own commercial real estate, but it’s generally the rental stock that people have had for a couple of decades. It’s not as much fun taking care of all of the tenants and trash and taxes and toilets and stuff now at 60 years, 65 years old than it was 30 years ago.
But they’re trying to figure out what’s the next step. And gosh, all of the tremendous appreciation we’ve seen in real estate in the last few years, really unprecedented. But that’s created an opportunity, but it’s also a lot of confusion. That’s something we try to address on this show. We’re always going back to basics. I like to do that as well here and just talk about 1031. So let’s talk through the basics of our industry. Tell us about 1031s.

Jeff Hertz:
1031s. I think we just surpassed 100 years that it’s been on the tax code. It’s evolved over the years. It’s both expanded and contracted. In some cases they talk about in the early days, simultaneous exchanges to farmers, trading deeds across the table. Very straightforward, very simplistic. But the idea that if you’re in, and this hits home to me because I spend a lot of time in places like Iowa and Nebraska, Minnesota where there’s lots of farmland. If you’re trading one piece of farmland for another piece, there might be differences in quality, but at the end of the day it is like kind. Right. So that term-

Wally Smith:
Absolutely.

Jeff Hertz:
… it was apropo in terms of how it was created. Now, of course, over that 100 plus years we’ve seen a great expansion of kind real estate. You could sell a duplex and invest into an office building or an industrial property. So like kind is quite broad.

Wally Smith:
Mineral rights, water rights.

Jeff Hertz:
Even things that are beyond real estate. And of course up until a few years ago, you even had what are called personal property exchanges. I could sell my Learjet and buy a Gulfstream. I could sell a Picasso and buy a Rembrandt. That of course was taken out in 2017, so were really back to more-

Wally Smith:
It was probably appropriate. I think they were abusing it a little bit.

Jeff Hertz:
The fact that you could sell a wine collection and 1031 exchange it, seemed a little odd.

Wally Smith:
You sell a restaurant, include all of the equipment and the wine collection.

Jeff Hertz:
It’s ironic my last name being Hertz, I worked with some firms that did rental car swaps. And so they would sell off, Hertz would sell off hundreds and thousands of vehicles, avoid the depreciation recapture by reinvesting the money into new cars. It was part of that industry, but ultimately I’m not sure that it really made sense as far as it being a relief for taxpayers who were seeking that.

Wally Smith:
I welcomed it when I saw there were a lot of folks were saying, it’s heavy handed government again, but I think actually every tax cycle has been on the chopping block. It’s looked at so many people as a gift to wealthy people or a gift to generational wealth, but it’s not. It is bedrock of capitalism, being able to keep your capital, keep your assets working productively. I’m glad they cleaned it up, I think that protected it for a while.

Jeff Hertz:
But keeping maintaining the 1031 code I think is important. Again, going back to some of the experiences I had years ago, you have multi-generational farmers and landowners and what’s happening in a lot of cases there is the kids that grew up on the farm now have moved to the city. They moved out of the area, and they don’t really want to continue to own farmland that is in where they grew up. And so having that ability to transition vis-a-vis 1031 exchange into other assets, maybe things that are more in their area of expertise, maybe geographically make more sense for them not to be burdened by having an asset that you just long term don’t want to own, can be very helpful.

Wally Smith:
We had a client come in, they are fifth generation, the clients are all in their 70s, and the land up in the Dakotas has been in the family for five generations. Nobody wants to work it now, and it’s just lying there. They’ve got people willing to buy it, but they’ve been scared of the capital gains. So the whole concept of 1031 into something that preserves the tax benefits, but is income producing, it’s been a tremendous tool really.

Jeff Hertz:
And personally I was involved in a family situation where you have family members who are co-owners of assets together and disagreements and lifestyle, people move to different areas of the country and don’t necessarily want to be tied to that. So it’s like the prisoners being handcuffed to each other. You don’t necessarily want to go the same direction as your family members. And quite honestly I’ve seen situations with siblings who are not even on speaking terms any longer and say, it doesn’t make sense for us to own this asset collectively. So to be able to unwind from a logistical standpoint can be very helpful.

Wally Smith:
Well, let’s talk about that a little bit. The rules are as clear as IRS can make them sometimes, and we hear many, many things about the structure has to be identical before and after as far as who owns the property, what’s the registration of the property? We talked to various QIs, some of them are the big guys, of course they are by the book, because if they blow something on one of them, it’s going to open up their entire book and all those clients basically to audit. If you have LLC with multiple members of it, and then they wanted to, they thought, well, we really would like to go our own separate ways. How does that work? What’s the mechanics of that? Can you touch on that a little bit?

Jeff Hertz:
Sure. There’s a lot of different structures that people will own assets in, as you said an llc, different corporations, different partnerships. Ideally people would own real estate as tenants in common, because that gives you the most flexibility from what I’ve seen, the ability to dissolve the TIC and individual participants go in their own direction. I guess I would say, obviously having a good tax and or legal advisor can be enormously helpful. I joke sometimes when I get questions saying, well, this investor’s in a C corp and they need to unwind this, and they’re asking me. And I said, well, I am not a tax professional. I don’t give tax advice. And you’re talking about-

Wally Smith:
That should probably be a disclosure as well, we’re not giving tax or legal advice on the show today.

Jeff Hertz:
And in many cases you’re talking about assets that have a seven, eight figure valuation to them. So you want to make sure just as in all business decisions that you have good qualified people. One such structure known as a drop and swap can be very helpful, where effectively you dissolve the entity that the owners were part of, and you’re able to portion out the individual pieces pro rata to the investors, and then they can go and make their own decision. Because again, what happens in a lot of partnerships for example, 20 years ago everybody was healthy and well and happy together. And then over the last 20 years, people have passed away. So now you have multi-generational considerations, you have liquidity considerations.
There’s a lot of activities that a good attorney/CPA can help you unwind. And one of the things that I recommend is make sure you’ve addressed those structural issues before you get too far down the path of actually disposing of the property. Because again, I had a personal situation where we had to restructure a corporation and then our attorney suggested that we wait a period of time to let the dust settle.

Wally Smith:
Do you find that, again, without giving tax advice, just in your experience, how far in advance of an exchange have you seen the drop and swap be implemented?

Jeff Hertz:
I’ve heard it said maybe jokingly, maybe this is more realistic, it depends on where, how should we say, on the coast, there’s certain places where people would say, boy, you can do one and then walk right into the next transaction the next day. There are some people who would say straddling a tax year might be a good, that way the paper trail is a little bit, we did one transaction one year and another transaction in another year. As you mentioned earlier, there aren’t a lot of bright lines with some of these aspects with the IRS. It’s really more of the investor and their advisors mentality as far as how comfortable they are with that.

Wally Smith:
Very good. Well we have resources that are available if somebody wants to learn more about drop and swap or the other way swap and drop. These are tools that are not, you don’t generally want to go in and tell the IRS, hey, what’s the best way to do my drop and swap? That’s not how that works. That’s lingo for the planners on the front side. Let’s see. So 1031s, they’ve been around a long time and it’s a like kind property held for investment purposes.

