A Guide to Evaluating Private REITs for DST & 1031 Exchange Investors

Private real estate investment trusts (REITs) have grown rapidly over the past decade, offering accredited investors a path to private real estate investing with relatively low volatility and consistent income. Increasingly, they have become the preferred exit strategy for DSTs offered by some of the largest asset managers, often through a 721 exchange. Private REITs may appear hard to differentiate, but beneath the surface, not all private REITs are created equal. The key to building a strong passive real estate portfolio is to understand the opportunities and risks posed by each REIT.

Here is a framework you can use to evaluate private REITs plus a candid look at the risks and the reality of valuations in this space.

Understanding the Return Profile

A private REIT's return comes from two components:

• Income distributions – Monthly or quarterly cash flow to investors.
• Total return – Income plus growth in net asset value (NAV) over time.

Not all distributions are created equally. Focus on determining whether distributions are fully supported by operating cash flow (often called AFFO coverage). Distributions funded with new capital inflows rather than true income can be a red flag for sustainability.

Portfolio Quality

The underlying real estate drives everything. While most of the major players tout highly diversified portfolios, there are sector or strategy specific REITs as well. It is important to understand the objectives of each specific REIT.

Here is what to look for when assessing a REITs portfolio:

• Property types – Are you getting exposure to durable sectors like multifamily, industrial, data centers, and infrastructure?
• Location and diversification – A portfolio spread across multiple markets mitigates geographic risk. Although many REITs in this space are concentrated in US, they often give have exposure to real estate globally.
• Tenant strength and lease terms – Credit tenants and longer weighted average lease terms (WALT) reduce volatility and provide a stable stream of income.

Understanding Leverage

Leverage is one of the key advantages to investing in real estate. It amplifies returns but also magnifies risk. In this environment it is particularly important to pay attention to how debt is structured within a portfolio.

Here are the main factors to consider:

• Loan-to-Value (LTV) – Conservative REITs often sit near 50% LTV
• Debt structure – A stable debt profile for a REIT means having loans that come due at different times in order to avoid refinancing pressure during tight credit markets.
• Fixed vs. floating debt – Higher fixed-rate allocations provide predictability when interest rates rise compared to a floating debt which can cause cash flow or liquidity issues when interest rates rise.

What is a 721 Exchange (UPREIT)?

A 721 exchange, also known as an UPREIT (Umbrella Partnership Real Estate Investment Trust), allows an investor to exchange a property for shares in a REIT's operating partnership, deferring capital gains taxes. For many investors, this is a two-step process that starts with a 1031 exchange that adheres to all 1031 exchange rules, into a Delaware Statutory Trust (DST). A DST is a popular vehicle for 1031 exchange investors looking for passive ownership. If the DST sells its underlying property to a REIT, the investor can often choose to have their interest in the DST converted into operating partnership (OP) units in the REIT via a 721 exchange. This provides a path from direct property ownership to a diversified, professionally managed portfolio without an immediate tax hit. For more details on this strategy, see our case study on a hotelier who used a 721 UPREIT strategy.

Private REITs vs. Public REITs: Key Differences

The primary differences between private and public REITs are liquidity and accessibility. Public REITs are traded on a stock exchange, so you can buy and sell them easily, and anyone can invest. Private REITs are not publicly traded, so they are illiquid with longer holding periods (often 5-10 years), and are typically only available to accredited investors.

Net Asset Value (NAV) Valuation Methods

Here's a breakdown of how private REITs (real estate investment trusts) typically evaluate their NAV, the key issues investors should be aware of, and how to compare one private REIT against another.

How Private REITs Calculate NAV

Unlike publicly traded REITs, which are priced daily by the market, private REITs rely on periodic internal or third-party valuations. Asset managers can conduct property-level valuations. This means that each property in the portfolio is valued, often using a discounted cash flow (DCF) model, income capitalization (cap rate), or recent comparable sales.

Other operators may rely on using third-party appraisals. This is where a sponsor hires independent valuation firms to validate or produce appraisals. The depth and frequency of these reviews can vary.

Asset values are then adjusted for liabilities. Outstanding debt, preferred equity, and other obligations are subtracted from the gross property value to calculate the equity NAV.

Issues and Risks with Private REITs

NAV Valuation Methods

NAV is often updated monthly or quarterly. However these figures may lag behind current market conditions, especially in volatile markets. During periods of contraction, we often see NAVs in private REITs remain higher for longer than public REITs. This lag may not be entirely explained by imperfect methodology used by private REIT sponsors to calculate NAV. This gap may partly be explained by public REIT investors' immediate liquidity which could unfairly punish valuations during periods of uncertainty where investors are eager to sell their shares and reallocate. The disconnect between the public and private markets becomes evident during periods of rapid interest rate changes or market stress like we have seen over the past few years.

