When is 3.5% Better than 5%?

When is 3.5% Better than 5%?

Delaware Statutory Trusts (DSTs) have become increasingly popular with 1031 exchange investors, in part because they provide potential tax deferral, diversification and access to institutional-quality real estate. Passive replacements also eliminate many of the day-to-day headaches involved in traditional real estate ownership–the so-called “Three Ts” of tenants, toilets, and trash.

In addition to these benefits, 1031 DSTs can provide potential distributions to investors (typically on a monthly basis), to the extent that their revenues less expenses and reserves remain positive. Some properties (e.g., triple-net pharmacies or warehouses) are designed to produce a very formulaic distribution, while others (multifamily or self-storage) experience continuous fluctuations in both revenues and costs.

But what about the actual yield on equity? Is higher always better? For example, although returns are not guaranteed, depending on how cash flow is generated, a stable 3.5% projected cash flow may result in a healthier outcome than a 5% distribution derived from controversial cash flow strategies. When comparing a small apple to a big apple, you need to check for bruises (or even worms). Here are some warning signs:

Making aggressive assumptions – Everyone likes to think they will be more successful at managing a real estate investment than their predecessor. But aggressive assumptions of future NOI (net operating income) growth, tenant quality, historical inflation, lease terms, and overall projected performance may bring about loss of income and/or principal if actual results differ significantly than projections.

Purchasing low-quality assets – One factor that contributes to the DST’s rate of return is the type of property or properties that are being held and managed. Buying low-quality assets in unattractive markets may result in the potential of a higher cash flow in the short term, but because DSTs can only pay for expenditures from current income and reserves, a lower-quality property should be a red flag.

Underfunding property reserves – One of the key takeaways from the Global Financial Crisis is that real estate investments need a significant rainy-day fund. In addition to budgeted property maintenance, a property may experience the need for a last-minute repairs or for structural upgrades. While holding this money in reserve may equate to a reduced cash flow, it could also lead to a more desirable investment.

Using reserves to supplement cash flow – Speaking of reserves, it’s important to remember that funds in a reserve account ultimately belong to investors. Sponsors may be tempted to return an investor’s principal in order prop up cash flow. If done excessively, using reserves to supplement cash flow could jeopardize a DST’s value, hold period and overall return potential.

Possible questions for would-be investors to ask DST sponsors:

• Does the sponsor have experience with multiple and varying types of commercial real estate investment options? How is the DST structured? If the sponsor does not have a documented record of success in these areas, this may be a risky undertaking.[1]
• Are its servicing fees competitive? Fees that are too high or too low might indicate that the sponsor does not know the market.
• Are growth projections reasonable without hype or conflation? While not guaranteed, understanding historical norms for a given asset type and current market conditions can be helpful to determining if the projections mentioned are likely or merely plausible.
• Does the DST have significant cash reserves? Sufficient cash reserves are needed to cover essential repairs and upkeep of the properties. Without them, there is a risk of the property not being maintained and losing value.[2]
• What is the long-term goal and intended exit strategy of the DST?
• Does the sponsor make sure independent analysis and reporting is performed by credible third-party sources on their company? How is this, and other communication shared with investors?
• How many DST offerings has the sponsor launched over the years? What types of properties have been in these offerings?
• How large is the sponsor company? Companies with significant assets and financial resources are often able to obtain better pricing on loan terms and purchase prices, as well as offer their own capital to purchase properties, providing a higher likelihood of close.

Although there are many benefits associated with investing in passive replacement programs, these investments are by no means guaranteed. Who you invest with matters. And while the search for return is understandable, sometimes it is better to sit near the low, slow-burning fire than a flame that quickly burns bright and then burns out.

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Potential cash flows/returns/appreciation are not guaranteed and could be lower than anticipated.

Because investors situations and objectives vary this information is not intended to indicate suitability for any particular investor.

This is for informational purposes only, does not constitute as investment advice, and is not legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.

There are material risks associated with investing in DST properties and real estate securities including liquidity, tenant vacancies, general market conditions and competition, lack of operating history, interest rate risks, the risk of new supply coming to market and softening rental rates, general risks of owning/operating commercial and multifamily properties, short term leases associated with multi-family properties, financing risks, potential adverse tax consequences, general economic risks, development risks, long hold periods, and potential loss of the entire investment principal.

The data contained in this material was obtained from third-party sources believed to be reliable; however, 1031 Capital Solutions, CIS, and CAM do not guarantee the accuracy of the information.

Securities offered through Concorde Investment Services, LLC (CIS), member FINRA/SIPC. Advisory services offered through Concorde Asset Management, LLC (CAM), an SEC-registered investment adviser. 1031 Capital Solutions is independent of CIS and CAM.

[1] DST Due Diligence in a Hot Market, FactRight.com, June 05, 2020

[2] Top Five Ways to Gain an Edge in DST Due Diligence, FactRight.com, November 10, 2021