Jeff Hertz:
Correct.

Wally Smith:
And also as far as the structural changes, it’s got to be for a business reason, it cannot just be to play the tax code. So there really needs to always be a business reason. Why are we doing this? To alter the structure, change the structure in it. But with the 1031s, I guess let’s talk about that a little more. They’ve been 1031 into, we’ve seen a variety, I had a farmer out in Nebraska who had a million dollars of water rights on a property and didn’t need them. And so he was able to do a 1031 exchange of those and went into multifamily apartment buildings, and gosh, might have been storage unit, something else. That was great. He had no idea you could do that.

Jeff Hertz:
There’s kind of, as they say, many ways to skin a cat. There’s a lot of different ways to look at it. It depends on, as you said, the rationale and the background of it. They may be looking at the financial reasons for doing a 1031 exchange and maybe to simplify their lifestyle, maybe they’re at a retirement age where they want to just not have the direct involvement in the real estate assets any longer.

Wally Smith:
We see that a lot.

Jeff Hertz:
We even see people who, I’m not sure if this is quite as much the case now, but owned investments in extremely highly appreciated markets. And I guess you could say that certainly here in Denver, you could be in a neighborhood or a part of the city that has gone up tremendously, and you say, I’ve got an opportunity to buy another property in another market, or another part of the country where I feel like there’s more runway to eventually see some appreciation. We’ve seen a lot of those types of situations.

Wally Smith:
We’ve had some of those recently, trades that have been owned for 50 years in downtown San Francisco. Pretty appreciated. And talk about the risks there, that’s another big element as far as if you want to reposition a piece of real estate. I always try to look first and foremost at the investment, it’s got to be a good investment. Then let’s look at the taxes. But if it’s not a good investment, taxes aren’t going to make up for it. Right. So being able to reposition into a better market, as you say it’s got more runway, more potential, or let’s say it doesn’t have as much what I call legislative risk. Where, for instance San Francisco, one of the things they were afraid of was the seismic assessments.

Jeff Hertz:
Sure.

Wally Smith:
Which complete wild card. They got out and were able to position them into, I think a portfolio of four or five different products around the country. So that was great. Geographic diversification, sponsor diversification, market sector diversification. That was a good one. 1033s, you run across many of those?

Jeff Hertz:
It depends on a couple things. Unfortunately with some of the wildfires out west in recent years, we’ve seen more just mentions of 1033 exchanges.

Wally Smith:
And let’s recap 1033.

Jeff Hertz:
Most people use the term a forced conversion, meaning your ownership of a property was taken away from you. And there’s really I’d say two main ways that we see that. One would be destruction of a property, floods, fires, those types of things. Second would be eminent domain. And that’s obviously much more common in, well, I actually came across it a lot in the Midwest because they were widening highways and things like that. And so the inconvenience of a farmer losing 10 acres, it changed the landscape of their assets. And so the government compensated them by paying them in a 1033 exchange. Couple of things that I think are very different about 1033 exchanges. Number one is the timing.
You typically have at least two years and sometimes even longer if the property was in a federally declared disaster area. So unlike a 1031 exchange where you have the 45 days and the 180 days and everything has to move very quickly, in a 1033 exchange, you generally have a lot more time on your hands. And of course, the other difference is the investor is going to take receipt of the funds themselves, and will basically just have the money in their bank account or wherever it’s going to be.

Wally Smith:
So that’s really important. They have a good CPA that understands it, but they don’t have to use a qualified intermediary. With the 1031, you do.

Jeff Hertz:
Correct. Exactly. And then there are some slightly more strict components of the 1033 exchange. The language is not like kind, but it’s similar in use or I can’t think of the exact words, but to be honest I’ve never seen a situation where the IRS challenged what investments the client went into. But yeah, similar in use.

Wally Smith:
You get out of a warehouse, maybe you need to keep it industrial, not be able to go from a warehouse that burnt down or was condemned into water rights or something far removed.

Jeff Hertz:
I was contacted about a case last week where the client still retained the land that the building was on, and they still had that land that had some value to it. The only thing they were getting compensated for was the destruction of the property itself. That’s quite a bit different than a typical 1031 exchange where you’re selling everything, the land and the building.

Wally Smith:
And there are also rules, with the 1033, I believe you just have to put the gain in that you’re able to actually retain the basis if you want to. So that’s unusual.

Jeff Hertz:
You also can use debt to offset the value of the property. So people tend to like higher leveraged assets because they can replace the value of the property.

Wally Smith:
Very good.

Jeff Hertz:
You don’t have to bifurcate the equity in debt the way you do in a 1031.

Wally Smith:
DSTs, we’ll talk about those in a minute. But I think to lead into that, first we should talk about tenant in common, TICs. TICs have been around forever. There’s some big pros and cons about TICs. What’s good, what’s bad? Why don’t we see them as often anymore?

Jeff Hertz:
When I first got into the space and I got into the securitized real estate space right when DSTs were being created in 2004, really just almost before they became created. When I came into the space, you had the TIC structure, and these were, I guess I would say there are, just for clarification, there are two types of TICs. There are securitized TICs where a sponsor will go out, acquire asset, and break it up into fractional components that individual investors are then going to invest into. And that industry was in high gear in the mid 2000s. I think at one time there was many as 75 different sponsors offer offering TIC programs.
There are also TICs that a few family members or business associates may create where they buy a building and then they set up a tenancy in common where they each have a fractional ownership of it, and there’s nothing wrong with that structure. As I said, it is probably the easiest to handle as far as liquidity and dissolving it. Where the securitized TICs got into some challenges, is number one, you had to have a unanimous consent. Let’s say we issue a TIC, five years later, we have an opportunity to sell the asset. You needed to get the consent of all 35 investors involved.

Wally Smith:
It is still a 35 limit.

Jeff Hertz:
There’s a limit of 35. Exactly. So it could have fewer than 35 investors. Secondly, because you can only have 35 investors per program, the minimums per investor got higher and higher as these deals got larger and larger. I personally saw offerings in the market back in 2004 or five that had a million dollar minimum, which meant that if you had less money than that you probably couldn’t invest in it. And you had concentration risk because you were putting so much money into one potential program. Finally, really more of a timing standpoint, a lot of TICs that were created in the early 2000s were in a mode where they were using generally shorter term financing than you see today, maybe five years.
Fast forward to 2010, 11, 12, the lenders had a real issue with those because each individual investor was on title and on the mortgage themselves. So they had to be underwritten. In the midst of the great financial crisis the banks just didn’t want to underwrite 35 smaller individual investors.

Wally Smith:
There’s several reliable. Aren’t they?

Jeff Hertz:
Exactly. They were also had recourse on the loans. There were a lot of issues, but I think it ultimately took the great financial crisis to see what those deficiencies were in real time. But TICs can also have some other, like I said, some positive aspects. You can have capital calls where you could ask the investors for more money if the property needed it.

Wally Smith:
That’s good for the TIC.

