The Appeal Of A 721 Exchange / UPREIT, With Keith Nelson

As real estate investors seek to lock in capital gains on past deals, 721 exchanges and UPREITs have gained in popularity. Now, some private equity funds are beginning to use the same structure used by private UPREITs, to allow for tax-advantaged investments from their LPs.

Keith Nelson, managing partner at Dual City Investments, joins the show to discuss the advantages of completing a 721 exchange, as well as the overall CRE landscape heading into 2023.

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Episode Highlights

  • Background on Dual City Investment, and how Keith started his career in CRE.
  • Why Keith believes a long term perspective is important, and how that philosophy has shaped the operations at his company.
  • How a section 721 exchange can allow investors to defer taxes while investing in a private UPREIT (or a similar private equity fund).
  • The similarities and differences between an UPREIT (or a similar private equity fund) vs. a DST.
  • Keith’s tips for LP investors and family offices who are evaluating various private placement offerings.

Today’s Guest: Keith Nelson, Dual City Investments

About The Alternative Investment Podcast

The Alternative Investment Podcast is a leading voice in the alternatives industry, covering private equity, venture capital, and real estate. Host Andy Hagans interviews asset managers, family offices, and industry thought leaders, as they discuss the most effective strategies to grow generational wealth.

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Show Transcript

Andy: Welcome to the Alternative Investment Podcast, I’m your host, Andy Hagans. And today we’re talking about the CRE market. Obviously, we may be in for some turbulent times here, as well as UPREIT 721 exchanges and some other very exciting topics. And joining me is Keith Nelson, who is managing partner at Dual City Investments. Keith, welcome to the show.

Keith: Thank you, Andy, for having me. Excited to be here.

Andy: Yeah, and I think we have some pretty exciting topics teed up. But before we dive in, could you please give us a little bit of background on Dual City Investments? How long has the company been around, and how did you get into the space?

Keith: That’s a great question and we probably need all of the show to follow up on how I got that point. But we started in 2014. I came from a law enforcement background, I was a special agent with the DEA. Myself and my partner, we were actually on surveillance one day in a very affluent area of New York, and we were just kinda sitting there eating out of an old pizza box and saying, “What life choices did we not make to be doing this and not be doing what these people are doing?” And after a couple of years of just reading and research, real estate was a common path to wealth.

So I decided to make the jump, and we formed Dual City in 2014, and we started off syndicating deals with friends and family. And that grew into our first fund in 2017. We did very well with that. And yeah, launched this… We call it our last fund because it’s evergreen, it’s gonna go on in perpetuity at the beginning of this year. So we’re pretty excited to see where 2023 takes us.

Andy: I love that. Just having one fund, having an evergreen fund. I have to say that that’s a new one. Your entry into the space, I haven’t heard… That’s definitely a new one. But you know, it’s interesting though, that just kind of commonality of investment into real estate for a lot of people is like a second career. It’s like, you start on one path, and then you kinda decide… You’re thinking one day, maybe not the exact scenario you were in, but you’re just thinking one day, is this really what I want to do?

Keith: And I think that makes you a better real estate investor and better at that career. You know why? Because if I came straight out of college and that’s all I knew, this business is hard, as you know, I’d probably would’ve burned out and not been in it. But I’ve done the 9 to 5, and I’ve done the living paycheck by paycheck, and I know what it’s like if I had to give this up and go back. So it kind of puts you in a different mindset. So I do think that’s important to have that life experience before you dive into this career path.

Andy: Yeah, I think that that motivation is so important, as is vision. And when I was reviewing the Dual City website, and I imagine that this kind of goes into your fund, but one thing that really stuck out to me was that your website mentions that you focus on providing commercial real estate investment opportunities that put investor security in the forefront. And I think that that actually is pretty unique, that a sponsor, a fund manager would really stress investor security as like the number one priority. So can you tell me a little bit, like why is that your mindset? What led to that being your priority?

Keith: Sure. Well, to start with, in 2014, there weren’t…it wasn’t as prevalent to be a real estate investor, or a syndicator, or a fund manager as it is now, right? I feel like everybody and their grandmother has their own syndication business. So when we started, it was family and friends’ money. And the last thing we wanted to do was lose their capital. So we did things the right way, we didn’t buy properties based off of an Excel spreadsheet. We analyzed it, overanalyzed and reanalyze it. And we’ve just come up with a conservative method of investing, and preserving their capital is always our first goal, obviously followed by a positive return as our close second, consistent return.

