Search the internet for Delaware Statutory Trust properties and sponsors, and an impressive list of options will appear. Every sponsor has a beautiful website, with an experienced management team collectively representing a hundred years of uninterrupted success. Broker websites describe the magic of DSTs and list an endless variety of property options, that can seemingly address any and every client requirement.
Are there truly this many quality sponsors in the market? Are there truly this many quality properties available at any given time?
Of course not.
DSTs are no different than any other industry. There are a handful of quality sponsors, with experience and a track record of success; and a vastly greater number of smaller sponsors, new to the industry and trying to cash in on the exchange surge in commercial real estate.
Guiding principles
- The investor is not only investing in a DST’s underlying property, not entirely. They are really investing in a DST sponsor who has purchased, and will manage, the underlying property. This is a critical distinction.
- The DST sponsor has total control. They cannot be fired, and the investor cannot cash out early if the sponsor mismanages the property. Every sponsor has material conflicts of interest in the event of a host of default scenarios. As such, the choice of a sponsor is paramount.
- There is nothing else quite like a DST in the real estate industry. Let us remind ourselves what a DST is – a passive trust created to meet highly restrictive IRS requirements for a 1031 exchange.
- Standalone trust
- Holds a single property, or a fixed portfolio of properties
- Cannot refinance within the trust
- No capital calls
- Cannot co-mingle revenue or expenses with properties in other trusts.
- Standalone trust
That last bullet point is particularly relevant. DSTs are entirely different from REITS or other partnership-type structures, where there is wide latitude in managing the portfolio. There are highly restrictive limits to the changes that can be made to a DST trust once it is established. All aspects of an investment over the holding period must be anticipated and capitalized at inception. Otherwise, if a DST sponsor over-pays for a property, or if vacancies have been under-estimated, there is a problem. If extensive repairs become necessary, and if cash reserves have been under-funded (to boost initial yields), that is a problem. If the loan term is too short, and the sponsor is forced to sell in an unfavorable market, that is a problem.
As such, DSTs are a highly specialized niche within the real estate industry. The only relevant experience in evaluating a DST sponsor is a successful long-term DST track record. This alone eliminates a vast number of the current sponsors.
- Size matters, especially in a capital-intensive industry like real estate. The largest sponsors often have access to the best deal flow. They have extensive relationships, and an internal acquisition infrastructure to evaluate many properties nationwide, to filter out the best candidates.
- A DST property must first be purchased outright – the sponsor is the initial owner and at risk until equity can be raised from outside investors. A well-capitalized sponsor has the resources to purchase a property and pay all the associated fees necessary to create a DST offering. A smaller sponsor will need substantial debt financing, which will often require personal guarantees by the principals. For many new sponsors, the first few deals are “bet the company” deals, since a failure to raise outside equity quickly enough will often bankrupt the firm.
- As such, smaller sponsors have a particular urgency to raise outside equity and reduce their personal liability (a conflict of interest generally acknowledged in the Private Placement Memorandum). Since sponsors know that most investors rarely look beyond yield, there are variables in an offering that can enhance the initial yield, such as a shorter loan maturity (short maturity = lower interest rate = higher yield) and smaller, potentially inadequate cash reserves.
- Longevity and track record. The financial recession in 2008-2009 was a dramatic illustration of the importance of both the size and the track record of a DST sponsor. Most of the larger, well-established sponsors sailed right through the recession. Many of the smaller, under-capitalized sponsors failed outright. Many of the failed firms did indeed have a strong management team and well-positions property portfolios. However, the length and severity of the recession overwhelmed their limited capital base, and thus the ability to adapt and survive.
- Practical considerations.
- If an investor is going to hand over complete control of a significant personal investment, it only makes sense to select the biggest, safest, most successful firms in the industry – those that have a long-term track record of stewardship of other peoples’ money.
- The individual investor should choose a sponsor that has the resources to do what they themselves cannot:
- Identify and select the best institutional-grade properties on the market
- Fill an empty building as vacancies occur
- Find the best source of financing in a tough lending market
- Get the best price when it is time to sell
- Identify and select the best institutional-grade properties on the market
- Regulatory fear. DSTs fall under the auspices of the Securities and Exchange Commission. Compliance, initial and ongoing, is expensive and time-consuming, and incidentally adds to the overall cost of a DST. A large sponsor, with dozens if not hundreds of properties under management, has almost more to fear from the SEC than it does from investor discontent. SEC oversight over a large sponsor is a form of insurance, that helps ensure that the sponsor is more likely to meet reporting and fiduciary requirements.
- Select a firm that offers the option, not the requirement, of a 721 exchange. This will be explained in detail in a separate article.