Jeff Hertz:
It could be good for the TIC, not necessarily for the individual investors.

Wally Smith:
Can you have a TIC that does not have several liability on the loans?

Jeff Hertz:
Not that I’ve seen. I think ultimately it would depend on the lender. If the lender felt that the asset and the sponsor of the TIC was substantial enough that they may not require that level of recourse, but suffice to say in today’s world I think the lenders are at a point where they want to have people to have skin in the game.

Wally Smith:
Well, without naming names, there’s a huge, huge building project going in in Chicago, and it’s in a TIC structure. And so what we’ve seen is, TICs may be great, they may be the perfect solution for a lot of people, but we run into people who are thinking of getting into them and they’re just not sufficiently sophisticated, understand the risks you talked about, the unanimous consent needed to do pretty much anything. There’s several liability, the potential for capital calls and that sort of thing, but the promises they can make is that, hey, put all the money in and then we’re going to give you a great tax free return of capital in a couple of years. That’s one of the things we run into a lot, and people feel like, hey, this is great. I’m going to get a 1031. I’m going to get my cash to work with, and there’s no risk. There’s no problems. No such thing as no risk.

Jeff Hertz:
I liken it to a school bus with 35 steering wheels. Ultimately you need to have, as much as people oftentimes don’t want to relinquish control of their investments, they want to be in control of them, but in, again, a securitized TIC structure, ultimately you’re putting your money in with as many as 34 other investors whom you don’t know and you have no relation to. I actually did see a long time ago at my previous firm, a sale of an asset that was held up by literally one or two rogue investors. So maybe not the best structure to own-

Wally Smith:
Absolutely. Let’s talk about DSTs then. That’s a focus of a lot of what we do, although we work with each of these tools out here, but the DSTs seem to have solved a lot of the issues that we’ve talked about there. So you said you’ve been in them just about since they were starting.

Jeff Hertz:
Almost 20 years since the creation of the structure.

Wally Smith:
Tell me about DSTs.

Jeff Hertz:
I guess I would preface it just to be as balanced as I can be to say DSTs are not for everybody and they’re not a perfect structure. I think they have some significant improvements over the TIC structure when it comes to securitized investors who are-

Wally Smith:
I guess we ought to say DST stands for Delaware Statutory Trust.

Jeff Hertz:
Correct.

Wally Smith:
What does it have to do with Delaware?

Jeff Hertz:
It has to do with the Delaware laws, and Delaware and Maryland are typically two states that are very favorable for banking and corporate legislations.

Wally Smith:
Because I’ve had clients call me and say they don’t want to invest in Delaware.

Jeff Hertz:
I don’t want to invest in Delaware. In fact I don’t think I’ve ever seen a Delaware statutory trust that invest in Delaware. So trust law goes back hundreds of years, even pre the United States. So using a trust has a number of advantages for investors investing in a DST. Number one, I guess one advantage is much lower investment minimums. Most program sponsors have a minimum of maybe $100,000, but I’ve even seen DSTs that accepted less than that.

Wally Smith:
Sure.

Jeff Hertz:
The idea is that if you have, let’s say $400,000, which in the realm of commercial real estate is not really that significant amount of money.

Wally Smith:
Sure. That’s one single family home you sold.

Jeff Hertz:
You could split that up into four different DSTs with strategies and four different locations. So from a diversification standpoint, I think it offers some great benefits. The managers of the DST obviously are something you want to spend a significant amount of time researching and feeling comfortable with.

Wally Smith:
Well, what you said a moment ago about TICs having some element of control. With the DSTs you don’t have any control.

Jeff Hertz:
Correct.

Wally Smith:
So you better be comfortable with who that manager is.

Jeff Hertz:
The sponsor of the DST is of enormous importance. People tend to invest in what they know, and I’ve seen clients that say, well, I like a certain location or a certain asset class. But ultimately being comfortable with the sponsor and their ability to not only manage the property in good times, but obviously deal with issues that may arise further down the road.

Wally Smith:
Well, we look at any given time on the, I guess the Mountain Dell report, it’ll show 40, 50 sponsors, and there are, I don’t know, probably eight or 10 of them who we do most of our business with. And it’s because they know what they’re doing and we’ve seen how they weathered the storm in 2008 or the lockdowns that were put on us. And the rest of them, they’re probably half a dozen of them I wouldn’t touch. Of course, we know too much about them, and the majority of the rest are probably great folks. They just don’t have a track record yet. And I want to know before we put life savings in it, how have the companies done during good times, bad? Some of them during COVID had their best years ever.

Jeff Hertz:
And generally speaking of DSTs, there is no preset time that you’re going to be in the DST. Generally it’s going to be at least two to three years, but I’ve seen DSTs that ran as long as five to 10 years. So you want to make sure that you’re working with a sponsor that has been in business for a significant amount of time.

Wally Smith:
And most of them are built on a 10 year chasy though, right?

Jeff Hertz:
Yeah. Exactly.

Wally Smith:
Is that statutory that it’d be a 10 year period?

Jeff Hertz:
It’s not. Really to me it’s all about the loan term, and that stems from the fact that when the IRS created and were blessed, I should say, the revenue ruling 2004-86, in 2004 they established what are known as the seven deadly sins, which are basically just guidelines of how a DST has to be managed. One of those is that you cannot refinance a DST. There have been some sponsors who have figured out a way to do that in a way. Exactly. But generally speaking you’re going to be in an asset that is going to be a 10 year lease, if not longer, with one caveat, which I’ll mention in a second, and generally 10 years of financing or longer.
Now, again, what we saw in maybe 2004, 05 was shorter term financing, I.e five years. And then the challenge that of course those sponsors ran into was, oh my gosh, five years is not that long of a time, and it happened to coincide with the worst financial crisis we’ve seen in our lifetimes. So most of the time you’re seeing at least 10 year debt on these assets. Like I said, you’re often seeing at least 10 year lease term, especially for a single tenant asset. Now, the one exception is of course when you’re talking about things like multifamily, student housing, self-storage, you have generally shorter term leases, I.e, one year, and that’s where you would have a master lease structure in place.

Wally Smith:
We’ll talk about that in a second because that’s inside every, what is it? The yin and the yang inside of every catastrophe is an opportunity, inside of each of the seven deadly sins there’s an opportunity for spinning a two year advantage a little bit. But the 10 years, as far as some of the lingo, when one of these things ends, we call it going full cycle, what should somebody expect? They have a DST, one of the pieces that we have is a resource for people to understand, okay, I bought it, now what’s the care and feeding of this thing? What do I have to do? The first year that it’s end of January or they’re ready to file their taxes and they don’t have any information yet? Why hasn’t it arrived yet? We then explain how, I think almost all if not most of these are audited each year.
That takes a while. They can’t complete an audit by December 31st. There are things to need to know, they’re not bad, it’s just information. Many CPAs don’t know how to spell DST. And so we have a sister company that’s a taxed and accounting firm and are happy to help them with that, help them understand that. So full cycle, somebody owns one, they’ve been receiving their monthly income, this is great. They get a little bump perhaps depending upon how the deal is structured, and it’s four or five years down the road and they get a notice from the company that what’s going to happen.

