Trawnegan Gall on Understanding the Risks of Investing in Delaware Statutory Trusts (DSTs)

Trawnegan Gall on Understanding the Risks of Investing in Delaware Statutory Trusts (DSTs)

DSTs are an increasingly popular option for investors, particularly 1031 exchangers who are attracted by the option of a passive, institutional quality replacement property. Many DSTs include properties NNN leased to credit or high-quality tenants, large, new or new construction apartment complexes in strong markets, self-storage facilities, student housing, etc. DSTs are professionally managed, typically have a income component, and are viable for a follow-on 1031 exchange upon sale. Most DSTs include non-recourse debt allowing exchangers to “replace” the debt of their relinquished property. In addition, the investment process is much simpler and quicker than a typical real estate acquisition.

IF the DST investment goes well the experience of the investor will entail an easy investment process, the receipt of rental income-based cash flow during the hold period, and a profitable exit upon sale receiving back their investment principal with appreciation. Furthermore, this appreciation can be sheltered from capital gains taxation by conducting a follow-on 1031 exchange into another DST or any viable replacement property. However, while on average over time DST investments have historically provided very attractive returns, a significant number of DSTs underperform and a certain number fail entirely. In these cases the experience of the investor can be much less pleasant. They may experience decreased cash flow or none at all, they may not receive back all of their principal invested upon the sale of the property, and in the worst cases they may suffer a total loss of principal. There is also the possibility of problems at the investor relations or asset management level. DST reporting may be insufficient or late, tax documents can be sent late, etc.

How can the typical retail investor/1031 exchanger understand and evaluate these risks? How can the investor discern the more serious and probable risks from the less worrisome and those which have a very low probability of occurring?

The first point the investor needs to understand and accept is that any DST investment absolutely entails significant risks. There is no DST investment which is risk free and any broker or sponsor who downplays the risks involved is either inexperienced or dishonest. DSTs are offered as private placement securities available exclusively to accredited investors. This accredited standard is intended to achieve a certain level of sophistication among the investors but it also implies that DST investors have a certain level of investment experience and sophistication. The DST investor should be able to read and understand the offering materials and investment documents, and to ask appropriate questions of their broker or financial advisor. At the end of the day, the investor will sign documents stating that and is assumed to understand that there is no guarantee to these investments, they do entail significant risks, and that the the investor will either reap the benefits of a successful investment or bear the loss of an underperforming or failed investment. If an investor/exchanger is not comfortable with the risk profile of these investments, if they are looking for a “safe” investment or if they would like an investment with sponsor backing or guarantee then a DST investment is probably not suitable for them.

But there are two mitigating points of importance. First, any 1031 exchanger, which represent over 90% of all DST investors, has sold a piece of real estate, their relinquished property, which probably had a higher risk profile than the DST into which they are considering investing. While it is true that their relinquished property was not a passive investment and their own elbow grease and financial support of their own property is important, these benefits are significantly offset by the fact that their relinquished property was almost certainly not institutional quality nor was it professionally managed. In sum it is very often the case that a 1031 exchanger will neither significantly increase nor significantly decrease their risk profile simply by completing a 1031 exchange into DSTs.

Second is the matter of diversification, probably the most important and strongest way to mitigate risk in DST investing. With official investment minimums as low as $25,000 it is very easy for the 1031 exchanger to diversify across multiple DSTs in the course of one 1031 exchange. If an exchanger diversifies in their exchange, this will significantly reduce their risk profile, effectively distributing their investment eggs from one basket into several baskets.

Of course, this depends on how diversified they are already. If a relinquished property only represents 5% or less of their total investment portfolio then it is likely suitable to exchange into one replacement property DST. But if that relinquished property represents more than 5% and especially if it is more than 20% of their overall portfolio, diversifying across multiple DSTs can greatly reduce their overall risk profile. I have worked with investors whose relinquished property represented 75-80% of their total net worth, which is a very risky position to be in, and helped them diversify into 8-10 different DSTs in the course of their exchange, thus greatly reducing the overall risk profile of their portfolio.

When evaluating the risks of any given DST offering, it is highly recommended, even assumed, that the investor will read the private placement memorandum, the risk section in particular. Only by reading this section themselves will the investor have a thorough understanding of all the risks of an offering. As to the specific categories of risk I would like to mention several for consideration: real estate risks, sponsor risk, structural risk especially illiquidity and lack of control, and securities risk.

Real estate risks are not specific to DSTs but rather general to all real estate investing or ownership. The broad categories of real estate risk include the characteristics of the land and improvements themselves, e.g. the age and condition of any buildings, the location of the property, local and national market factors, tenants and leases, occupancy rates, market rental rates, financing risk and property management. It is not within the scope of this article to go into great detail on the various types of real estate risk, but it is important to note that real estate risk is probably the most important category of DST risk. Therefore, the investor should understand that they are fundamentally investing in real estate and that all the risks of the particular piece of real estate into which they investing will affect the performance of their investment either positively or negatively. If occupancy or rental rates decline, or if a tenant defaults on the lease, these factors will negatively affect the performance of the investment.