So yeah, I mean, we’ve seen a lot of…I don’t wanna say shady, but not above-board groups make a lot of money and raise a lot of money. And they lined their pockets first and whatever was left, hopefully there was, they gave to their investors. And I know this firsthand because a lot of our investors came from a lot of those groups. And I think this upcoming environment, I think we’re gonna see a lot more groups exposed and hopefully, the good groups are the ones that rise at the top and stick around. And there’ll be less options, but quality options available for investors.

Andy: Yeah. You know, I think you kind of hit on something, the long-term thinking, the long-term approach. I’m reminded of the three rules of a family office, don’t lose money, don’t lose money, and don’t lose money. So that capital preservation, first and foremost… Like you said, there’s gonna be a down market cycle, and if you burn investors, then great, I guess you made money in one market cycle and now you’re out of the game, right?

Keith: Yeah. I think that’s the thing. We’re gonna see that.

Andy: Yeah. So, I wanna now turn to your offering, so the Dual City Advantage Fund. And from the webpage, I’m gonna quote this exactly, “The Dual City Advantage Fund is a blind pool private equity evergreen fund, which follows the same structure as a private UPREIT.” So before we dive into the strategy of the fund, I actually just want ask about UPREITs and 721 exchanges because I know a lot of our listeners are familiar with those, but probably a lot of our listeners are not familiar with UPREITs and 721 exchanges. So would you be able to walk us through how those work?

Keith: Sure. So we modeled our fund after an UPREIT, which is essentially a REIT, which is a real estate investment trust. But the UP portion of it, which actually stands for umbrella, I dunno where they got UP, U-P, from. But that gives the REIT the ability to use the 7.1 tax exchange where they can absorb properties, issue shares, in a REITS’s case, in lieu of cash. And by doing that, that defers the capital gains tax on that property for whoever owned it. So they could come into that UPREIT, own shares, have all the benefits as if they put cash in, but they just got paid out shares. And when they cash out of those shares, that’s a taxable event, they’ll be taxed on their basis in that original property, at that time.

So we took that model and we found out that, well, I could do that in a private equity structure [inaudible 00:07:57] and yeah, we started that, and we just modeled everything as if we were an UPREIT. So we have the 90% of net profits go to investors, we follow a similar fee structure of 1.5% AUM fee, and then the 10% to the management team. But it’s evergreen, which means there’s no lockup period. We have lines of credit available to cash out investors if they wanna take their cash and leave. We just started this year and we’re doing pretty well. We have a consistent, just about 70% return, and we hope that climbs over the course of time. And we just keep growing and hopefully, we get to that UPREIT model as well.

Andy: So the 721 exchange, that’s basically an alternative to a 1031 exchange for an investor who wants to exit like an individual property, defer the capital gain stacks, but by doing the 721 exchange into an UPREIT or an UPREIT-like fund, then they can become a passive investor after that exchange, versus exchanging into a property that they have to actively manage. Is that essentially the benefit of this?

Keith: You hit it spot on, yes. I like to tell owners of investment properties, like, in my opinion… I mean, well, not my opinion, there’s just way more flexibility in doing this than 721. The only downside is when you cash out, you have to pay the tax man, and there’s no more rolling… 1031, you could swap until you drop. In this, once you’re in the units, you either stay in, or when you go to cash, you gotta pay your gains. But there is an interesting component, you could tax plan this, right? So if you had a $1 million gain, it’s not all or nothing one year. If you wanna buy a lake house, you could take out $300,000 one year, leave the rest in, and then tax plan subsequent years.

Andy: Interesting. So, I don’t know how familiar you are with DSTs, it sounds like this type of product would be roughly analogous to a DST, but structured as a REIT, there are rules, regulations that go along with that particular product wrapper. The DST by contrast, also has its own rules and regulations, but in my experience, those are… They’re pretty strict with a DST, with the seven deadly sins and the type of assets that a DST can hold and operate. So is the UPREIT structure, is it more flexible in terms of the types of assets? I guess, why would an investor choose an UPREIT versus a DST? What would be the deciding factor that could help them choose?