Jeff Hertz:
Right. Right. The sponsor has found an opportunity to sell the asset. I think that’s another good question when it comes to doing due diligence on a sponsor is what is the business plan? Hope is not an investment strategy, as they say. So if it’s a multifamily asset, is it a situation where they’re going to put capital into the property to improve it? How are they going to raise rents? What is the business plan? Because ultimately, if the property never grows and the market doesn’t move in your favor, then an exit strategy becomes much more challenging to achieve. Typically 60 to 90 days prior to the close of the sale, notifying the investors, notifying them about when they’re going to be receiving their proceeds, because they’re going to go then start the whole process over again, notify the qualified intermediary, have an account set up, and obviously have replacement property options set up to take those assets.
It’s a good problem to have. We’ve seen a lot of it in the last several years in our industry. But I think it’s also, it’s one component of the experience of being in a DST. It can also be capital preservation, and of course income. Most DSTs obviously provide income, not all of them do.

Wally Smith:
Well, that’s another difference with the TIC, again, to get that sold. Maybe it happens, maybe it doesn’t. A lot of our investors are accustomed to two long term holds. Real estate people are different. They don’t expect the stock market liquidity. But they also would like to know, well, what’s the end game on this? When is this going to happen? And being able to know that, well, at some point in the time you have another 1031, you own a piece of real estate. It just happens to be a fractional piece. It’s securitized. But when it sells, it’s as if you just sold the condo again and now you have choices. You can do a full 1031, you can do a partial, take some boot, take some money back out of it. Those are great opportunities, and that’s what we’d really try to do is teach. We spend so much time teaching, how do these things work?

Jeff Hertz:
And also to recognize that the tax liability that you had five, 10, 15, 20 years ago in terms of that deferral that you’ve been enjoying by doing the 1031 exchange, that’s all going to continue. And in some cases, you may have additional capital gains as well as additional depreciation recapture. The rationale for doing another 1031 exchange in the future might be even greater than it was originally when you got into this process. Unfortunately the only way to truly get a step up in basis is to pass away or swap till you drop, as we say. So in many cases it’s more about just keeping that investment intact and continuing to defer the taxes.

Wally Smith:
Now after generally, again, no bright lines, but if you did have an LLC, there was a family corporation that owned a property, did a 1031, I think it’s safe to say most tax advisors will tell you that after two years is a fairly safe period of time, because life happens, people’s plans change. And so if you had that after about two years, you could make a change, you could break that out, change the ownership, make it a partnership or joint tenants or tenants in common.

Jeff Hertz:
Retitle it. Absolutely

Wally Smith:
Retitle it however you want. And the sponsors will help with that. They’ll get some paperwork fees, but otherwise it’s can be very helpful with estate planning.

Jeff Hertz:
Yeah. Because there’s huge differences between revocable, irrevocable trust, charitable trust, there’s a whole lot of things, but we do see people that maybe they own the asset as an individual and they want to move it into their trust. As you said, just having appropriate guidance from tax professionals can be very helpful.

Wally Smith:
Okay. More institutional players seem to be getting into the space. I think we both saw a news clip this morning about one of the big companies opening up one of the $3 billion REIT that they were going to be doing. Can you talk about that a little bit? The difference between Ma and Pa Kettle investing in a DST and then the role that these huge institutional players play?

Jeff Hertz:
Sure. Again, there are a lot of people that for better or worse want to control their own destiny, completely buy and sell their own assets, do their own 1031 exchanges. That’s great. That is completely understandable that they would want to be able to push the button when they want to sell the asset. Where again, people sometimes have run into situations is maybe a spouse dies and the other spouse has not been involved in the management of the property, the kids, so forth. This transition into not only securitized investments like DSTs, but larger institutional players, we’ve seen that played out over a couple other areas like non-listed REITs and other real estate solutions.
I think it’s a reflection of these companies have seen that the maturation of this space and seen that there are larger companies coming into the space. That’s good from a standpoint of having for the advisors to have more options for their clients. Generally speaking, when institutions come into these types of spaces, it drives down fees, because if I’m a multi-billion dollar corporation that’s been in business for 100 years, I don’t need to make all my money on a specific product. It’s more about offering those solutions. But maybe the con to that, just play devil’s advocate, is, does a large institution understand the liquidity needs of an 85 year old who is living on a fixed income? So you need to be cautious that you’re working with companies who their goals and their strategy aligns with your own.

Wally Smith:
Well, to that point, let’s talk about the advent of the 721, the UPREIT, how that works. That’s really recognized now as being the answer for the liquidity solution, but whether it’s compulsory or not, whether it’s an option. I know some of the sponsors require it, but let’s go back, tell me about 721s.

Jeff Hertz:
721 has been around for several decades, quite simplistically it is a related part of the tax code. It’s different than 1031, but it has similar attributes. So in a 721 exchange, I may own a piece of real estate. I’m looking to sell it. I’m approached by a large institution, let’s say it’s a real estate investment trust, and it would be better for them from a cash management standpoint to acquire my property without having to pay me cash. And it may be better for me from a tax planning standpoint to not have to do a 1031 exchange. So the old school original version of a 721 is I transfer my ownership of that property to that REIT in exchange for equity in that REIT, which is a non-taxable event and-

Wally Smith:
Non-tradable.

Jeff Hertz:
Well, it could be traded or it could be non-traded.

Wally Smith:
Okay. But for it to be at a tax free thing, it has to be on the non-publicly traded side. Correct?

Jeff Hertz:
It would be-

Wally Smith:
Operating partnership.

Jeff Hertz:
It would be operating partnership units. It could be in a publicly traded REIT. I could sell my warehouse for lodges and they could give me equity in that REIT if that’s an option that’s available for them. But we definitely see it more in the non-public REIT space.

Wally Smith:
So instead of Ma and Pa Kettle selling the family farm and putting that directly into an Amazon warehouse or something like that, they would actually take that. And it’s probably a bad example using a family farm. You don’t have that many REITs.

Jeff Hertz:
Well, it’s a good example in terms of where I was leading with that.

Wally Smith:
Sure, sure, sure. But being able to take the, maybe the doctor has an apartment building and now he doesn’t want the apartment building, it fits into a real estate portfolio of a large sponsor, and they say, well, that would fit right in with what we do. So now they exchange that. That’s not a taxable event at that point.

Jeff Hertz:
Correct. Correct. Then I guess the challenge is then you end up owning that REIT for an extended period of time. Maybe you do some selling sporadically and so forth.

Wally Smith:
The nice thing about it is, let’s say it’s a $20 million apartment building that’s fully depreciated. Instead of having this huge capital gain, now once it’s in the REIT, after it’s been in there for I guess a year, you can start to dribble it out, maybe take a couple hundred thousand dollars a year of liquidity out of it at a much lower tax rate.

