The Importance of Due Diligence with FactRight | The 1031 Show™ | Episode 22 | Brandon Raatikka

Show Chapters:

00:00 – 00:13: Bumper

00:13 – 00:28: Greetings

00:28 – 06:27: Spotlight: FactRight and Brandon Raatikka

06:27 – 10:24: Why To Do a 3rd Party Report and FactRight’s Process

10:24 – 12:04: What’s Happening in the 1031 Space

12:04 – 15:08: What is a DST and What Kind of Properties Can Be DSTs?

15:08 – 17:45: The Key Benefits of DST Investments

17:45 – 21:46: The Key Differences Between TICs and DSTs and the 7 Deadly Sins of The Industry

21:46 – 25:43: What is a 721 Upreit?

25:43 – 27:37: What is Due Diligence? Why is it Important? What are the Mechanics?

27:37 – 32:48: The 3 Things to Look For in a DST Sponsor

32:48 – : End and Disclosures

Show Transcript:

Wallace:
Hey, Brandon, how are you today?

Brandon:
Doing well, Wally. How about you?

Wallace:
We’re doing well. We’re enjoying our wonderful Colorado springtime here, so it’s a good time to be here. Let’s jump right in. Let’s chat a little bit about FactRight. Can give me some background on the company.

Brandon:
Yeah. So FactRight is known as a third party due diligence firm. So we perform due diligence on alternative investment programs and then advise independent broker dealers and registered investment advisor clients so that they can make the best investment decisions to their clients.

Wallace:
Okay.

Brandon:
So our analytical team is made up of attorneys, CPAs, CFAs, MBAs, and other professionals with experience in the industry and we are designed to assess an investment program, I would say from a comprehensive perspective, from the legal to the financial to the asset specific considerations.

Brandon:
Now, we were founded in Minneapolis in 2006 so we’ve been doing this for quite a while. We originally helped clients assess syndicated tenant in common investments for 1031 exchanges and since then we’ve grown and diversified with the industry into other forms of alternative investment programs but 1031 investments remain a large share of what we cover.

Wallace:
Okay. Do you guys get into doing any appraisals and that sort of stuff, or you just … You review the reports that come in?

Brandon:
Yeah, that’s a little bit of outside the scope of what we do, but that is a key part of the due diligence process when we’re looking at investment programs, and I’m sure we’ll get into that a bit later in our discussion.

Wallace:
Okay. So FactRight is one of only very few that do what you do in this industry. You said it’s primarily, or a lot of it’s the 1031 business. All of its alternative investments, right?

Brandon:
Correct.

Wallace:
Okay. So who hires you? Is it the property, the sponsor, generally?

Brandon:
Yeah. So typically the investment sponsor manager engages us on behalf of their selling syndicate, if you will, as a matter of convenience. The due diligence is time to be ready when the offering becomes available to investor clients so often our review process runs parallel to the sponsor finalizing the terms of the investment, but we do also work directly with BD and RIAs through customized consulting relationships where we’re engaged directly by our clients and we sit as a member of that broker dealer or RIA’s investment committee and make program recommendations to that firm based on their client needs, their risk profile, and their areas of interest.

Wallace:
Okay. Are you ever hired by lenders?

Brandon:
We are not, no.

Wallace:
Okay, but would lenders rely on the third party report?

Brandon:
You know, our reports are primarily for the wealth management community, again to aid them in making investment decisions. I’m sure lenders have seen factor reports in the past, but usually they’ve completed their underwriting by the time we sort of get involved in the whole process.

Wallace:
How long does a report generally take to prepare?

Brandon:
Well, it can really vary based on the type of investment. For DST reviews, anywhere from two to four weeks, and I’m sure we’ll get into this a little bit later in terms of what our due due diligence process is, but there’s sort of a lot of back and forth with the sponsor during that process. We also … Not only do we look at investment programs, we do about 150 to 200 of those per year, we also do due diligence on the sponsor from an operational perspective as well. So oftentimes when we’re looking at a program, we’re also looking at the sponsor and so that process can take much longer, as you can imagine. It’s a bit more intensive than looking at a property investment, especially if we’ve seen sort of the structure, the shell, of that investment program through prior reviews of that sponsor, if that makes sense.