Keith: So my experience with DSTs is that they are closed-ended funds or raises, and they’re typically locked up for a significant period of time. When I was looking at them several years ago, I think the typical term is like 10 to 15 years of a lockup. The main difference here is we have a liquidity component where you’re not locked up, and you can tax plan request funds out, and if the funds are available, you can go on your own way and do what you want. And it’s not an all-or-nothing thing. So if you’re in a DST, when you exit that, you either have to 1031 to something else, or cash out 100% at that time. So those are the two main differences. As far as the asset types, I don’t know how it is exactly for DST, I’d assume it’s the same way, but as long as we identify what we’re looking for in our PPM, those are the guidelines that we go follow.

Andy: Yeah. DSTs are a lot more strict in terms of being very limited into how much capital improvement they can do to an asset. So they’re kinda limited to like core, maybe core plus type assets, where at no…as far as I understand, rarely ground-up construction, no value add, no opportunistic. The interesting thing to me with the UPREIT, or an UPREIT-like structure would be as contrasted with a DST, you’d have that option for more immediate liquidity whereas, a DST, I think typically, 5 to 10 years, maybe as much as 15. But then on the other hand, if your fund is perpetual or evergreen, could an investor stay invested for, let’s say, 20 years and just indefinitely let it ride?

Keith: Sure, yeah. We’re also looking into the ability for investors to compound their returns, right? So we pay out quarterly and instead of taking that outta cash, could they reinvest it? We’re working that into our software, so we’re able to do that, and they’re able to see it real-time. But yeah, they can, sure. And that’s my goal, right? So my goal is if someone puts capital with us, they can request it out by… Our goal, as fund managers, is to get that dividend up as high as possible and consistently, which is the most important word. Meet those…not miss a payment, and consistently raise our dividend as we get more profitable.

Andy: Interesting. Okay. So I wanna ask about DCAF specifically, a couple more aspects of it. So I noted from the literature that this fund can utilize the tax-deferred exchange to transact in more situations than the competition. I saw that quote on your website. So what exactly does that mean? What are the situations where you have the flexibility to transact where the competition would not?

Keith: That simply means that most private equity funds don’t have that 721 code written in their documents. So unless they go rewrite all their documents, they won’t be able to do it. I mean, I’m not saying it’s impossible, it could certainly do that. But we’re just set up day one, we don’t have to go back and get all our investors to agree that we’re gonna start doing this. So we’re just set up that way. It’s probably…could use a better wording in that scenario but…

Andy: No, no, I think I get it though. The point is, by structuring it that way upfront, you’re reducing the friction, right? Even though that type of transaction might be possible with another fund. You also mentioned the liquidity, that you have lines of credit or capital pools for investors who want to exit. Is that something that’s typical with a fund of this structure?

Keith: Of an evergreen fund, I would say, yeah, there’s gotta be some liquidity component to it. But again, we are structured as a private equity fund, so there’s no secondary market. So if we don’t have the capital available, we can’t return investor capital, right? [Inaudible 00:15:36] we’re gonna start selling off assets and hurt everyone’s return. But if it’s available, our lines of credit are there, then we’ll meet that request. Our goal is to take us to, eventually, the secondary market, which means we have to become a publicly traded UPREIT. So that’s our ultimate goal, is to have this structure and be able to flip that switch when we’re at that size and have a secondary market for our investors to take advantage of.

Andy: And what is that, the AUM size or market cap size? What is that number where economics make sense to become publicly traded?

Keith: That’s a great question. We’re not that far down the line to you could consider that yet. Like I said, we just launched this, I think in February. So the answer is, I don’t know. I would think 500 million under management would probably be the size that we’d look at to do something like that.

Andy: Yep. That sounds about right to me. So another kind of unique thing about your fund, you acquire assets through all stages of the CRE market cycle. So what does that mean exactly? I mean, in practice, are you investing in ground-up development? Are you doing value add, or core, core plus? Is it a mix? Could you talk through what exactly does that mean?

Keith: Sure. Well, buying through the market cycle, I’ll touch on that real quick. So we closed up our first fund, we were gonna launch a second closed-ended fund, I wanna say like January 2020, and then the pandemic hit in what, February or March?

Andy: Sure.

Keith: So we were about to launch that, and we just pumped the brakes and said, “Look, we don’t know…” Nobody knew what was gonna happen during this pandemic. I’m like, “I don’t feel like locking up capital and buying assets at…” We were at the top of the market at that time. I wouldn’t feel comfortable building a fund at the peak of the market not knowing what the next several years were gonna hold, right? So…

Andy: Not knowing we were standing on a peak of a mountain that was right next to another mountain that was even steeper, right?