Jeff Hertz:
So then the more recent version of the 721 exchange, what some referred to as the two-step transaction relates to the fact of exactly what you were saying. If I own farmland in Iowa and who’s going to buy that from me? It’s not going to be a large institutional REIT, because there aren’t that many that specialize in farmland. If I own a duplex here in Denver, same thing. I’m not going to sell it to any large institution. So the two step 721 allows an investor to cash out of something that is not necessarily desirable by a large institution, do a 1031 exchange into a DST, but that DST has already been predetermined that it is going to be pulled up into a larger REIT, a larger diversified REIT vis-a-vis that 721 transaction.

Wally Smith:
That would’ve to be generally after two years.

Jeff Hertz:
Correct.

Wally Smith:
And then another year hold before you could then the taxable events when you take the non-publicly traded operating partnership units and move them over to the publicly traded side to liquidate them and sell them.

Jeff Hertz:
Exactly. Exactly. And there’s a lot of scenarios that that works for. One, just simply diversification, right? If I take my million dollars and I invest into a single DST that happens to be a single property, I’m no more diversified than I was to begin with, right? So knowing that that DST is going to be pulled up into a multi-billion dollar REIT, I know that I’m going to be much more diversified down the road. It eliminates the need to do future 1031 exchanges, which can be attractive or not attractive.

Wally Smith:
How does the step-up in basis work on that whole process?

Jeff Hertz:
They effectively would maintain their same cost basis by going into the REIT. The nice thing, if there is any nice thing about passing away is when you pass away you have an immediate day of death valuation based on what the shares in that REIT are worth at that time, whether they’re valued on a daily, monthly, or annual basis.

Wally Smith:
Now it’ll depend on each REIT, but now the due diligence, instead of looking at doing a 1031 into a DST and having to have the due diligence on that DST itself, the sponsor, the property and everything, now you’re really looking at being in bed with that REIT. And so you are generally going to want to have a very robust, strong, big REIT that’s been around a while, that’s very diversified, got a great track record.

Jeff Hertz:
At the end of the day you’re in that DST as a launchpad to being in a larger entity generally no more, well, I shouldn’t say no more than two years, but at least two years. But in terms of how long you’re going to be in each phase of that transition, you’re going to be in that individual DST a lot shorter time than you’re probably going to end up being in that REIT. So you probably want to focus your due diligence more on the sponsor and the REIT itself.

Wally Smith:
Well, with the aging baby boomers, we’ve got several clients who are very thoughtful and I don’t know, they’re aware that they’re not on the top of their game, and they’re saying, well, I think I’m processing everything right now, but I know I really had to study this. I don’t know how I’m going to be processing and thinking where my cognitive abilities are going to be in five or 10 or 15 or 20 years. And so really knowing that they’ve got something that is going to be understandable, something that their heirs can work with and not burdening their, that’s one of the things we run into is people saying, I found this, I understand it, but my kids will never be able to figure this out, or my spouse will never be able to. I think that’s one area where, and not to mention names, but there’s some very big strong storied companies that have some wonderful strong REITs, right?

Jeff Hertz:
Absolutely. There are portfolios that people would put money into irregardless of the tax advantages. It just happens that they get that tax deferral. But no, to your point, I met with an investor years ago who owns something like 25 individual properties in a certain market. He loved, he had a property management company that he worked with who managed all the assets. And his primary concern was, if I go first, whether it was his wife or his kids were going to have to deal with it, and they just were not involved in that management. So he was looking at it from a transition in the state planning standpoint, which is-

Wally Smith:
Well, it’s so wise too.

Jeff Hertz:
Exactly.

Wally Smith:
It’s not controlling from beyond the grave, but it’s just understanding that maybe, again, it’s a baby boomer thing, but the idea of I’ve been a provider, and not just providing materially, but providing guidance, providing the options. And what I like to say, whenever you have more than one kid in a family, parents will tell you, they’ll say, this kid is this, this kid’s that. Right? And we work with attorneys on estate planning and that thing, and living wills. There’s one kid that’ll say, dad’s going to be a fighter, he’s going to hang in there, keep him on the machines. And the other one said, no, dad said seven days and let’s pull the plug. But there’s always some kids who are going to be able to handle inheritance better, be able to be better stewards of it and protect it. It’s a great tool, the 721, using a REIT and being able to leverage their way into that.

Jeff Hertz:
And I guess just to broaden that a second, we talk oftentimes about DSTs, especially like a 721 strategy as being very attractive for somebody in the later phase of life, baby boomers, whatever term you want to use. But what is our whole society trying to get towards? We’re trying to get towards simplicity, quality of life, and being able to manage things from our phone, not from a spreadsheet. And so DSTs can be attractive or these types of strategies in general can be attractive to a wide range of investors who simply say, I want to travel more. I don’t want to let my investments be another full-time job for me.
And so ultimately, a DST might be a solution for somebody who’s much younger, who can still stay in the game and run real estate. I even came across situations years ago where somebody said, I don’t like where the market’s at right now, so I’m going to 1031 exchange into this DST. But I know on the other side, when it liquidates, I could have the option to go back into direct real estate that I manage myself. It’s not like once you go down that path of DSTs that it’s forever going to be the way that you invest.

Wally Smith:
Now, if you’re in a REIT, you do the UPREIT, you’re not going to have-

Jeff Hertz:
That is an end game.

Wally Smith:
… that exit capability. That’s correct. Well, this has been great, we’re touching on a lot of different things. Let’s talk about new stuff. There’s been, what, five, six years ago now, they came out with something called a QOZ. What is a QOZ?

Jeff Hertz:
Qualified opportunity zones was an idea that an individual named Sean Parker, who was the founder of the Napster file sharing or music sharing service back when I was in college in the early 90s, started and he was the first president of Facebook. He is, as they say, a serial entrepreneur and also a serial philanthropist. And so he had been running around this idea of encouraging people to invest into lower income areas, and by doing that giving them significant tax advantages. It was actually written into the Tax Cuts and Jobs Act, which went through at the end of 2017. To my point earlier, interestingly, that legislation also eliminated personal 1031 exchanges, as I mentioned earlier equipment and those types of things. So those types of exchanges for personal property were actually taken out.
The reason they were taken out is that the opportunities on legislation was so much broader, where you could invest gains from any asset sale into an opportunity zone investment or an opportunity zone program. So think a stock portfolio, a business sale, cryptocurrency, collectibles, real estate, almost anything with a gain, short or long term, can be invested into an opportunity zone. And for the purposes of this, let’s say they’re investing into a fund, just to keep it more simplistic, what that fund is going to do is they’re going to construct real estate assets in defined areas that were defined by that 2017 legislation. Quite simply what the treasury department did is they looked at the most recent census data from 2010, outlined areas that were lower income.
They then went to each of the 50 state governors and said, of the areas that exist within your state, you can outline 25% of these areas that will be designated as qualified opportunity zones, basically designating them as being areas where you can get the tax advantages of the program by developing an asset there. Quite simply what an opportunity zone investment allows you to do is to defer your capital gain for a period of time. Right now that timing is 2027. You would get to defer that capital gain until 2027. But much more importantly, any growth that you experience over the next 10 years in that investment, you can then take out tax free. It’s similar to a 1031 exchange, except the application is much broader than just real estate.