Wallace:
So I would imagine getting a, I don’t know, not necessarily a comfort level, but getting that familiarity with a new sponsor is going to take a while. Is this kind of a niche? How did you get into it? What’s your background?

Brandon:
Yeah. So appropriately enough, I think I took kind of an alternative pass to the industry. Was a history major in college, went to law school at the University of Minnesota. I focused my coursework there on business law and estate planning. Also took a securities regulation course, which was fascinating. I always wanted to get into real estate. Ever since I can remember, I’ve just really enjoyed geography and architecture and even in law school, I suspected I’d do something a little different than traditional practice.

Wallace:
Sure.

Brandon:
So after a foray into site acquisition work for telecommunications companies, which prepared me for some of the more technical aspects of the work that I do now, I joined FactRight as an analyst and been here for 15 years. I’m the COO now, and I oversee our 1031 syndication review practice, so I’ve seen literally hundreds of DST programs during my time with FactRight.

Wallace:
Well, you’ve seen an exciting time in the industry. You got in right before the hiccup back in ’08 so seen some ups and downs.

Brandon:
For sure.

Wallace:
So the due diligence. Almost every product we see out there has a third party report. It’s strange, occasionally one comes through where they haven’t decided to do one. How is someone supposed to due diligence a product if they don’t have a independent objective third party report?

Brandon:
Yeah, that’s a good question. You know, I think it behooves anyone doing business in this space to get as many different perspectives, research inputs as possible. You know, I think our clients, if they have the time and the resources to really underwrite a sponsor in offering a program deeply, they might have the tools to do that on their own, but again, it doesn’t hurt to consult the third party research. We might see some things that they haven’t seen.

Brandon:
I think one of the benefits of working with us or viewing our due diligence is that we see a wide swath of the market so we have, I think, a good perspective on what what’s good and what’s not so good, what’s quality, what is not customary or favorable to investors.

Wallace:
Well, and occasionally you get blindsided, like the whole industry did with COVID and now you’re … Gosh. Think about some of the hospitality industry and in a course of 60 days, it went from 85%, 90% occupancies to 10%. That was difficult to anticipate that, of course, but the due diligence on that, you’re still looking at with the due diligence, is the sponsor doing what they said they were going to do. Are they … I mean, you’re never certifying a projection. You’re never verifying or opining on the quality of a deal, are you?

Brandon:
I mean, we’re not certifying projection. There’s risk and uncertainty in every piece of real estate held for investment, every DST program. Obviously you can’t really anticipate those black swan events.

Wallace:
Oh yeah.

Brandon:
But you can do a lot of things and you should do those things to really put yourself in the best position that you know you’re mitigating every possible thing and you’re proceeding with confidence in your in investment decisions.

Wallace:
With your process, then, do you opine on the documents themselves on, the private placement memorandum at all? Do you ever advise that, well, you should be including risk elements that you’re not disclosing, that sort of thing?

Brandon:
So primarily our advice is to our broker dealer and registered investment advisor clients.

Wallace:
Okay.

Brandon:
We will take positions on particular terms or structures or features of an offering or an asset in our reports. We’ll tell them what we think based on our assessment relative to the rest of the market, so there is that, I guess, form of opinion in the reports themselves. Oftentimes more informally, we do provide feedback to sponsors, especially when the terms aren’t finalized yet. They’re sort of in the program development phase and we see it as sort of a win-win for our clients because we’re helping to improve the deal, at least from our perspective, for our end clients at the end of the day. So, yes, that’s something that we do undertake when we think it’s appropriate

Wallace:
The DST industry. I mean, we’ve never seen anything like what’s going on right now. I think we should be … We’re projected now to be double, at least, last year and last year was a record year. What is your feeling with it? I mean, are the deal flow just getting overwhelming. Are you guys having to staff up to meet the challenge?

