Delaware Statutory Trusts - An Alternative to the Higher Risk Conventional 1031 Exchange
I’ve been sitting down face to face with clients and prospective clients quite a bit lately, and I hear the same concerns repeated over and over again. Most of these property owners are over 60 years of age and have owned an industrial building for roughly 20 years or more. Most have used it for their business, which they are going to sell or have recently sold. At this period in their lives, high-risk, high-reward investments are of little interest. Instead, stability, reliable cash flow, limited hands-on responsibility, and avoidance of large out-of-pocket expenditures are of the utmost importance. Limiting or completely deferring their taxes, many of whom will be facing substantial capital gains when they sell their property, is also a high priority. Most have heard of the conventional 1031 “like-kind” exchange, whereby they can relinquish their property and exchange it for another of equal or greater value, and defer their capital gains tax liability. Very few, however, have heard of the Delaware Statutory Trust (“DST”), which may be a more appropriate alternative for them.
What is a DST?
A DST allows investors to purchase shares of interest in a trust that holds an investment property or a portfolio of investment properties. Each investor has fractional ownership in the trust, which has a property manager (a trust sponsor) who retains all decision-making authority. As DSTs are an investment offering, they are regulated by the Securities and Exchange Commission with extensive disclosures and a requirement that all investors are accredited. Unlike a conventional 1031 exchange, in which an investor may purchase one or more properties to “replace” the relinquished property, a DST often invests in multiple properties, oftentimes a portfolio of dozens, thus mitigating the risk that many conventional 1031 buyers face with future vacancy and needs for additional capital. Real Risks These vacancy risks are real. Several years ago, I worked with an older couple who lived out of State and had just a couple of years earlier purchased a net lease real estate investment in the Triangle as part of a 1031 exchange. It was custom-built for the tenant. As is the case with many of these deals, the rents during the long initial lease term were quite high, oftentimes reflecting the cost of new construction. With high rents in place, the value of the property is inflated, which many investors can justify when the lease has a long enough term and the tenant is creditworthy. In this case, the tenant, which was local, was unable to generate the business they expected at the location. Pretty soon, the rent checks stopped coming, but the expenses to own and maintain the property, now paid by the landlord instead of the defaulted tenant, continued. We were asked to prepare a broker price opinion and sell the property. Unfortunately, even with the rosiest of evaluations, the BPO showed a minimum half million dollar loss, but likely more, relative to what the owner had paid. Our BPO was correct, and it ultimately took a seven hundred thousand dollar hit, on top of the carrying costs while it was vacant, to unload the property. Ironically, it was promptly torn down and redeveloped for another net lease tenant.
Reletting a vacant space is another option for the 1031 investor who has lost their tenant. If that is the case though, they can expect high costs. First, there is the vacancy period, which can be extensive, where they are paying all operating expenses including taxes, insurance and all maintenance, as well as any mortgage payments. Then, there are brokerage commissions, which quickly get into six figures at the time of the lease. Then there are tenant improvement allowances and other lease concessions. It’s one thing to deal with these costs when you are a professional investor and prepared for high risk, high reward outcomes, but if you are heading into your golden years looking for stability and preservation of capital, look out! Fortunately, the DST offers a compelling alternative.
Q and A with a DST Investment Advisor
Nick Prassas is an investment advisor with Prassas Capital and has been advising investors on the benefits of investing in a strong-sponsored DST. I had the pleasure of discussing DSTs in great detail with Nick, and the following Q and A nicely summarizes our conversation.
CG: Nick, from a risk standpoint, what are the advantages of investing in a DST as opposed to a 1031 exchange?
NP: When you replace a property with another one, the way you would in a conventional 1031 exchange, you still maintain a lot of risk. Tenants go belly up, declare bankruptcy or, in the case of net lease deals signed to “credit” tenants, their credit gets downgraded. Look at Walgreens, whose bond rating just went to junk status. People who thought they had a safe investment are looking at very different valuations when it is time to refinance or sell, or they may be looking at a store going dark. There are different types of DSTs, but many invest in portfolios with tenant and geographic diversification, which mitigates risk significantly. A portfolio of shopping centers in the Southeast, for example, is going to have a very different risk profile than a single fast food restaurant where you are in North Carolina, or anywhere for that matter.
CG: A lot of my clients fear capital calls. What if I need to replace the roof of my property? I don’t want to buy another property and then have to deal with capital expenses, brokerage commissions, tenant improvement allowances and landlord work. How does the DST differ?
