“The ABCs of DSTs!” (Delaware Statutory Trusts)

Legend has it, Delaware got its nickname “The Diamond State” from Thomas Jefferson because he described it as a “jewel” among the other states. What is not commonly known is that Jefferson gave the State this distinction due to the Delaware Statutory Trust Act (DST Act) of 1988!

Well . . . clearly the second statement is untrue, but the DST Act has sure helped many investors polish some “diamonds in the rough” within their real estate portfolios! Small as it is, Delaware has often led the way in innovation, such as being the first state to ratify the U.S. Constitution. They were also the first state to adopt the statutory trust concept for investing in real estate! There are numerous uses for a Delaware Statutory Trust (“DST.”) For many investors, DSTs are the premier investment option for diversified and professionally managed real estate investing . . . “Imagine That™”!

What Can a DST Do for Me?

The DST structure and treatment facilitate the pooling of funds from potentially hundreds of accredited investors to enable direct ownership in numerous forms of properties. In many cases, DSTs offer exposure to properties that would otherwise not be investment options at the individual level. Further, the DST structure offers its investors limited liability not found in personal investments without the formation of a separate business entity (i.e., a corporation or limited liability company.)

Can Anyone Invest Using a DST?

Only an “accredited investor” can invest in a DST and is someone who:

• Has earned income over $300,000 if married ($200,000 if single) in each of the prior two years and expects the same for the current year,
• Has a net worth over $1 million, not including a primary residence, or . . .
• Holds in good standing a Series 7, 65 or 82 license (as an investment advisor)

Whether you ask a savvy investor with deep pockets or someone just looking for a path to a comfortable retirement, real estate is inevitably an important topic for conversation. But there is a big issue with this. These two individuals have VERY different definitions and opportunities when it comes to direct real estate investing. While many may find real estate opportunities in a single-family property, condominium, or a duplex, there is still a laundry list of other possible real estate investments: multi-family apartment complexes, hotels, industrial buildings, office buildings, self-storage facilities, student housing . . . the list goes on and on. Most importantly, some of the most lucrative investments in the real estate world are found in the commercial sector – not the private sector.

This is where the DST comes in. There are several well-managed DST sponsors who offer investments across various segments of commercial real estate. For many individual investors, DST sponsors facilitate the opportunity for direct ownership in diversified commercial real estate with relatively small minimum investments ($25,000 – $100,000.) But as we have discussed in previous newsletters, diversification does not just mean owning different stocks and bonds; it’s owning different assets that lower “correlation” within a portfolio. (Correlation is a fancy word which describes how alike or dissimilar the returns are of an asset class as compared to another asset class.) A well-planned investment strategy focuses on expected return AND standard deviation (or the “turbulence” – the “wiggle” – a portfolio may experience.)

While a basket of stocks, bonds, cash, and residential rental properties may be a successful portfolio, being able to add alternative investments (e.g., commercial real estate) can provide return potential while simultaneously reducing the volatility/wiggle of a portfolio. This is because an asset class has been added to the portfolio that does not have a perfect positive correlation with the other assets (i.e., the assets do not move together perfectly.)

For example, allocating $5 million across several single-family properties still leaves an investor wholly allocated to the risk of the broader residential real estate market. But from a risk perspective, wouldn’t it be ideal to allocate that same $5 million to several segments across residential and commercial real estate? It would be ideal, but you wouldn’t be able to buy a single-family property, hotel, office building, assisted living facility, and self-storage facility all with $5 million, at least not in the U.S. and most other developed countries.

Fortunately, DST options are available so that a diversified real estate portfolio can be constructed in addition to an investor’s traditional asset portfolio. DSTs offer investors the ability to obtain direct ownership exposure to numerous alternative real estate assets without having to put all their investment eggs into one basket.

What is A DST and How Is It Different Than a Real Estate Investment Trust (REIT)?

A DST is a separate legal entity which the IRS recognizes as a direct owner of real estate. A REIT, on the other hand, is an entity that owns real estate – and the investor owns shares of the company which owns the real estate. Make sense? Slight difference perhaps, but the direct ownership feature of a DST allows it to be used in a tax-deferred 1031 exchange when selling appreciated real estate.

The same is NOT true for REITs. REITs cannot be used in a 1031 exchange because investors own the shares of the ownership entity – not the real property itself. And while publicly traded REITs can be easily sold on the public market, DST investments can make up for their typical lack of liquidity by paying higher monthly income distributions.

What are the Advantages and Disadvantages of a DST Investment?

For many, the greatest benefit found in exchanging their rental property for various DST investments is the professional management of a DST. Who doesn’t want truly passive income if they can get it without management headaches? No rent check collections, no rushing out to meet the plumber for an emergency, just the expectation of reliable monthly income distributions.

The advantage of a professional management team is not confined to the operations. This management team can extend to the DST investment property identification and vetting. So not only are the DST properties professionally managed, but in many cases, the identification of properties for investment is done by experts. Also, properties generally held by DSTs are high-grade commercial properties, which can often mean more reliable cash flow as the tenants and their leases may be more dependable than residential tenants.

So, let’s recap the advantages:

• Diversification
• Relatively small minimum investment (as low as $25,000 for cash investments)
• High-grade commercial properties
• Potentially higher income
• Professional management
• Passive investment
• Limited liability to the DST investor
• Ability to be used in a tax-deferred exchange (1031)

But, as suitable and advantageous as DST investments can be for a variety of accredited investors, this investment space is not without potential disadvantages. For example, the typical holding period of a DST investment is 3-10 years, with all control of this holding period being in the hands of the DST sponsor.

Without an active secondary market, lack of liquidity is a possible issue with a DST investment. After all, bad things DO happen to good people from time to time!

Which leads to the next disadvantage, no management control. While this is an advantage to many (and we list it as such above), plenty of investors prefer having some control over their real estate investments. So, if this is you, a DST investment might not be a good fit.

Other possible drawbacks are that DSTs cannot raise new capital or refinance. Careful consideration by the DST Trustee is needed to plan for sufficient cash reserves in the event of a necessary capital expenditure. This does put the distributable profits at risk. Looking further, a DST cannot refinance an existing mortgage upon maturity, which is why most DST properties are sold in advance of this date and the sale proceeds are distributed to investors.

To sum up the potential disadvantages of DSTs:

• Not a good fit for short-term investors
• Lack of liquidity if you need to exit the DST and sell your investment
• No control over how the DST manages its assets
• DSTs cannot refinance or raise new capital

Conclusion: DST Investments Offer Great Opportunities and Diversification to Investors

There is a place for real estate in most individuals’ portfolios, and with DSTs, investors can appropriately diversify across several real estate sectors to generate favorable passive income. If you are looking to invest into new properties, or re-invest a current property via a 1031 exchange, but would like to avoid the hassle of dealing with day-to-day operations, there are plenty of opportunities with several well-managed DST sponsors.

Let’s schedule a complimentary 20-minute conversation to discuss whether a DST investment makes sense for your situation. Investing in real estate without having any landlord duties and instead deciding how you’re going to spend your distribution each month. Sounds great to me . . .