The gap between private and public valuations is a moving target and does not give you any actionable insight if you just look at valuations on one single day. There is context to understand how the relationship has changed over time and which economic factors these markets are reacting to. Because investors typically don't track the delta between private and public valuations over time, it is important to consult with your registered representative and interview the sponsor of the REIT you are considering. During that conversation you can gain insight on that REITs specific valuation methodology. Keep in mind, even when third-party valuation firms are engaged, the sponsor has significant influence over assumptions like cap rates, discount rates, and expense forecasts.

Appraisal Timing and Lag

The gap between the public and private markets is usually only an issue when there is significant volatility such as in periods of rapid interest rate changes or economic stress. Appraisals can significantly overstate NAV because cap rate adjustments or declining rent projections are based on market data available at the time of the report, often lagging reality by weeks or months.

For example: In 2022, as rates spiked, some private REITs continued reporting stable NAVs for months, even as public REIT valuations corrected sharply.

It is important to note, that if your entry to a private REIT is via a DST, you may be committing to purchasing a REIT 2-3 years from the day you 1031 into a DST. It is impossible to predict what the market will look like in the future or what the NAV of that REIT will look like. That's why it is so important to get to know the sponsor you are investing with and how they faired during past periods of economic stress.

Assumption Flexibility

We as investors need to look at an asset manager's performance over time to see if they have been able to accomplish their goals. NAV today is not the best metric because they depend heavily on inputs and assumptions like:

• Cap rates – The capitalization rate used to value properties, calculated as net operating income divided by property value
• Rent growth projections – Forecasted annual increases in rental income from existing and new tenants
• Expense escalations – Anticipated annual increases in operating costs such as utilities, maintenance, and property taxes
• Discount rates – The rate used to calculate present value of future cash flows, reflecting investment risk and time value of money

Sponsors or internal valuation teams guide or influence these assumptions and even small tweaks can swing NAV materially. For example a 25 bps change in cap rate assumptions on a $10B portfolio could shift NAV by hundreds of millions. Because sponsor's have this much influence on performance in the short-term, we seek out sponsors with established, long-term track records that have demonstrated they operate in their investors best interest and are capable of accomplishing their business plan.

Illiquidity and Lock-Up Periods

Unlike public REITs, you can't just sell shares on an exchange. Redemption programs may exist but can be limited, suspended, or repriced during downturns. Sponsors limit liquidity when valuations fall rapidly, most recently we saw this when interest rates rose at an unprecedented rate. Investors in many private REITs were not able to access their capital during this period. While this was unfortunate for shorter-term investors who wanted to reallocate, long-term investors benefit from this scenario. To meet mass-liquidity needs for investors all trying to sell shares at once, a sponsor would have to sell properties in the REIT. This mass-need for liquidity is usually the result of values falling so the sponsor would be selling properties for a loss to pay investors who want to get out. This scenario would punish long-term investors because quality assets could be sold for a loss for no other reason than to provide liquidity. If you owned a property outright you probably wouldn't sell it when the market is at a low if you didn't absolutely have to. You would likely hold onto it until the market recovered. This is what private REIT sponsors are trying to accomplish when they limit liquidity.

Pros and Cons of a 721 Exchange

Pros: You can defer capital gains taxes, diversify your holdings by joining a larger portfolio, and transition to a more passive investment.

Cons: You lose direct control over the property, you cannot 1031 exchange out of OP units, and your investment becomes illiquid for a period.

Fee Drag

Management and distribution fees reduce the net return, and they are sometimes deducted before NAV is published, making comparisons tricky. Make sure you understand the NAVs you are comparing.

Non-Standardized Accounting

Metrics like NAV per share, AFFO (adjusted funds from operations), and yield are not standardized, so direct comparisons require deeper due diligence. Your registered representative can guide you through this.

Incentive Misalignment

Sponsor compensation is often tied to NAV. They can receive performance fees or incentive shares which means that it is in their best interest to keep NAV high. A high NAV is a great thing for long-term investors. However, if a sponsor has kept the NAV high artificially, it could mean new investors are over-paying for the real estate.

Even when appraisers are technically independent, the fact that they are hired and paid by the sponsor introduces subtle pressure to produce "favorable" valuations.

Investors rarely have visibility into whether a sponsor overrode or influenced assumptions. Over the long term, you can see which sponsors have operated successfully, this is another area it is important to understand a sponsor's track record and reputation in the industry. Your registered representative can provide insight here.

What to Look for in a REIT Sponsor

The quality of the sponsor is often the best predictor of performance. Look for experience managing through multiple market cycles, a strong balance sheet and meaningful co-investment, and finally a clear, consistent strategy that matches your risk profile.