Keith: Well, 100%. And we were like, we can’t launch this now and fall victim to that. So by making it evergreen, even if we bought at the top and we continue to buy as it goes down, and we continue to buy as it goes up, those returns over time should be most beneficial. Reverses buying at the top, locking up the capital, crossing your fingers, and hoping that our exit timeline lines up with the market. So that’s what I meant about that. And to answer your question about the types of assets, we could do construction and development and all that, but right now, we’re focusing on core, core plus, assets to build our base dividend return. But once that’s big enough and strong enough, then we’ll start looking at value add, and some developed deals, and those sort of things to really juice up the return and the equity gain.

Andy: That makes sense. Yeah. So acquiring assets through all stages of the CRE market cycle, that’s really a feature, not a bug, of an evergreen fund that is raising capital continuously, deploying it continually.

Keith: Yeah.

Andy: Allowing you to be opportunistic, I suppose, for the best opportunities that you can find while also… I don’t wanna say dollar cost averaging in, but maybe that is kind of a way to look at it, from one perspective.

Keith: Yeah, yeah. That’s the thesis right behind it.

Andy: So where are we in the CRE market cycle? This is the million dollar…well, billion, trillion dollar question? Where do you see us… Obviously, we had this market top going into 2020, and then I kind of heard the theory that there was kind of a reset of the market cycle. So then obviously, there was another leg up. But I, at least, heard the theory that the lockdowns and all that kind of threw old valuation models down the window. We were at the new…beginnings of a new cycle. Obviously, we’ve hit some headwinds now in the second half of 2022, so do you think we’re headed for a little bit…? I don’t know. First of all, would you say we’ve had a slight correction? Would you say we’ve had a moderate correction, or are we still waiting for the real correction?

Keith: It’s a great question. If I had a crystal ball, I’d make $1 billion. We have seen a slight correction. Actually, there were statistics that just came out not too long ago, like some metropolitan areas have seen as much as 20% reduction in value, which to me was a shocker. I think we have seen slight, slight correction right now. I think we’re in store for further correction, the front part of 2023. How long that lasts, or how deep it goes, I have no idea. But I do think there were a lot of syndications and funds that bought assets at the very peak. And I think they’re gonna have to sell at a break-even or at a loss in the next couple quarters. And I think that’s gonna loosen some things up in the market that are available for the opportunities for other people. So, I do think it’s gonna be a little bit more of a correction, probably. I’d like it to be quicker and more severe versus drawn out and going on several years. But yeah, I mean, that’s my theory, but that’s only my opinion so.

Andy: Do you think that there’s enough dry powder, so to speak, on the sidelines that provides a little bit of a floor? I don’t wanna say that’s my concern, I think that’s almost… I’d almost be hoping for a more disruptive contraction to see more, what I would call, realistic pricing. But I’m kind of concerned that we’re not gonna see that really desirable pricing.

Keith: I’m with you. I was hoping that’s what I said, I hope it to be a little more severe and short. But there is a lot of cash on the sidelines and mostly from the institutional layers. I’m hoping that for me, and Dual City, and our fund, we are in that small mid-market range, right, 2 to 10 million is kind of our sweet spot. So we’re kind of under the radar of a lot of the big houses. So I’m hoping that’s gonna be a little more available. But yeah, I agree with you. There is a lot of capital just waiting to pounce. And I think that time is when they start dropping that interest rate. I think you’re gonna see a lot of cash flood the market again.

Andy: Are the valuations more favorable? Like that kind of end of the market that you play in the small to mid-market, from a dollars and cents and proforma angle, are the economics better there? Is there more competition? Is there less competition?

Keith: There has been increasingly more competition from obviously when we started in 2014/15. That’s the part that I think is gonna get the most shooken up from a lot of groups just buying everything and anything they get their hands on these last, I don’t know, 12, 18 months. As you said, we saw valuations just skyrocket to prices that… For three years ago, prices were at a point where we were like, “What the heck are these people doing?” And I just don’t… I didn’t understand it then. And a year ago, I was really scratching my head like, I just don’t get it.

But to each their own. Some companies have to do deals to keep their lights on. That’s one thing about us, we have a sister finance company, and we also have a sister commercial brokerage company. We share a lot of the same expenses so we could be conservative and kind of hang back, and we haven’t bought anything in two quarters because of the market. And we’re only able to do that because we don’t have a large staff, and we don’t have to do deals to keep our lights on. So, I think a lot of those companies are gonna be folding up and liquidating their assets.