Brandon:
Yes. Yes, we are. I’m probably not getting as much sleep as I did about a year ago, but that’s okay. It’s very hot, I mean, as you know, Wally. I think a lot of people are probably looking to sell their highly appreciated real estate in this market and defer taxes on the gains through a Section 1031 exchange. I mean, like you said, I think we had $7 billion, in excess of $7 billion, of equity raised in the industry last year, which as you said, was a record. I think we’re seeing increased demand for this product because I think investors are being made more aware of the opportunity to defer gains into a type of program that provides other types of benefits to them and I think we’re seeing some larger, well known asset managers becoming sponsors of DST programs because they recognize the demand, they recognize the demographic shifts in the investor population and I think that these products are becoming more mainstream than they ever have before.

Wallace:
You know, let’s go over some real basics. Describe what is a Delaware Statutory Trust. Pretty basic question.

Brandon:
Well, yeah. So, I mean, it’s essentially a wrapper or a type of legal entity that’s established in the state of Delaware. In our context, the trust holds title to the underlying property or properties and investors are beneficiaries of the trust. They will be entitled to the revenues of the trust and ultimately the assets when the trust terminates. I guess the reason we care about this, the reason why we’re having this conversation, is because the IRS has blessed the DST structure for purposes of a Section 1031 exchange, meaning that the beneficiaries of the trust will be deemed to own an undivided interest in the trust held real estate and that allows for like kind exchange under the Internal Revenue Code, so investors who own real estate and want to exchange it for another real estate interest and defer taxes can use a syndicated DST investment to do so.

Wallace:
So what kind of … What’s the range of products that you see going in? I mean, certainly apartment buildings, warehouses, that kind of thing. Are there any unusual assets that you see in a DST structure?

Brandon:
Yeah, I think some kind of real estate asset classes work better in a DST structure than others, but as you mentioned, we see all kinds. The major asset class right now is multifamily, it makes up about half the market in part, because the market believes in the multifamily thesis over the long term, but we see plenty-

Wallace:
People have to live somewhere.

Brandon:
That’s true, yep. We see plenty of net lease retail, industrial office, self storage. We are seeing hospitality come back into this space after being on the sidelines for a couple years, for obvious reasons. Some of the more esoteric ones that you might be asking about, we’re seeing some sub-asset classes that are emerging, like manufactured housing communities, student housing, senior living. Those are all offshoots of multifamily. We’re seeing life sciences as sort of a sub-asset class of industrial. I wouldn’t be surprised if someday we see telecommunications or cell phone antenna towers as part of these structures.

Wallace:
You see those in the alts, that’s for sure.

Brandon:
Yeah, and I mean, all you technically need is an interest in real estate and I would say that any property that has stable, positive cash flow and does not require major structural improvements would likely be a good candidate for a DST program.

Wallace:
How about, I don’t know, mineral assets, oil, and gas, that kind of thing? Do you see energy properties being appropriate?

Brandon:
We do, and there is sort of a limited sliver of the industry dedicated to that kind of underlying asset.

Wallace:
Okay. So the key benefits of somebody buying a DST as opposed to buying another property. I know a lot of folks will say, “Well, that’s my property. I know that property. Why would I want exchange for something I don’t know?” What do you see as the main reasons, the main benefits?

Brandon:
Well, we’ve already talked about tax deferral. We’ve already talked about regular income to investors. As I mentioned, a lot of investors are of retirement age, so DST programs can help with the income planning piece. Obviously, if an investor already owns real estate, hopefully they’ve already been doing … Been enjoying the benefit of income, but really the biggest benefit from that standpoint then is that a DST is a turnkey passive investment. So the sponsor, or perhaps a qualified third party, will manage the property. The investor doesn’t have to deal with tenants. They don’t have to worry about maintaining the property. Really their only responsibility in this whole thing is receiving hopefully a regular check from net income from the property. So in exchange for that, the sponsor will earn fees for syndicating, managing, and selling the property.

Wallace:
Okay.

