MLG Capital recently notched a major milestone in its Legacy Fund, surpassing $1 billion in assets nearly two and a half years after its initial launch in February 2021. Although billion-dollar funds are hardly a novelty in the commercial real estate industry, what is unusual is that the fund is seeded largely by property owners that are contributing properties in exchange for ownership units.
“We’ve had a lot of success growing our fund because we offer a new approach to helping a high-net-worth person become a passive investor and entirely relieve the burden of owning and managing real estate without recognizing a taxable gain,” said Billy Fox, senior vice president at MLG Capital. Its performance also has helped attract owners interested in contributing their assets to the fund. Its target total annual return for investors is 10% to 12%.
The demand to exit actively-managed properties is as strong as it’s ever been with demographic tailwinds from an aging baby boomer population and trillions of dollars embedded in illiquid real estate assets, noted Drew Reynolds, chief investment officer and head of the research group at Realized, a platform that assists investors with 1031 exchanges across real estate and DST products. “The challenge is really in the financing market and real estate transactions in general,” he said.
The higher interest rate environment has resulted in a disconnect between buyer and sellers that has slowed sales activity. Property owners that want to transition from active to passive ownership are looking at alternatives that include contributing their properties to private investment funds, DSTs or REITs in exchange for shares in those investment vehicles. “There has been a noticeable increase in property owners asking if a contribution is a viable option,” said Steve Friedman, a director at law firm CohnReznick. Sponsors also are more interested in exploring contributions to conserve cash on acquisitions in the current market in which financing is more difficult, he added.
Trading property for ownership units
Property owners who want to complete a tax-deferred contribution of a property into a private fund, REIT or DST all follow a common path by using a 721 UPREIT. The UPREIT structure leverages Section 721 of the Internal Revenue Code, which allows investors to contribute ownership of a property to a partnership subsidiary of a REIT in exchange for a partnership interest or operating partnership (OP) units. Effectively, the OP units are used as currency. The property seller can defer capital gains taxes or depreciation recapture taxes until the time that they convert those units into shares of stock.
“We have seen a number of new funds arising over the past few years that pair a traditional 1031 DST exchange with a planned 721 UPREIT exchange,” said Jack Rybicki, a managing principal at CliftonLarsonAllen Wealth Advisors LLC. In this option, the seller does a 1031 DST exchange into a property that a fund manager has identified as a strong candidate for a future 721 UPREIT exchange.
The DST must wait two years or more to execute the 721 UPREIT exchange, so there is a risk that the UPREIT transaction may not materialize. “This option is typically used when the seller wants to end the cycle of using 1031 exchanges to defer taxes and wants the benefits of ownership of a diversified pool of real estate that an UPREIT structure offers with potential liquidity,” he said.
According to Fox, one of the key differentiators of MLG’s Legacy Fund is that it offers real estate investors shares in a private real estate fund rather than a public REIT. “Very often the investors that we're talking with not only have significant wealth in private real estate but also have real wealth in equities that have that daily volatility and correlation to the public markets,” said Fox. So, they are looking for a private real estate investment vehicle that is less volatile and less correlated to the stock market, he says. Another differentiator is the LLC structure, which allows investors to maximize ongoing depreciation deductions.
Finding the right fit
One of the hurdles for contributions is that a property has to fit a REIT or fund’s particular strategy. For example, while the Legacy Fund owns more than 80 properties across 17 states, 95 percent of that portfolio is multifamily. In addition, the fund wants properties that have at least 100 units and an owner with at least $3 million in equity.
Realized is working with one client that is interested in contributing a $40 million property to the Legacy Fund, in part because the traditional buyer pool for that asset has dried up. That deal may or may not go through because it is difficult to get properties across the finish line, noted Reynolds. “It is a very good strategy for deals that work, but that box for those parameters is very narrow,” he said. For example, Realized typically generates 20 to 30 leads per day, and out of that robust pipeline they currently only have the one investor that could be a fit for a contribution to the Legacy Fund.
Valuation of a contributed asset also can be challenging, and it is typically not the highest offer a seller might get compared with a competitive bid in the investment sales market, added Rybicki.
Another barrier to entry for both sponsors and property owners is that UPREITs are challenging to structure from both tax and legal perspectives, and those complexities linger after a property has been contributed. Contributing a property—particularly an encumbered property—requires sophisticated accounting and analysis to protect tax benefits and avoid potential missteps, including liability sharing rules for partnerships and contribution rules under IRS section 704c, notes Friedman.
“These are not easy things to get done,” agreed Reynolds. So, while there is more interest in property contributions, there are factors that put a cap on the growth potential of this niche. “What I think you will see generally, especially in the non-institutional space, is more seller financing to get deals done,” noted Reynolds. Seller-financed transactions tend to be easier than contributions to funds, he added.
Owners weigh pros and cons
Property owners need to consider a variety of factors when assessing a potential contribution. Firstly, are the tax implications. Generally, a contribution only makes sense if the owner can fully defer the capital gain and there is no tax cost on that contribution. Another friction point is making sure the accounting and legal fees don’t gobble up the tax benefits. As such, contributions are generally better suited for large properties that recognize a sizable gain.
As with any investment, owners also need to complete due diligence on the new investment. A contributor is effectively ceding control of an asset to another group. The question is, how good is that group at managing the asset? Can they create value that drives appreciation and dividends? “An evaluation of management is something that we think is really important and probably doesn’t get the substantive due it’s entitled,” said Friedman.
Owners also need to look at the quality of the investment they are getting in return for their contribution—the underlying portfolio of assets backing those ownership shares. What is the after-tax return, and what is the likely growth in value post-closing? Another important factor is the exit strategy for that vehicle and future liquidity for the owner. Potentially, lack of liquidity can be a big impediment to the value an owner might be getting from the tax-deferred contribution, noted Friedman.
Despite challenges, MLG Capital anticipates a good runway for growth ahead for its Legacy Fund. One reason is because the complexity of contributed property transactions creates a sizable barrier to entry for new competitors entering the space. Educating investors has been a critical piece to growing the fund. A challenge for the Legacy Fund early on was getting some of the first movers to buy into the concept,” said Fox. “Now that we have some real momentum, I see a path to more growth.”