Wally Smith:
And so you’re only putting in the gains-

Jeff Hertz:
You’re only putting in gains. You get to keep basis.

Wally Smith:
So you get to keep your basis. In 2027, you do owe the capital gains taxes on those gains.

Jeff Hertz:
Correct.

Wally Smith:
So the structure of the opportunity zone investment has to, I think everyone I’ve seen provides liquidity of some kind or return of capital when it’s time to pay the taxes on that.

Jeff Hertz:
That would be the goal. I just, belt and suspenders, I would say don’t rely on that because the money changes and make sure that you have money available to pay the taxes in 27. But yes, that’s a common misconception that your gain, your original gain, that you get to step away from that. You get to defer it, but you do not get away from it. But what I refer to as the gain on your gain is working for you from day one in that fund. And again after a period of no less than 10 years, you can then take out your money out of the fund, and any growth you’ve experienced in the fund would be tax free.

Wally Smith:
Now, you said something interesting, I want to make sure that listeners or viewers catch it. The opportunity zones were based on what census?

Jeff Hertz:
2010. In the midst of the great-

Wally Smith:
Has it changed at all since 2010?

Jeff Hertz:
It’s almost a running joke, or I wouldn’t say a joke, but it’s a hobby of mine to find areas that were designated as opportunity zones that I do a lot of travel.

Wally Smith:
Which basically means that they’re beaten down and it’s lower level. Not necessarily slum lords, but we’re generally thinking Section eight housing or the blighted part of the town.

Jeff Hertz:
Or areas that are just in transition. Right? There are areas in major cities that are transitioning from being very heavy industrial to being more businesses and multifamily. Obviously here in Denver, like LoDo, there’s a lot of areas like that. Rhino. But the Houston Medical District, East Austin, where Apple’s building their new headquarters, downtown Los Angeles, we see a lot of urban areas that have been transitioning over the last now 13 years.

Wally Smith:
San Jose. Places in San Jose.

Jeff Hertz:
And even areas around college campuses, college students eat ramen and don’t make a lot of money. And so you can build buildings that are within blocks of college campuses where there is still great opportunity.

Wally Smith:
I don’t know the status of it now, perhaps you do, the recent attempts at legislation to say, okay, now let’s update it based on a current census essentially, or current areas. But they were also talking about extending, when it first came out, they had the 15%, the 10% rules as far as exclusion. Step up. Do you know, have they decided to continue that or to renew that or to extend it or modify it?

Jeff Hertz:
I should mention, because people, and I think you mentioned legislative risk on another topic, people want to make sure that this is something that isn’t going to be taken away. And obviously I don’t have a crystal ball. I don’t know if it could ever be taken away, but it’s important to note that the opportunities on legislation did in its inception and today enjoys bipartisan support also bicameral support. So the original architects of it, Corey Booker, and Tim Scott, a representative, Democrat and Republican co-sponsors of the bill.

Wally Smith:
Surprising bedfellows certainly.

Jeff Hertz:
Right.

Wally Smith:
They came together on this.

Jeff Hertz:
Ultimately 50 Republicans and 50 Democrats supported this legislation. There was a proposal last year to extend the deferral timeline, another two years out to 2029 to exclude certain high income areas to basically, to your point, back out some of those census tracks that no longer are considered lower income. However, if you already own and are developing right in an existing zone, you would get grandfathered in. There also is a proposal to potentially add back in that step up in basis. Because originally when this was introduced in 2017, it took two years for the treasury to issue additional rounds of regulations that clarified and quantified how we could-

Wally Smith:
There was a lot of confusion originally.

Jeff Hertz:
How a manager would operate one of these funds. But in order to entice early investors, there was at first a 15% step up. Then later a 10% step up, that went away a couple of years ago. There is talk of reintroducing that that step up as well.

Wally Smith:
But all that’s still just influx at this point.

Jeff Hertz:
It is. I think generally speaking, the perception is that the Republicans like the OZ program slightly more than the Democrats do. So maybe the shift in the house gives a little bit more weight to those potential changes.

Wally Smith:
Okay. Very good. Let’s talk about inflation protection. Well, talk a little bit about master leases because you said there’s seven deadly sins. One of them is you can’t change the lease, right? So you’re a DST, you set up a trust, it is now leased to Acme Corporation or Walgreens or Amazon, pick a name. And they’ve got a lease and it’s generally going to be on a 10 year DST. It’ll be 15 year lease, for example. But how does that work then with fractional student housing, multifamily storage units?

Jeff Hertz:
Generally speaking I would say the longer term your lease is, and the fewer the assets you have, the less likely that you would need a master lease structure. To your point, where you have a 15 to 25 year lease with a single tenant, let’s say they’re investment grade, just to add in an additional layer, and I wouldn’t say there’s a consensus among all DST sponsors, some DST sponsors may put in a master lease even in that scenario. Others may say, hey, if something happens to this tenant who is again on the hook for 25 years in investment grade, we’re going to have a lot bigger issues to worry about than just refilling that space. So anytime you have assets like multifamily, student housing, self-storage, certain healthcare assets, you’re going to have a master lease structure. And so effectively, to satisfy the requirements of the IRS, it is considered to be a fixed lease. It is there in place to satisfy that lease.
Underneath that master lease is where all the sausage making happens, where you have tenants moving in and out, you have leases being signed, you have things like reserves and master tenant reserves. And really what that enables the sponsor to do is to manage the asset. If you have a 350 unit apartment complex, but you know you’re going to put in $8,000 a unit to upgrade the units. You know that there might be seasonality in leasing, you need to escrow taxes. That master lease can be extremely helpful in order to just manage that property on a daily basis. Again, it’s necessary to adhere to the DST regulations, but it also just can be in practicality, a very important way of managing the property, because-

Wally Smith:
So with a master lease, there’s generally going to be a fee. There’s a manager, so a master lease company will charge something., But explain how strong that is in an inflationary environment, it’s a huge benefit.

Jeff Hertz:
So then ultimately through the master lease structure, if the property performs better, maybe it performs in line with expectations which were to grow rents in revenue, or maybe it outperforms those situations, then it actually allows the sponsor to pass through that outperformance to the investors. DSTs cannot have what’s called a promote structure. In the private equity world you typically have a two and 20 where anything above and beyond a certain hurdle rate gets passed onto the investors. DSTs can’t technically have that because that would make them considered to be a partnership structure. What they do have in place of that is effectively a split with the investors.
Let’s say the split is 80, 20 or 90, 10, which means that above and beyond a certain threshold, the sponsor can pass through additional revenue to the investors. Different sponsors have different ways of distributing that. Many will do what’s called a 13th check, meaning that they’ll reconcile the books at the end of the year. If the property performed better than expected, then they’ll pay out an additional distribution to the investors. That’s all part of that master lease structure.

