Summary
- 1031 exchange investors have several alternatives to consider, including Delaware Statutory Trusts (DSTs) and direct real estate ownership.
- DSTs can provide access to 1031-compliant passive real estate investment, but drawbacks include lack of control, prohibitive fees and costs, a lack of liquidity, and capital restrictions.
- For many high net worth investors, direct real estate ownership outweighs the high costs of DSTs and other 1031 investment alternatives.
- Granite Peak provides 1031 exchange investors the ability to achieve investment objectives through a combination of the control provided by direct real estate ownership and from active investment management by a team of professionals with over 100 years of combined owner and operator expertise.
The Granite Peak Solution
Granite Peak’s customized real estate services enable clients to benefit from direct real estate ownership through the strength of our team’s experience. We create and preserve wealth through actively managed real estate investments from strategy to execution, while providing our clients with the ability to maintain control and timing of all ownership decisions, such as acquisition, capital structure, financing, leasing, management, and disposition.
Many of our clients are faced with significant 1031 exchange events that require large equity investments in real estate to defer capital gains taxes. 1031 exchange investors have several options to consider, including investments in Delaware Statutory Trusts, or DSTs. This article highlights several aspects of DSTs that investors should consider before choosing the structure that best fits their 1031 exchange needs. DSTs contain several drawbacks for investors to carefully consider, including lack of control, high fees that limit investor returns, and financial restrictions such as raising additional capital or refinancing a property. For many high net worth investors, the advantages of direct real estate ownership outweigh the high costs of DSTs.
Background
Delaware Statutory Trusts, or DSTs, provide investors with a tax-deferred, 1031-exchange compliant opportunity to purchase fractional shares in real estate assets or portfolios. Given the tight IRS timeframes required for 1031 exchange compliance, DSTs can provide a relatively quick solution for investors to exchange into institutional-quality assets. With over $2.5 billion of equity raised in DST offerings annually, DST investments can be a viable solution for individual investors who seek to passively invest in tax-deferrable commercial real estate. However, investors with the financial ability to directly own institutional-quality investment properties stand to achieve much higher risk-adjusted returns through the control of timing and financial structuring. These control considerations are prohibited by DST investments.
Lack of Control
The IRS stipulates that the DST structure for 1031 exchanges must prohibit investors from having any operational control or decision-making authority with regards to underlying properties. As a result, DSTs prohibit managerial control for investors, leaving sponsors in charge of all decisions from day-to-day management to determining the timing of the sale of properties and the use of debt.
Without the ability to vote or directly influence any decisions, the DST structure is completely passive for investors. Distribution decisions are made by the sponsors, which can create misaligned incentives between investors and sponsors, especially in multifamily properties (which typically operate under master leases). With the decision-making authority residing solely in the hands of the sponsor, distributions can be cut or withheld even after the rental revenue has been collected into the trust.
The decision when and if to sell is critical for the overall success of the investment. Given the financing restrictions imposed on the DST structure, sponsors have a limited window to exit the investment, regardless of the market conditions or stage of the real estate cycle. DST investors lack the ability to influence the sale decision; and as a result, can be forced to quickly find a replacement property in order to continue realizing the tax deferral benefits provided by DSTs when the investment is sold. The DST sponsors will of course have a new high-cost investment available for investors to roll into, but the combination of timing pressure and limited replacement options can lead to lower long-term investment results and an imbalanced portfolio.
Fee and Return Structure
DSTs contain a prohibitively high fee structure that rewards sponsors and multiple intermediaries at the cost of investor returns. While transaction costs are customary in real estate acquisitions, such as legal, loan and lender expenses, and other closing costs, DSTs include additional upfront costs that negatively affect investor returns. The way in which DSTs are sold to investors creates additional layers of fees, including selling commissions to registered investment advisors, broker-dealer fees and allowances, wholesale fees, managing broker-dealer fees, and offering and organizational fees that are included in addition to the customary acquisition, management, and disposition fees that sponsors receive. Recently, these upfront load fees represented 20% of the equity raised (money received from investors) and 10% of the purchase price of the real estate included in the DST real estate investment offerings [1].
In addition to the significant upfront fees, cash flow distributions to investors can be limited in favor of compensation for the sponsor. For example, the median acquisition cap rate in 2018 was 5.9% for DST investments, while the median Year 1 cash-on-cash return was 5.2%, with the difference going to the sponsor. In addition, these DST transactions included significant leverage with a median loan-to-value of 55%. Taking these factors into consideration, the benefits of leveraged returns went directly to the sponsor, and investors received cash returns much lower than if they purchased the entire property in an all-cash transaction. In many investments, investors aren’t being compensated for the additional risk inherently generated by the higher debt, while sponsors disproportionately profit from the property’s performance by withholding distributions to investors at the master tenant level.
Direct real estate investment enables owners to capture the benefits of both positive leverage and the profitable performance of the assets. Eliminating the prohibitive fee structure and restrictive economics would allow the investor to achieve double-digit annual distributions after debt service, and more than double the 5% cash-on-cash return from DSTs from the exact same property and financing structure.
Lack of Liquidity and Capital Restrictions
While real estate as an asset class is generally illiquid, DSTs typically include hold periods between 5 and 10 years. Without control of investment decisions, DST investors are “along for the ride,” with the only option of exiting the investment prior to disposition being through the costly secondary market. Sponsors are working against the clock to ensure the investments are exited before the negative effects of leverage such as amortization begin to set in after the interest-only period on the loans. On the other hand, direct owners in real estate control not only the timing of whether or not to sell given the market environment, but can also benefit from the ability to refinance a property, taking advantage of both lower interest rates as well as realizing additional equity appreciation without exiting the investment.
In addition to the longer hold terms, DSTs are restricted from both raising additional capital as well as refinancing the investment. As a result, unforeseen changes in real estate markets can have negative effects on cash distributions and overall returns. For example, major capital items such as roof replacements could limit distributions over several quarters or longer. Unexpected changes in the market environment of the property, such as vacancy increases or rent decreases, can significantly reduce cash flows. Without the ability to raise additional capital, the property must rely only on reserves, which are collected at the very beginning of the investment and may already be substantially reduced. Without these limitations in place, direct real estate owners have the flexibility to invest additional capital throughout the lifecycle of the investment in order to provide protection during turbulent market conditions while also capitalizing on opportunities to generate additional value.
Conclusion
As a full-service real estate advisor, Granite Peak’s services are customized to provide our clients with the control of timing and financial structuring to optimize real estate portfolios to meet the specific needs of each client over the long term. As a result, Granite Peak provides 1031 exchange investors the ability to achieve investment objectives through the control provided by direct real estate ownership through active investment management by a team of professionals with over 100 years of combined ownership and operator expertise. The Granite Peak team makes the transaction process seamless and less complicated while operating and managing the properties on an on-going basis, allowing a passive involvement for ownership so that owners can enjoy the other things in life that wealth has afforded them.
[1] Mountain Dell Consulting. Typical Fees and Metrics in DST Offerings. February 7, 2018.
