How to Capitalize on the "Ups" and "Downs" of REITs

How does the following sound to an investor looking to divest their assets? Why not defer the recognition of gain on the sale of your property, locking in your profit, and diversifying yourself in the process? 

Such is just one potential benefit of UpREITs and DownREITs, largely unsung vehicles that can provide another way to defer the tax bite of an asset transfer. In that sense, they’re not unlike 1031 exchanges, but given the target on the back of like-kind exchanges placed there by the current administration, Up and DownREITs should be on every investor’s radar. Let’s look more closely at each:

In an UpREIT (the “up” is for Umbrella Partnership) the REIT itself is at the top of the structure with a partnership–still the owner of the real estate–below it. Thus, the REIT simply owns an interest in the underlying partnership and not title to the actual properties themselves. A DownREIT, on the other hand, will acquire some properties outright, with an interest in a lower-tier partnership that directly owns the assets.

Let’s focus on UpREITs for this conversation, although much of what we’ll cover is also applicable to DownREITs. Under current tax regulations, such a transfer of assets isn’t considered a taxable event. Of course, that changes when and if the partner converts their share of the properties they brought to the table into shares of REIT stock. Then, the gain has to be recognized. That means that in addition to the tax deferment, the investor gets the choice of timing. This of course assumes that you’re dealing with a publicly traded REIT.

But both do carry slightly higher transaction costs, and there’s more complexity to the closing. Also, remember that REIT stocks are just that–stocks, not real estate per se. Keep this in mind because, as stocks, they track with the S&P 500 much more closely than they do typical real estate performance benchmarks, like interest rates.

But back to the benefits, which includes asset diversification. For example, if you own only a single property, there lies the entirety of your risk. By contributing that property to the REIT and receiving operating partnership (OP) units in the REIT, you’re effectively diversifying that risk across all the properties in the portfolio, which now includes yours. Not surprisingly, this is a major attraction for incoming participants.

Another reason to consider UpREITs as opposed to 1031s or traditional deals is liquidity. If you’re lucky, a traditional sale can take up to 90 days to monetize. Compare this to the mere days or weeks it can take to convert OP units and sell the resultant shares.

Three other benefits also need to be considered. First is the freedom from management responsibilities. REIT’s come with staffs to handle those chores, and the success of the REIT is based in large part on their talents to effectively, efficiently run an asset.

Next come simplification and predictability. The OP unit holder can rely on regularly scheduled cash distributions in amounts rivaling the cash flow derived from an individual property. They’re simply receiving a check for their contribution. Plus, consider the reporting requirements of REITs in general. It’s safe to say that there’s no other industry that does as good a job at providing information to its investors as the REIT industry does.

So, investors looking for a relatively safe-haven vehicle in a time of economic uncertainty and threats to the practicality of 1031s should look more closely at the advantages of Up and Down REITs.

Jonathan W. Hipp is head of Avison Young’s US Net Lease Group.