Wally Smith:
When we look at interest rates, we can’t stop today without talking about interest rates and how things have changed. I know you were author back in November of an article that was, I think in real estate assets, one of the trade magazines. He was talking about the 60, 40 portfolio being broken and 60, 40, 60 stocks, 40 bonds, interest rates killed the bonds.

Jeff Hertz:
Everything went down.

Wally Smith:
Everything went down. So people are then looking around, I need some non-correlated assets. And so that’s something that we see in the investment advisory side of our sister company. People are looking around for what do we have, if it’s not 60, 40, what are we going to do? What’s non-correlated? That’s really where we get into the alternative investments. So let’s say that you just give an example, four years ago you bought into a multifamily and they had projected maybe 2% a year growth on rents, and now they’re seeing inflation where rents are going up 10%, 12%, 15%. In a master lease environment the structure of that is going to flow through.

Jeff Hertz:
And it goes back to, again, the quality of the sponsor. If they underwrote the property at levels that were not appropriate and not sustainable, then that DST is going to miss the mark. So you also want to be careful of saying, boy, this operator thinks that they’re going to raise rents 10% per year. That’s just not realistic on a long term basis, and you can’t count for that being the case. To your point, on the opposite end of the spectrum, you see DSTs that were underwritten, I think conservatively and hopefully appropriately, that have outperformed those numbers and are able to actually pass on greater cashflow to the investors. But that’s not true of all real estate assets.
If you have a 25 year lease with either flat rents or maybe one to 2% contractual increases, it becomes much more like a bond. And that type of real estate maybe doesn’t perform as well in an inflationary environment. That’s why sometimes it’s good to diversify. Maybe a client has some longer term net lease assets that are going to be stable and hopefully good times and bad will continue to generate cash flow and then potentially some shorter term assets like a multifamily or a self-storage, that are going to hopefully have a little more horsepower during inflationary times.

Wally Smith:
Well when we sit with a client and we’re trying to figure out what to put in their portfolio, my father used to joke that one of the first things they teach you in medical school is how to say it depends. Who of us haven’t heard that when we ask the doctor about a specific answer? But the same with real estate, which DST would be best? Well, it depends. Are you solving for, maybe you have so much income from other, the last thing you need is more taxable income, then maybe you go into a highly leveraged position instead. Let’s say that yield is the most important thing or you don’t have kids, okay, you don’t have any heirs that you want. It really does come down to what’s important to each client.

Jeff Hertz:
Again, to your point, I had a situation a number of years ago where the client decided not to go into a DST. They bought their own single tenant net lease asset, and their attitude was, it’s a 20 year lease, I don’t care what happens at the end of 20 years, I’m going to clip that coupon for the next 20 years, and if I walk away from this property 20 years from now, from a risk standpoint, they felt they were better off. Other investors take the exact opposite approach, which is, hey, if I’m not growing in my real estate value, then I’m losing ground because of inflation.

Wally Smith:
DSTs if you just plan to hold it and let the next generation deal with it, then it is more of a bond like. And again, the strength of the sponsor or the queues, the quality of the sponsor, quality of the property, quality of the income is what’s going to be important there. Last thing I guess to close out. Well, two things. We talked about master leases. Have you seen anybody successfully yet doing master leases with single family rental communities?

Jeff Hertz:
There are a few sponsors that have gotten involved in that space, and I think there’s a lot to be attracted to that space. It is much more, I think, management intensive than say a multifamily property, because the difference is when you have, let’s just use the same numbers, you have a 200 unit apartment complex. You can have specials, you can have food trucks, you can have pottery making classes. You can do a lot of things to enhance not only the value and attractiveness of the property, but the experience of the residents there. When it comes to single family rentals, it’s a very different scenario. The properties might be in the same town, they might be spread out across multiple states-

Wally Smith:
And IDing them can be a nightmare.

Jeff Hertz:
The identification can be a real challenge, and that’s where, again, it’s easy to buy, let’s say $100 million dollar apartment complex, that could be one property, one check, and you’re done with it. $100 million dollars in single family rentals, buying in bulk can be challenging in that space.

Wally Smith:
Well, if it could be more like, I don’t know, a manufactured housing community for example, where this is defining the addresses, is that plot of land with all those dwellings on it.

Jeff Hertz:
I just wonder honestly how they deal with the maintenance. Because if you had 100 homes that maybe don’t all have the same furnace or the same washer and dryer or the same appliances, all of a sudden now you have a lot of, again, that’s where multifamily can be nice from the standpoint that most multifamily properties are very homogenous, what’s true in one unit is true across all of them. So from a management standpoint could be maybe a little easier to deal with.

Wally Smith:
I think the way they’ll crack that code is when it’s build to rent.

Jeff Hertz:
Exactly.

Wally Smith:
The whole community, so you still get that homogeneity that you would get in a multifamily. They just happen to have yards.

Jeff Hertz:
Exactly. Exactly.

Wally Smith:
I guess two things left. We could talk all day, it’s been a good interview. I appreciate it.

Jeff Hertz:
I geek out on this stuff, so I appreciate it.

Wally Smith:
I enjoy it too. We had a call, gosh, last week, and we were talking about typical interest rates, and again, we never talked product on the show, but the interest rates that are typical in the DST space. And he said, he saw this other project that was paying a ginormous interest rate and it turned out when we drill down on it was lands and sticks, getting ready to build something. And so that really prompted the whole question of a DST has to be what’s called stabilized. Okay. Can you talk about stabilization, value add, how much can you do before it comes becomes development?

Jeff Hertz:
DST, I believe the line in the seven deadly sins is you cannot substantially improve or build a property. So DSTs are never going to do grounded up development. They’re never going to buy a building that’s 50% occupied and hope to renovate it and lease it up to a much higher rate. So you’re always buying stabilized cash flowing properties, sometimes brand new. I’ve seen situations where the sponsor literally was buying the property from the developer, but the developer already leased it up to at least let’s say 85, 90%. They’ve gotten a certificate of occupancy. And again, I think from the investor’s standpoint, I’ve certainly talked to investors who have a little bit higher appetite for risk, but in a DST you really need to understand the cash flow and where it’s coming from.
And if the property was not properly leased up, then you would incur potentially a lot more risk in terms of wondering what those rents were going to do on a go forward basis. But in terms of value add, I usually say new carpeting, new countertops, great. Knocking down walls and building additional units is probably not going to fly. And I don’t think, again, the joy of the IRS is, things are fairly vague, but I think it is suffice to say that if your reserves and your overall budget for renovations is going to be higher than the purchase price of the property, then that’s probably not going to fly for a DST, plus the cash flow of the investors

Wally Smith:
Hundreds of units in a property and they to keep up with the competition and the live, work, play world that we’re in now, they say, hey, we need to put in some amenities and maybe it’s $100 million dollar project, maybe they put $3 million into a new club and a pickleball court and upgrade the pool or something like that. Expand the dog park.

