Most individual property owners start small. They save and eventually buy something close to home, in a market they feel they understand. The bank requires them to co-sign the loan, which they are willing to do since they have conviction in the investment. The property is within driving distance, so they can check up on things quite easily. The tenants are local businesses, or local families. They may collect the rent themselves every month, to save on expenses and to look for maintenance issues. If there is a problem, they have a local network of tradespeople they can rely upon. Frequent visits afford the opportunity to observe changes in the local marketplace.
Over time, the investor may acquire more property, and eventually develop a substantial portfolio. The moment arrives when the investor decides it is time to sell. Perhaps the market has become overheated (I’m thinking of California, but applies to any growth market). Maybe there have been detrimental zoning changes. Perhaps the neighborhood has just gone to hell. In any event, the investor sells their property, and upon being told of the magnitude of the tax bill, decides to reinvest in a 1031 exchange.
The investor is now responsible for the reinvestment of a substantial amount of money; money that represents the financial security for the family, the children, and perhaps even the grandchildren. The investor must now look for viable options beyond their comfort zone, to locations far from home, even perhaps in other states. The investor does not know these markets, may in fact have to get on a plane to visit the property. Far away markets in which the prime opportunities have long been snapped up by the locals. If there is a problem, the investor does not know anyone in the area. They must rely on (and pay) third parties to carry out all the maintenance issues. If the tenants are behind in their rent, the investor must navigate the local collection and eviction laws. The investor will still have to co-sign the loan, but now it is for a property in which they have far less control or conviction.
Some investors may not be prepared for the responsibility of such a decision. Perhaps they are not the original investor, who created the wealth in the first place. Maybe it is an inheritance. Perhaps a spouse has passed away, and the surviving spouse must make such decisions for the first time.
Until 2002, real estate investors had no choice. If they sold their property, and wished to defer the taxes, they had to reinvest in their own property. The subsequent tax law change now gives investors a viable alternative.
A fractional ownership exchange has now been possible for twenty years, and DSTs have become more broadly accepted in the last few years. However, while investors are quite comfortable investing in managed funds in their retirement accounts, there still often exists a debate about the merits of buying your own property versus a fractional ownership. As such, let us compare the two exchange alternatives.
Investing in your own property
- The investor has complete control. The ability to do as they wish with their own property. To paint the building purple. To refinance and pull cash out when they need it. To buy and sell when they choose.
Control also equals complete responsibility – for everything.
- Individual investors generally buy and sell real estate very infrequently, maybe just a few times in a lifetime. Selling is easy. But reinvesting the proceeds – does the investor indeed have the experience and skill set to do so? Are they focused on the current yield and little else? Are they correctly estimating the competition or the strength of the local economy? Have they missed anything in their due diligence?
- Real estate is labor-intensive. Properties need to be maintained. Vacancies need to be filled; rents collected. Either by the owner, or a paid third-party.
- In weak market or economy, control is far more consequential. Can the owner fill an empty building, competing against a sea of other empty buildings? Can they get a loan during lean times, when lenders everywhere are pulling back? Do they have the liquidity to carry a property with a flat or negative cashflow.
- Lack of diversification. Individually owned real estate is almost unavoidably a highly concentrated investment. The price of even a modest commercial property often requires additional debt financing to complete the purchase. A single large, leveraged asset in one location, often with a single tenant. The antithesis of diversification.
- Credit quality. Smaller properties attract smaller local tenants. Small family businesses. Families depending on the local job market. Evicting a non-paying tenant can be long and expensive, with no offsetting revenue.
- Financial responsibility. The bank requires a co-signer for the loan. The building needs a new roof. The gas bill is higher than expected. The rents are not enough to cover the loan payment. Guess who makes up the short-fall?
- Maintenance. The grass needs to be cut. Trash pick-up is late again. The toilet is over-flowing in Unit B, at 3 a.m. Maintenance can be outsourced, but results in less net income
- Triple Net – the holy grail? Triple net properties are generally seen as the perfect solution for the individual owner. The tenant signs a long-term lease, so there is no re-leasing risk (in theory. In fact, tenants break leases all the time.) The tenant pays all the expenses associated with the property. The investor sits back and receives a check every month.
- A triple net property requires far less personal involvement from the investor. It is the primary advantage.
- Real estate appreciation is predicated on a growing income stream. A triple net tenant makes a fixed lease payment, with perhaps a small periodic increase.
- As such, a triple net lease is a great place to park your money, not make money.
- The triple net landlord is reliant on the success of a single tenant, and that tenant’s underlying business, in order to receive their lease payments.
- A triple net lease may bear interest rate risk, if the loan term is shorter than the lease term. If the interest rate on the refinancing is higher than expected, the triple net yield could fall precipitously or even go negative.
- Triple net values will certainly rise in a falling interest rate and cap rate market, as the fixed income stream becomes more valuable. The past five years or so have been the perfect conditions for a triple net property.
- Triple net values will just as certainly fall in a rising interest rate or cap rate market, as the fixed income stream becomes less valuable. The next five years or so may impose significant headwinds for a triple net.
Fractional ownership
- Professional management. The top Delaware Statutory Trust sponsors are in the real estate business. They are accomplished transaction negotiators and investors.
- They are constantly buying and selling properties and portfolios in the marketplace. They have an experienced acquisition team, with disciplined buy and sell criteria.
- They are national in scope, with substantial assets under management. They are evaluating candidates nationwide, and have a sense of relative value in many markets throughout the country
- They have extensive industry relationships, by virtue of their market activity and portfolio size. They will often get the first call from brokers on many choice investments, since they have the experience and liquidity to make a quick decision.
- Class A properties, investment grade tenants. Properties are generally new construction in a prime location, with investment grade tenants with an established history.
- Potential for diversification. DSTs generally have an investment minimum of $100,000, and are offered in a variety of locations, industry sectors, and structures. Some are all cash deals, some are conservatively leveraged, and others are highly leveraged. An investor can diversify with a portfolio of DSTS, in a manner that cannot be duplicated by any other approach.
- Non-recourse loan to the investor. And there can be no capital calls within the DST structure.
- Passive income. A DST is truly passive income. The sponsor handles everything, and sends out a quarterly update, as required by law. In practice, most sponsors are exceptional at keeping their investor base informed of ongoing events.
- No investor control. In the early years, when the Tenant-in Common (TIC) structure was commonly used, investors had voting rights on major issues. In the market downturn in 2009, those voting rights were a disaster. The Delaware Statutory Trust sponsor has total control. It is the customary approach with other managed funds, and the most effective. The established sponsors have proven to be responsible stewards of other people’s money.
- Lack of liquidity. Liquidly is the primary drawback of a DST. Once an investor commits to a DST, they must remain invested until the sponsor decides to sell the underlying property. There is no secondary market for DST interests, although a sponsor will try to help if an investor needs to cash out prior to a sale. In practice, most sponsors have very good instincts about the timing of the sale, and generally behavior as most investors would if managing their own money. Each DST has an anticipated hold period, which is described in the Private Placement Memorandum.