Since the mid-2000s, the popularity of using Delaware Statutory Trusts (DSTs) as 1031 replacement property has increased among wealthy Americans and their financial advisors. There’s a good reason: A 1031 exchange transaction is an attractive investment that allows investors to defer taxes on real estate capital gains. So, it’s no surprise that billions of dollars are pumped into DST offerings each year. According to Mountain Dell Consulting, more than $2.4 billion in equity has been raised for DST investments so far this year in sectors ranging from office to retail and self-storage. Multifamily is the largest sector of that total, representing 42% of available inventory.
However, investing only to save money on taxes can come at a significant cost if the investor chooses the wrong DST. Fees can be obscured in the deal’s marketing materials because it’s hard to sell a product when the investment is reduced by 15% to 20% on day one. Instead, sponsors point to yield because it shifts the investor’s focus to income, and yield is an easily understood metric. However, it only tells part of the story—and not a very useful one at that.
High Yields Can Come at a Cost
Yield is only one component of the total return equation, which also factors in appreciation and fees. A $1 million investment that generates a 6% yield for five years equals $300,000 in cash flow. If the investment grows from $1 million to $1.2 million, the investment will reap an additional $200,000. Between cash flow and appreciation, the total return is 50%, without taking fees into account.
Fee loads on DST interests sold through brokers and commission-based financial advisors can top 15% and generally are the result of selling commissions, sponsor acquisition fees and a host of other fees. These fees aren’t often easy to identify unless one is willing to dig deep into the DST’s financials. An upfront fee load of 15% means the value of a $1 million investment is reduced to $850,000 on day one. Between cash flow and appreciation, the property must generate an 18% total return just for the investor to break even. The key question to ask is, “What would my investment be worth if I sold it one day after buying it?”
Below are four factors investors should consider to ensure they are maximizing their potential returns with a DST investment.
1: Upfront Fee Loads in DST Structures
Like any investment product, DST fees pay the sponsor and cover organization and operations. In most DST structures, the sponsor typically takes fees at three points: upfront, during the hold period and at disposition. While some DST offerings syndicated through brokers can have upfront fee loads on equity exceeding 15%, most often, they range from 7% to 12% of equity invested. These loads commonly include:
- Acquisition fees
- Organizational and offering expenses
- Selling commissions
- Managing broker-dealer fees
- Dealer-manager fees
- Financing coordination fees
Let’s say a property costs $50 million and there are $6 million in sponsor fees plus another $1 million in standard closing costs such as legal, debt, title and other third-party costs. That means the sponsor must create a DST offering of $57 million even though the property is only worth $50 million. A DST investor in this example would be down 12% on the first day, and it would take years of cash flow and appreciation just to get back to even.
How Upfront Loads Impact Total Returns
To show how upfront loads affect an investor’s total return, let’s use two hypothetical DST offerings as an example. Option 1 has a yield of 4.5% with upfront fees and expenses totaling 4% of the offering proceeds. Option 2 has a 5.0% yield with upfront fees and expenses totaling 16% of the offering proceeds. If yield is the primary focus, most investors would choose the DST that markets the higher yield. However, that’s not the full picture. The table below illustrates the difference in returns after the first year.
Fee Loads and Total Returns
After one year, Option 1 investors have a positive return of 5.3%, while Option 2 investors have a loss of 6.8%. The higher yield and appreciation can’t make up for Option 2’s high fee load, assuming all else is equal. If the property were to lose value in year one, the loss would be even higher.
2: Manufactured Yield Enhancement
However, to enhance target yield and attract more investors, sponsors may raise more equity than is needed as a means to inflate their reserves to supplement investor distributions. That higher cash flow is nothing more than a return of capital and can create tax consequences for 1031 exchange investors. When an offering’s target yield seems very high, we urge investors to dig further. Details of this type of reserve could be buried in the offering document’s fine print.
3: Potential for Property Appreciation
How much—or how little—a property appreciates in value over the DST investment period can mean the difference between a return or a loss for investors. Investors should focus on factors such as the following when assessing a property’s potential for value appreciation.
Location, location, location: As cities grow, their footprints tend to expand in a path of growth. That path could include infrastructure development such as freeways, public transportation system extensions and community walking and bike paths. They also include new retail amenities such as shopping centers, restaurants and entertainment venues. With growth comes demand, and an apartment property in the path of growth has more potential to generate higher rents and to increase in value over time compared with an apartment outside that path of growth.
Asset quality: Generally, a poorly constructed apartment property is less valuable than a new, well-built property with attractive amenities. The inferior property can’t demand rents as high, and as it ages, generating rent growth becomes less and less feasible without making significant capital improvements. In the case of DSTs and 1031 exchanges, which limit the capital improvements a manager can make to a property, investors should seek well-built properties that possess desirable attributes and amenities that can stand the test of time.
4: Potential Risks
As with any investment, there are always risks involved, and the goal of any private investor is to find opportunities that generate the highest returns possible with the least amount of risk.
When comparing DST offerings and their potential returns, a key metric is the amount of leverage used in the capital structure. More leverage means more risk. If the property performs well, the use of leverage will magnify investor returns. However, leverage can also magnify investor losses if the investment does not perform.
There are many options when choosing a DST sponsor. The sponsor is ultimately responsible for the investment’s outcome, and experience is key. To avoid the chances of a bad outcome resulting from poor execution, investors should focus on the following criteria when vetting sponsors:
- A strong performance track record in real estate investments
- An experienced team
- Robust risk management framework
- A focused investment strategy
Investors should take the time to get to know the sponsor on a personal level before committing their hard-earned capital. Tax incentives alone are not a good reason to invest. We urge investors to treat their DST due diligence process no differently than they would for any other investment.