A second very important category or risk is sponsor risk. While the real estate is what it is, the conduct and capacity of the sponsor from the initial purchase of the property, through the hold period and up until the disposition of the property can and usually does have great impact on the performance of the investment overall. Key matters to look for in a strong sponsor include:

  • Institutional Capacity—are they well-staffed for the duties of asset management, property management, acquisitions and dispositions, investor relationships, quarterly reporting and yearly tax reports?
  • Track Record—Do they have a significant track record and what is their overall average rate of return? Are there past deals which have underperformed or failed altogether and if so how many, how much and why?
  • Personnel—The most senior people at a sponsor matter. What is their own experience, capacity and track record (see their bios)? And of course the character of the leading people at a sponsor affects everything else, who they hire, their investment strategy, and their conduct when the going gets tough.
  • Conduct when an offering is challenged—Segueing from personnel, the character of a sponsor is especially important when an offering is underperforming. Do they have a history of supporting struggling properties either with financial support but perhaps even more with intensified focus, attention and creative thinking? Do they have a track record of putting investor interests first? At a bare minimum is their communication regular and transparent even when an offering is underperforming?

Next I would like to discuss two of the most important aspects of structural risk, i.e. the risk of the investment being structured as a Delaware Statutory Trust. These are illiquidity and lack of control. All real estate is considered illiquid in that it cannot be converted to cash immediately. The sale of a real estate asset will typically take several months even if the process goes quickly. Still, a direct owner of real estate can convert the property into cash within a reasonable period of time. This is not the case with DSTs. In almost all cases the investor will need to remain invested it the DST until the property is sold on the back end. This hold period will typically extend from 5-8 years but depending upon the circumstances the hold period can extend beyond 10 years. While it is permissible to sell one’s DST interest prior to the conclusion of the offering, this process is very difficult and will almost always result in a discounted sale price, i.e. the investor will receive less than the current market value of their interest. It is really not comparable to selling a piece of real estate on the open market. Therefore the DST investor needs to give serious consideration to the illiquid nature of this investment and its projected hold period, realizing that an early exit would be difficult and expensive though possible.

The investor also has no control over a DST investment. This is not like a tenant-in-common investment where the tenants in common have voting rights. The sponsor, functioning as the trustee of the trust, makes all the decisions regarding the investment and they are not obligated to consult with the investors. Specifically the sponsor will decide when to sell the property which is often to the most important decision of all. As a caveat, in extreme cases a sponsor can be removed as the trustee of the trust, but this is very rare. In almost all cases the investor will be reliant on the conduct and decisions of the sponsor for the duration of the investment.

Lastly, I would like to mention the matter of securities risk, specifically their expense. Because most DSTs are marketed as securities they will entail significant additional expenses above and beyond the expenses normally involved in a real estate transaction. The securities related expenses are combined with other front-end expenses, financing costs, acquisition fee, etc. to constitute the “front end load”. This is the load which must be overcome by the appreciation or income of the investment in order for the investor to be made whole or receive profit from the investment. While these expenses by and large result in a greater number of professionals involved in the transaction which does provide an element of protection to the investor, it is important to understand how much front-end load there is with any given DST investment. Load varies from one DST to another. Before proceeding the investor/exchanger needs to be comfortable with the amount of front end load believing that the expenses are outweighed by the strategy and profit making potential of the investment.

In conclusion, a DST investment can be an excellent and suitable investment, especially for 1031 exchangers who will benefit from the tax deferral of IRS section 1031. But it is critical that the investor/exchanger understand and account for the risks involved. Diversification can significantly mitigate risk across a portfolio but the risks of each individual DST investment remain. The better informed and educated an investor is about the risks of any given DST investment, the better decisions they will be able to make regarding which DST(s) is best for them, and the more pleasant the hold period will be as they will better understand the possible ups and downs of DST investing rather than being caught off guard by unforeseen events. Overall DSTs are increasing in popularity for a reason. They have historically provided very decent overall returns to investors, albeit with some losing investments among them, in addition to the very substantial tax benefits of 1031 exchange.

About Trawnegan Gall

Trawnegan Gall is the Senior Vice President of Cornerstone Real Estate Investment Services and is located in Dallas, Texas. Cornerstone serves a national clientele, helping clients invest in institutional quality securitized real estate offerings, including DSTs for 1031 exchange.

Mr. Gall has brokered more than $350 million into real estate securities over the last 10 years. He is the co-author of Modern Real Estate Investing, the Delaware Statutory Trust, and is one of the field’s strongest proponents of industry best practices.

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