NP: Capital calls are not possible with a DST. Once an investor has committed their funds, that is it. The fund will capitalize capex needs or pay them as needed from operating expenses, but investors will not be writing checks to cover additional expenses.
CG: What about capital gains? If somebody sells their building, can they invest in a DST and defer it?
NP: DSTs are 1031 eligible. You can replace your sold property with an investment in the DST. You can even replace your debt, if you have any debt requirements, within the structure of the DST. Essentially, you go from recourse debt in your name to non-recourse debt placed by the DST sponsor. This is a really big deal, as most people love getting rid of personal guarantees!
CG: How are DSTs managed? Many of my clients are at retirement age and don’t want to manage property, deal with tenants, financing, lender reports, etc.
NP: The DST sponsors that I work with are large, sophisticated real estate investment groups with billions of dollars in assets under management. They manage all of their properties professionally and there is no work for the investors. In fact, this is intentional. An earlier form of fractional ownership in real estate, called the Tenant-in-Common (TICs), was pretty much a debacle because of the lack of separation between the sponsor and the investors. Decision-making was nearly impossible and disagreements made it difficult to manage. The DST sponsor has a fiduciary responsibility to manage the trust in the best interest of the shareholders. Those shareholders do not have an active role and do not need to deal with anything at the property level.
CG: What other benefits are there?
NP: Because strong DST sponsors are so large, they get access to properties that most of us would never have the opportunity to participate in. They also have access to capital at much lower interest rates, so the debt they place on their properties is cheaper. Of note, DSTs do not over-leverage their properties, another way that risk is significantly reduced. Because of their size, they also have leasing relationships with national tenants and have their ear when it comes to leasing space. This is not as easy for a small investor. In fact, many national tenants see small, undercapitalized landlords as a risk and will not deal with them.
CG: Alright, these advantages sound great. But what are the downsides?
NP: DSTs are not meant for people who are looking to get rich. This is not a buy and flip and make a million dollars, but it is not a buy and flop and lose a million dollars either. The returns are relatively modest, depending on the specific DST offering and the market at the time. The DSTs that I place clients into usually range from 4.5%-6.0% return on cash. It’s lower risk and lower reward, but look at what you can get on a supposedly “safe” net lease deal these days. It’s not much better, if even better at all. I’ll also note that not all DSTs are created equal. During upmarkets, many new sponsors come out of the woodwork and use the DST structure to raise capital. Less sophisticated, they promise big returns, which come with unacceptable risks. They are vulnerable during a downturn. I do not work with this kind of group. The only DST sponsors I work with are large, experienced and very well-capitalized with professional, pedigreed managers. They run their operations thoughtfully and conservatively and have been doing this consistently for years, through both upcycles and downcycles. Last, with a DST, when you invest in the trust, you have to keep your money in it until the properties are sold. Like any property, your money is not liquid, but in this case, it has to remain in the trust until the sale. The prospectus that the sponsor provides will give the timeline though, so you go into the investment knowing when that will be.
CG: Nick, who do you feel are the best candidates to invest in a Delaware Statutory Trust?
NP: I’ve got five candidates. 1) Anyone with real estate assets who no longer wish to be personally responsible for property management. 2) Older clients, who are less physically capable of property management. 3) Investors looking for greater asset and income stability by exchanging into larger institutional properties with a diversity of creditworthy tenants. 4) Investors in areas who are looking for higher returns than the markets in which they are located. Think California, New York, Boston. 5) Anyone considering a conventional 1031 exchange at the end of their 45-day identification period. That short window greatly increases the risk of purchasing a property that will come back to bite you in the rear. Why do a conventional 1031, especially if you are older, retired, retiring and at the point in your life where the goal is capital preservation, not high risk returns? A DST with the sponsors I work with is a much safer investment.
CG: You are saying think twice before you buy that Dollar General store in rural eastern North Carolina with 6 years remaining on the lease?
NP: Or that Walgreens in the Raleigh-Durham-Chapel Hill market that has 20 years remaining, yes. — If you would like to learn more about DSTs, please do not hesitate to reach out to me today.
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Carey Greene, Managing Director of SVN | Real Estate Associates and leader of the Ascend Industrial Team at carey.greene@svn.com or by calling 919-287-2135. Did you enjoy this article? Want a digital copy? Please let me know!