From: Christina Nielson
Date: January 19, 2018
Delaware Statutory Trusts (DST) are rapidly becoming an avenue of 1031 Exchange Replacement property that investors have been transitioning towards over Tenancy-in-Common (TIC). There are a number of beneficial aspects to DSTs, but like all good things, there are a number of drawbacks that can pose risk to potential investors that one must consider before deciding that DSTs are the right choice.
Firstly, DSTs are not for short term investments – DSTs are best suited for properties with longer-term leases (around 7-10 years) and certain properties types such as (apartment complexes, office towers, commercial and retail facilities, medical complexes, etc). If you as the investor are more interested in temporarily storing your money while waiting for other lucrative investment opportunities to come along, DSTs would likely not be the right path to consider since DSTs are illiquid. Due to 1031 requirements that restrict an investor’s ability to transfer funds, and that there is no significant public market for investors to liquidate or repossess their money once the investment is made, most consider DSTs to be illiquid. Thus, putting money into a DST is a long term investment due to the nature of the holding periods dictated by the offering.
Secondly, DSTs typically only net an annual income of 5% to 6%. For individual investors that are used to being the sole owner and investor in their property, these returns at around 5% can be seen as a drawback for those used to more lucrative returns. But for the trade-off of having to do little work for these returns, some may find this an easy adjustment to make.
A third drawback that one should take note of, is that the trust cannot raise new capital once the DST offering is closed. This means that should the property need to cover unforeseen expenses, current or new investors cannot provide further funding or contributions to the DST. One may have to evaluate the “springing LLC” option available to DST structures which can create capital gain tax ramifications.
A fourth consideration is that Delaware Statutory Trusts (DSTs) are investments in real estate subject to the same market, leasing and competitor risks of traditional property. Clients occasionally ask if DST investments are guaranteed like a bond – they are not. Whereas many DSTs perform right at projection or better, DSTs can underperform creating less cash flow and total returns than anticipated. If an investor wants guaranteed returns, they may best research alternative investments with their tax and other advisors. However, the investor must recognize that bond funds investments must come from after tax proceeds. For example, if the investor is in a 40% or greater total tax bracket, and they have $1,000,000 of net sales proceeds, there would only be $600,000 remaining to invest in other vehicles. The projected, but not guaranteed cash flow of a DST, is based on the full tax deferred proceeds of $1,000,000.
Finally, the heaviest concern to consider when deciding whether or not a Delaware Statutory Trust (DST) is right for you, is what level of involvement in the management of the property you would like to hold. If the answer is little to no involvement, then the passive involvement of DST investors may be for you. In a Delaware Statutory trust, the trustee overseeing the DST is the one making decisions, not the investors. While this a huge draw for retirees looking for a more hands-off way of having ownership in real estate that generates income, there is another side of the coin here that poses risks to the investors.
Unlike in a TIC, which requires 100% unanimous approval for major decisions, the trustee of a DST could theoretically choose to sell the property without the approval of all or any of the participating investors. Voting rights for the investors in how the property is managed are non-existent. Investors must rely on and trust in the DST’s Sponsor to make decisions that will provide a successful, productive and smooth operation of the property and its tenants.
If involvement in your property and its tenants is something that you as an investor are looking for, perhaps DST may not be the answer you’re looking for. While you would be an investor that owns a share in the DST, you would not be the owner that gets to know each of their tenants on a personal level – your ownership is passive and you would have zero management responsibilities and obligations. Much of the sponsor management risks can be mitigated by working with long-term, full-cycle, track record sponsors.
If DSTs seem like a viable investment path even knowing these risks (what may be a disadvantage to one could be an advantage to another), talk with your financial advisors to see if this path is the right choice for you.
Corcapa.com has additional information on the pros and cons of DST Delaware Statutory Trust investing at: https://www.corcapa.com/dst-1031-exchange/ or contact Corcapa 1031 Advisors with questions at (949) 722-1031.
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