The Delaware Statutory Trust is actually the second version of a fractional ownership legal structure. The first version was a tenant-in-common (TIC) structure. TICs are commonly and successfully used in other, smaller scale real estate partnership arrangements; and was a logical structure to adopt and modify for the fractional ownership market.
Each owner had to be separately underwritten by the lender; each had to form a special purpose entity to hold their fractional ownership; and major decisions, such as lease renewals, refinancing and selling of the property required unanimous approval of the TICs. Alas, the TIC structure proved fatal on the scale-up to larger, more complex real estate transactions, which became abundantly clear in the recession of 2009. The DST has been the dominant legal structure ever since.
DSTs must conform to the regulations of two governmental agencies – the Internal Revenue Service, and the Securities and Exchange Commission.
Delaware Statutory Trusts are strictly regulated. The IRS Revenue Ruling 2004-86 established the requirements for a DST to qualify as a 1031 exchange eligible replacement property.
- No additional capital contributions after a DST offering closes
- Trustees cannot renegotiate DST loan terms
- Trustees cannot reinvest DST sales proceeds
- Capital expenditures are limited to standard repairs
- Cash reserves must be invested in short-term debt
- Cash must be distributed to beneficiaries on a current basis
- Trustees cannot renegotiate leases (properties such as multi-family and self-storage are managed under a master lease)
A Word about Fees.
DSTs have fees associated with each offering, similar to the fees in mutual funds, REITS, and other packaged products in the securities industry. Investors are certainly justified in asking, “are all these fees necessary, and if so, are they reasonable?”
- The sponsor performs all the activities, pays all the expenses, and bears all the risk in identifying and acquiring the property. The expense and expertise of consistently acquiring the best institutional grade properties, in competition with other large funds seeking the same assets, is often under-estimated and under-appreciated by the outside investor. This singular quality is what often differentiates the most successful sponsors, and is arguably the one activity the individual investor cannot duplicate on their own – access to the best deals, on the best terms.
- Th sponsor performs all the activities necessary to own and manage the property. These are tasks and fees that an individual investor would otherwise have to perform individually or pay for on their own.
- DSTs fall under the regulatory umbrella of the Securities and Exchange Commission. The rules and regulations of the SEC are designed to enforce disclosure and protect the individual investor. Unfortunately, this protection is expensive. The due diligence material and all the legal fees add considerably to the total expense.
- The itemization of all the fees is detailed in the Private Placement Memorandum, as required by law. Nothing is hidden or withheld.
SEC Regulation and Compliance
SEC regulation and compliance is expensive and time consuming. It is unquestionably a burden to any company or entity required to comply, but the purpose of such compliance is to protect the public. The process ensures that a potential investor has all possible information at hand to make an informed decision, and will continue to receive such information for the life of the investment.
- Accredited investor. The SEC requires investors in some classifications of securities to demonstrate a degree of financial sophistication, by establishing a minimum net worth or annual income. This ostensibly protects the investor from themselves, from investing in an asset they may not fully understand. DSTs fall within this asset category.
- Executive summary. This is a summary document of the Private Placement Memorandum. It is generally less than ten pages long, and offers a synopsis of the property, the surrounding market, the marketing plan, and the overall terms of the transaction
- Private Placement Memorandum. In a private real estate transaction, the investor generally has 30-60 days to perform their own due diligence on a prospective purchase. They must gather all the pertinent information, and frankly hope it is sufficient to make an informed decision within the escrow period. If negative information surfaces after the closing, the investor must bear the consequences, or commence legal action if there is some justification of fraud – none of which is a pleasant outcome.
- The Private Placement Memorandum (PPM) is a fantastic document that most investors do not read, because it is generally 300-400 pages long, and contains a lot of legal language and disclaimers. This is a mistake. The PPM is an exhaustive document, required by the SEC, that details every possible aspect of the property and the offering in one concise, well-organized format. A PPM contains a complete description of the security offered for sale, the terms of the sales, and fees; capital structure and historical financial statements; a description of the business; summary biographies of the management team; and the numerous risk factors associated with the investment.
- Thoughts on the PPM (in no particular order)
- The Table of Contents – Read it. It makes the rest of the document much less intimidating.
- Legal disclosures. Every security contains language warning that the investment is not guaranteed, and that loss is possible.
- Full description of the property – note if the property is new construction, or an older property that requires substantial renovations. What is the current occupancy, or the anticipated ramp-up? Is it realistic?
- Marketing plan – how is the sponsor going to maintain a high occupancy and grow the rental income?
- Competition from similar properties – note if there are any barriers to entry from new projects that may erode your occupancy.
- Description of the surrounding market – ask yourself, why is this project desirable? Why here and now? Is it a boom town? Is it another luxury apartment, in a sea of new luxury apartments? Is this a strategic purchase, or just following the herd?
- Deal terms –
- how long is the term of the financing? Since a property within a DST cannot be refinanced, the anticipated holding period is usually a few years short of the loan maturity date. A long (ten year) fixed rate financing gives the sponsor the flexibility to choose the best time to sell. A short (five years or less) loan has a lower interest rate, and thus a higher initial yield. It also forces the sponsor to sell the property within five years, which imposes a substantial timing risk.
- If a single tenant, how long is the lease? Are there automatic renewals? Does the tenant have a purchase option that can pre-maturely shorten the holding period?
- A full itemization of the fees – are they reasonable, given all the tasks and roles required of the sponsor?
- Description of the sponsor – how long have they been in business? Have they experienced bear markets, and if so, how was their performance? How many properties have they managed full-cycle?
- Conflicts of interest – between the sponsor and the investors
- Summary of the Trust Agreement – full agreements available upon request.
- Does the sponsor offer a 721 exchange? Is it optional or mandatory? How do they address the inherent conflict of interest?
- The Table of Contents – Read it. It makes the rest of the document much less intimidating.
- Quarterly updates. Sponsors will distribution, at a minimum, a quarterly review on the property and its current performance. In extraordinary times (for example, during Covid), updates were more frequent. In general, sponsors are quite communicative with their investors.