Brandon:
I would also say that DST programs can provide an opportunity to own a share of the type of property that investors might not otherwise have access to. So many people who go into DSTs through a 1031 exchange, maybe they own rental duplexes or small retail properties, but since you’re pooling your capital alongside other investors, because the sponsor has acquisition and financing relationships, a DST program could allow you to own a piece of a much larger institutional type asset, like an Amazon distribution facility.

Wallace:
Sure. I remember seeing a advertisement at one point where it had the contrasting rundown, two plex or four plex with the sign on crooked and the grass grown up and it said, “Would you rather own this or that?” It showed it right next to a big, bright, shiny office building of some kind, and that’s true. I mean you get out of one, you get into the other and I think one of the things I hear a lot is the non-recourse loan, people being able to get that debt off of their personal balance sheet really appealing to them.

Brandon:
Yeah.

Wallace:
Can you describe a tenant in common investment, then? I know there used to be a lot of those before the DSTs.

Brandon:
Yeah, so essentially a tenant in common, or a TIC investment, is another way to structure the syndication of estate for Section 1031 purposes. Each investor owns an undivided interest in the real estate as a tenant in common with the other investors. You can have up to 35 co-owners of the property. Major decisions require the unanimous consent of those owners. It really was the dominant structure of the industry leading up to the Great Recession. What we found was that in times of economic disruption, especially during that financial crisis which was primarily driven by commercial real estate, getting up to 35 investors on the same page to save the investment was often impossible to do, so many TIC properties required a cash infusion to re-tenant a property because the main tenant had blown out, but you needed all the owners to agree to that capital call. In a lot of cases, some investors weren’t willing to do that and so many deals went into foreclosure.

Brandon:
So while it still might be appropriate for certain investor groups, TICs have really fallen out of favor in our industry for syndications for investors who don’t really know each other, they might have different objectives, et cetera.

Wallace:
Well, I think the capital call aspect was really a scary thing for a lot of TIC investors knowing that they … And the fact they had a full responsibility, individually, for the liability. Everybody was on hook for the whole thing, so that was scary to them. With the DSTs, then, that’s been solved. You can’t refinance a DST and they can’t do a capital call.

Brandon:
Yeah, that’s right. So that is … I mean, that’s sort of a key difference between a TIC and a DST is that the guidance that the IRS provided on DSTs for Section 1031 purposes imposed some substantial limitations on what the trustee can do, and there’s essentially seven things. We call them the seven deadly sins in our industry. So for instance, the trust can’t enter into new property leases during the ownership period. It can’t make structural improvements to the property like expanding the footprint of the building. Like you said, can’t refinance the property, can’t accept new capital contributions from investors and if it has to do one of those things to preserve the value of the property, the trust will be converted into an LLC. Investors will receive limited liability company interests in exchange for their beneficial interest in the trust and then they can’t undertake another Section 1031 exchange once the property is eventually sold.

Wallace:
Can they go back from that springing LLC back to a 1031 or to a DST?

Brandon:
That’s an open question. I think you might have to talk to IRS’s council on that. I actually, I don’t think that there’s … I think sponsors have done it or tried to do it, but I don’t know that there’s any firm guidance one way or the other, whether that’s that’s permissible.

Wallace:
Well after the COVID and the effect on hospitality, I’m aware of several that are in that process right now. So I think we’ll see. We’ll see soon enough, right?

Brandon:
And what’s interesting, Wally, is that Congress passed … Or not Congress. I believe it was the IRS, passed some relief during COVID that relaxed some of the rules around DSTs accepting new capital and such, so I think a few DSTs availed themselves of that relief.

Wallace:
I think you’re right. We’ve seen a lot more 721 UPREITs being introduced and available. It’s like any of the big companies are trying to position themselves to have one. Could you talk a little bit about UPREITs?