Jeff Hertz:
And that’s a way that existing property owners can compete with new construction. New construction generally is more expensive, generally smaller unit sizes. I’m speaking obviously specifically about multifamily, but we’ve certainly seen situations where if we were to come in, put in new flooring, new countertops, new lighting, even some of these cool amenities like Wi-Fi or lighting, smart lighting, smart door locks, there’s a lot of things that you can do that will enhance the value of the property because at the end of the day, it’s all about driving NOI and maybe you’re lucky enough that your property just is next to the best place to go to restaurants or whatever, it’s blessed with that, but in general, you need to rely on things that are going to happen organically within the property to drive rents so that you’re going to drive value.
Because at the end of the day, the real estate market doesn’t always go straight up despite what most people might think. And if you can drive value within the property itself, then you could effectively within a vacuum, create value for the investors.

Wally Smith:
Well, good. I think summarizing that is that if it sounds too good to be true, maybe it is, see if it’s stabilized or see if you are buying into something that is much more speculative development, that hey, we’re not even going to be cash flowing for one, two, three years or something on a long project.

Jeff Hertz:
And to tip to your side of the table, to work with a quality advisor who helps the clients understand what they’re looking at because these documents can be hundreds of pages long. There can be boiler plate, there can be legal opinions and things like that. And to look at let’s say three different multifamily DSTs and say, well, why is this one paying five and this one’s paying four? There’s probably a reason for that. It might be a completely logical reason. In other cases it might be using a higher distribution rate as a marketing tool, not as a reflection of the realistic cash flow of the property.

Wally Smith:
Well, that also comes back to some of the knowledge our managing director of alternative investments, Rich Arnitz, he’s a good friend. He’s been in this industry so long that he’ll tell me, but I’ll ask him sometimes, well, why are these rates so much different? He’ll say, I got to tell you about the sponsor. This one they charge much higher fees. They promote some of their own properties, they’ve got their hands in the tilt several different ways. It’s good to know. It’s really good to know a lot of background about them and we’re very fortunate for the depth of our bench and our team.

Jeff Hertz:
Or it could be as simple as the asset class, right?

Wally Smith:
Sure.

Jeff Hertz:
There’s certainly going to be a discrepancy between an investment grade credit with a long-term lease where you know there’s very little chance something’s going to happen to the tenant, versus any number of asset classes that can be much more economically sensitive. We don’t have to go back very far in time to see where that’s been the case, whether it was COVID or previous recessions or different issues where certain asset classes got substantially altered due to the economy where others, let’s face it, if you owned an Amazon distribution facility in 2020, you had very little concerns because they kept the lights on pretty well.

Wally Smith:
Well, and getting back to what I talked about earlier, out of 40, 50, 60 sponsors who were out there, the ones who when the lockdowns came, or in 2008 when the Community Reinvestment Act finally blew up and took the whole real estate industry down, the stronger sponsors, many of them said, okay, we’re going to waive any of our fees. We’re in this with you. We’re going to invest more. And they came alongside. They had the depth, they had the strength, the financial, the balance sheet to be able to do that. So that’s really what we’re looking for for our more risk averse clients. It’s still real estate. It’s an investment. There’s always risk, but let’s mitigate those risks wherever we can.
Last thing, I saw, I think you might have posted it, interview with Howard Lutnick on in Davos with Maria Bartiromo. It was brief, but he wasn’t forecasting that, okay, we’re going to be back to zero, one, two, 3% interest rates. He was basically saying this new normal is probably what we should expect. It’s probably going to be like the historic normal. How have interest rates changed? Let’s close on that.

Jeff Hertz:
The bond market has had an unprecedented run for basically 40 years since the early 80s. And we’ve basically just been on a long-term interest rate decline, basically coinciding with different economic cycles, whether it was the Fed lowering rates during the great financial crisis or of course during COVID. But I guess I would say first and foremost, Howard tends to be somewhat of a bear. He’s been through some unbelievable times in his helm at Cantor, and so I don’t blame him. And plus he’s a bond guy. The bond guys tend to be a little bit bearish. I think the idea that interest rates are going to go back down to where they were a year ago, they could, and they certainly are factors why that could be the case, but a lot of people feel that given where inflation is, and as you said, a new normal, that interest rates may normalize and stay at these levels for a significant period of time.
I think commercial real estate is slowly starting to adjust to that mindset, and at the end of the day it’s probably not the worst thing for our industry to just cool down. For a while we were running at 120% it felt like, of what was normal. To maybe cool down to 95%-

Wally Smith:
That’d be nice.

Jeff Hertz:
… might be a good thing. Because what it does is it hopefully gives opportunities to more conservative companies who are realistic about their projections and expectations and maybe put some of those players who are saying, well, I don’t understand why rents won’t go up 15% per year, they did for the last four years. Hopefully they go in the penalty box of that aggressive mindset that is just long term not sustainable.

Wally Smith:
Well, and I feel for young people who are, and when I say young people, perhaps younger than 30, they’ve never seen what you and I would consider a normal market. But in Austria in 1966, my family built a home in Naperville, Illinois. Interest rate was 5.5%. And then they moved back. My parents moved back to New Jersey in 82. Remember interest rates in 82?

Jeff Hertz:
Like 12.

Wally Smith:
I think it was 14 to 16% is what they ended up having. Unfortunately they worked for Ma Bell and Ma Bell took care of all that pesky interest rate stuff. But I remember my dad saying, man, we are never going to see interest rates at five and a half again. And then what we’ve seen in the last few years has been unprecedented. I think five to six, I would agree with Mr. Lutnick that that’s probably historically more of a normal, and then it gives the Fed room to respond when you do have a crisis of some kind.

Jeff Hertz:
That’s the whole key is, if you don’t have any slack or any dry powder as they say, then when these situations come along, the Fed has no way to react to it.

Wally Smith:
Very good.

Jeff Hertz:
We’re hopefully in a good spot there.

Wally Smith:
Well, Jeff, thanks so much for coming out today. This has been informative. I feel like we could have talked for another hour, but that’s good.

Jeff Hertz:
We’ll do a second installment down the road. I appreciate it.

Wally Smith:
Very good. Good to see you.

Jeff Hertz:
Thank you so much. Appreciate it.

Disclosures:
Impact 1031 is a DBA of Ridgegate Financial LLC. Not an offer to buy, nor a solicitation to sell securities. All investing involves risk. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing. Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication. Investment advisory services offered through AE Wealth Management (AEWM).Emerson Equity, Ridgegate Financial LLC and AEWM are not affiliated entities.

Disclosures:

© 2023 Ridgegate Financial. All Rights Reserved.

“Purpose. Planning. Portfolio.®” is a registered trademark of Ridgegate Financial in the United States.

Impact 1031™ is a DBA of Ridgegate Financial, LLC.

Not an offer to buy, nor a solicitation to sell securities. All investing involves risk. Past performance is not indicative of future results. Speak to your finance and/or tax professional prior to investing.

Securities offered through Emerson Equity LLC Member: FINRA/SIPC. Only available in states where Emerson Equity LLC is registered. Emerson Equity LLC is not affiliated with any other entities identified in this communication. Investment advisory services offered through AE Wealth Management (AEWM).

Emerson Equity, Ridgegate Financial LLC and AEWM are not affiliated entities.