Andy: Okay. Could be healthy…could be healthy for the overall market. So back to the beginning, we talked about your philosophy of keeping investors’ security in the forefront. And we’ve talked a little bit about the CRE market, how hopefully it’ll correct a little bit. That sounds like you have some dry powder, so that might create opportunity for you. But what are the risks…what are the challenges right now in this market environment going into the first half of 2023? What’s the main risk, I guess, on behalf of your investors that you really are looking at, this is the thing we need to manage right now?

Keith: I think the main risk is the economy, and fears of the recession, and how long that may be, or if it’s already over. Stock market yesterday was pretty [inaudible 00:25:52.672]. But I don’t know, that’s why we made this evergreen fund. As long as we are cautious on the assets that we are buying, and we’re buying it for long-term holds, and the valuations are not grossly over-promised at the time of purchase, I think we’ll be okay. And then that will give us the ability to buy through those up-and-coming hard times, so to speak. So as long as we follow that game plan, I think investor capital will be secure.

Andy: Understood. So then, those risks, those challenges in the economy, do you think those are… Are they mainly a good thing? I mean, are they creating opportunities for your fund to acquire assets at more attractive prices, let’s say, than two years ago?

Keith: Yeah, on the real estate side of things, sure. I mean, I don’t wanna see people lose their jobs just so we can buy real estate. But I think… I hate to keep going back to it, but I think a lot of the companies that were gluttonous, at that time, I mean, they kind of deserve what’s coming up. And that doesn’t phase me if they have to close up shop and leave, because, I think, they took advantage of their investors, right? And yeah… I mean, look, I hope we don’t go into any 2008 scenarios, I don’t think we will, but yeah, I do think it’s gonna be shake up, and I do think you’re right, it’s gonna be healthy for the economy in the long term.

Andy: So that being said and, by the way, I think you’re hitting the nail in the head with that idea of a shakeout. Would you have any advice or tips for LPs, for family offices, for accredited investors who are evaluating private placement offerings and trying to select sponsors and issuers that put investor security, return of capital, at the forefront? Do you have any, I guess, tips for LPs when they’re evaluating private placements?

Keith: Yes, I do. And I’m not gonna take credit for this because I saw it on some social media channel. Some investor said, “I just made 40% on a deal I was invested in, and I’m furious at the sponsor.” And what that essentially means is there are a lot of people that can ride a wave, but it’s not the same thing as knowing how to swim. Which means there are a lot of groups that made a lot of money just riding the market, right? I would say family offices, larger investors, asked to see a P&L of a property. Maybe at the time that they purchased this, and then at the time where they sold it and see if there was actually value added. It wasn’t just riding the market and just people being greedy and just paying top dollar for stuff. See if they actually added value. Did they increase the NOI? Did they increase rents? Decrease expenses? Look at that. I think you look at the group and you look at somebody’s track record, and if they could show that they can perform, those are the groups that I would list.

Andy: Well, I think that’s good advice. I mean, you have to add value, right? That’s the whole point of active management is… I guess, anybody can raise capital and go buy something, and then the question is, are you adding value beyond that? So I think that’s more than fair. So Keith, I appreciate all those insights as well as just walking us through the UPREIT structure, the 721 exchanges, and how all that works. I think there’s a tremendous amount of interest in that type of product right now. Have you seen their… A lot of your investors coming in, is there a lot of interest in that UPREIT structure? Has that been a tailwind for your company?

Keith: We’ve really just started kind of a marketing push, so to speak. We’ve always been grassroots, word of mouth, friends and family, kind of grown organically. So like our networks are pretty much tapped out at this point, so we’re just trying to get the word out now. So I appreciate you having me on as part of that, but yet to be seen. I think people in the last quarter have been a little cautious about putting money into anything, and rightfully so, I think they should be. But I do believe we just keep doing the right thing and our returns stay consistent…consistently growing, then it’ll happen. And hopefully, we gain some traction and get some larger investors interested.

Andy: Absolutely. So where can our viewers and listeners go to learn more about Dual City Investments and your fund?

Keith: Just the website,

Andy: Sounds great. And I’ll be sure to link to that website in our show notes which, as a reminder, are always available at Keith, thanks again for joining the show today.

Keith: I appreciate it, Andy, any time. This was a enjoyable conversation. Appreciate it.

Andy: Absolutely.

Andy Hagans
Andy Hagans

Andy Hagans is co-founder and CEO at AltsDb, and host of The Alternative Investment Podcast. He resides in Michigan.