Brandon:
Yeah. So it used to be the primary exit strategy for these programs would be you would sell the DST property to a third party prior to the loan maturity and then investors would be able to do a subsequent 1031 exchange, or they’d be able to cash out and pay the taxes, whatever was optimal for them. That’s still one of the potential access strategies for most programs, but more and more we’re seeing sponsors essentially structure an option that their affiliated REIT investment program holds to acquire the property some years down the road, and that would provide an exit for the DST investors and in exchange DST investors would be able to do something called a Section 721 tax deferred exchange into the REIT, or the operating partnership of the REIT, and so essentially it would give investors a sort of a diversification opportunity. So instead of owning an interest in a single property or small portfolio properties, the idea is that you would own an interest in a large REIT that might have a pretty diverse portfolio.

Brandon:
One thing you got to keep in mind with that kind of thing is some DST programs provide investors optionality to choose kind of which path they want to go down should that REIT program exercise its purchase option. Other programs do not, so you have know that in advance.

Wallace:
Right.

Brandon:
Am I going to have optionality or am I going to be converted, essentially, into a REIT reinvestment?

Wallace:
Right. Or it’s conditional, if they fail to meet some goals and they go into a hyper amortization phase. That’s another similar loss of the option. It’s not automatic. You got to be careful. If you want an exit with a 1031, you got to make sure you’re not going to lose that.

Brandon:
Right. Right. You really got … Yep, exactly. So, I mean, that’s a key part of due diligence. I know we’re getting ahead of ourselves a little bit, but that’s just … Kind of knowing the mechanics of how the back end works is critical.

Wallace:
You bet. Well, and I think just to kind of summarize that 721. Somebody has a property, it could have been a condo or a small office building or whatever they want, they can do a 1031 into a Delaware Statutory Trust, the sponsor of which also has a large REIT, real estate investment trust. At some point, usually it’s after, I think it’s after the third year, is typically when that would happen or no. It’s after the second year that would happen.

Brandon:
And it can vary. Yep. It can vary from sponsor to sponsor on that timeframe.

Wallace:
I think most of them use that two years as a kind of a safety zone. I don’t know that’s written down anywhere, but at least two years, and then what they would do is convert their share, actually contribute it, I think technically, to the REIT for operating partnership units and that can then end up giving them some liquidity that they would not otherwise have. That’s still not a taxable event, but when they go then, if they wanted some liquidity, let’s say they’ve got a million dollar DST. It’s not an all or nothing deal that they’re going to sell it and have to take that tax hit all at once. They could go into the 721 UPREIT and then if they wanted to liquidate $50,000, $100,000 a year and have much more control over their taxes, those are some of the appeals that we see, especially with the financial planning that we do at our company.

Wallace:
So, I guess in our last section here, let’s go back to the basics. You know, we’ve talked about it a little bit, but what is due diligence? Why is it important for clients?

Brandon:
Yeah, so I would define it as a reasonable investigation of an investment program in order to come to a thorough understanding of the risks. Now, its scope should include verifying the types of facts that would be material to somebody who’s deciding whether to invest or not, and I think you know what successful due diligence is by what it produces, which is confidence in making an investment decision. It’s critical because we want to make sure that the investment represents the right opportunity for the client. We want to verify that the risks that they will take on are reasonable and ultimately due diligence is intended to keep everybody out of trouble down the road, to the extent possible.

Wallace:
As a practical matter, does the process … I mean, are you going to source? If they say, “Here’s a document, our financial,” then do you go to the source to verify that, or what are the mechanics of doing due diligence?

Brandon:
Yeah. So we definitely … Anything that’s material, that’s something that we want to verify or corroborate, so to speak. I think that’s a key part of the due diligence, sort of verifying the disclosures that are put in front of investors. We also bring to bear independent research and sort of our own perspective, and we keep a database of DST program so we can kind of compare fee metrics and other things to the program under review. So I would say all of those types of things go into a review.

Wallace:
What are the important things you’re looking at when looking at a sponsor versus an offering?

Brandon:
Well, I would say sponsored due diligence is really critical and it’s … Unfortunately it’s often overlooked or there’s not as much emphasis placed on it. I would rather do a mediocre deal with a good manager than what I think might be a great deal with a bad manager. As we discussed, the DST investment is passive. The sponsor is going to make all the investment decisions related to the program and you can’t audit every single number. You can’t confirm every single representation that the sponsor is making so you have to be strategic in how you look at a sponsor in order to establish the necessary comfort level and I would say that there are three key items to focus on and probably a few other things that I can mention as well when doing due diligence on a sponsor.

Brandon:
So first, one thing we do is we perform extensive background checks on sponsor executives and affiliated entities. This includes not only criminal, but also civil and regulatory records. We’re really looking for is there a pattern of regulatory or litigious behavior on the part of key principles that could be a red flag or is there some bad actor disqualification event on their record.

Brandon:
Next, you’re really not going to be as much of an expert on the property or strategy as the sponsor is, or at least you shouldn’t be, so you don’t know how things are going to turn out for an investment program in the future, but what you can do is analyze whether the sponsor has done what they said that they were going to do for past investment programs.

Wallace:
Really track record.

Brandon:
Yeah, exactly. So we call it assessing prior performance. Did they achieve their targeted returns?

Wallace:
Okay.

Brandon:
Just as important, did they actually take the steps that they said that they were going to take to accomplish those returns or did they drift from their stated strategy, and maybe take some unwarranted risks that may or may not have worked out in the long run.

Wallace:
Okay.

Brandon:
You know, what’s their experience in different market cycles, and I think a really underrated consideration is what did they learn and what did they do to help investors when things didn’t go right.

Wallace:
Okay.

Brandon:
You can really tell a lot about the integrity of a sponsor and its people by really drilling down on that one.

Brandon:
And then the third thing I’ll mention is that you want to understand how well capitalized and profitable a sponsor is. You know, there’s a fine line here because the lion’s share of returns of a DST property should go to you as the investor because you’re taking the risk, but you also want the sponsor to make money and that’s because DSTs are commonly five to ten year investments, and you want the sponsor to continue to be around to manage the property and the trust.

Wallace:
Right.

Brandon:
You know, not all sponsors in our space have been doing this for a long time. Now, most of those sponsors have been a real estate investment shop for a long time and that’s something to look at, but thankfully I think most sponsors have the financial wherewithal to continue to service their investors.

Wallace:
Well, I know we routinely will, when we’re educating people about the DST marketplace, we talk about the 40 or 50 sponsors typically that are out there at this time and there are a handful of them I’d rather not work with, but there are about 10 or 12 that I’m thrilled to work with. They’ve got that pedigree, they’ve got that track record, they’ve done what they said they were going to do, and they’ve been around long enough to … I’ve heard it said you don’t want to follow a general up the hill if he’s never been in a battle before, right? So these guys they’ve been tried, they’ve been tested. How did everybody do during COVID? I mean, that was a real interesting experience there and some of the companies were phenomenally responsive and conservative, maybe even too much so, right out of the gates. Some of them didn’t didn’t react quickly enough. So seeing as how they have responded, there’s about 10 or 12 I’m really comfortable dealing with, and I’m sure there are a lot of great folks out there make up the rest, but like you said, a lot of them that just haven’t been doing it long enough.

Brandon:
And COVID is kind of an interesting case study because you really got to see, and you probably saw this from your perspective, Wally, which sponsors were really good at communicating transparently with the investors and advisors and which ones weren’t. That’s a really big thing.

Wallace:
Yeah. I think I’ll put a bullet point next to that. The communication. I heard it said one time that something like 83% or 87% of investors don’t leave because of performance. They leave an advisor because of lack of communication. It’s kind of … That’s pretty believable, really.

Brandon:
Yeah, for sure.

Wallace:
Very good. Well, sounds like FactRight’s got it dialed in here. I’d love to see the responsiveness. I know the reports that we get, the emails, we look forward to them. They’re great. You guys have a great conference that you do every year and anyway, I appreciate you coming on today, Brandon, and we will see you at the next conference.

Brandon:
All right. Sounds good, Wally.

Wallace:
All right. You have a good day.

Brandon:
Sounds great.

Wallace:
Thanks.

Brandon:
You too. Bye bye.

Wallace:
Bye bye.

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