Yield Tricks DST Sponsors Play

A DST offering is sold, first and foremost, on its projected distribution. Sponsors know it. Put two offerings side by side and most investors will lean toward the one quoting 5.5% over the one quoting 4.75%, often without asking where the extra three-quarters of a point comes from.

That creates a powerful incentive. A sponsor has usually bought the property with its own capital or a short-term loan before the offering opens, and every month the equity is not raised costs it money. It competes for properties against institutional buyers, and then competes for investors against every other sponsor. A slightly higher headline yield is the easiest way to win the second contest.

Some of the ways it is done are perfectly reasonable. Others simply hand investors their own money back and call it income. The question I ask of every offering is the same: how much of the projected distribution is produced by the property, and how much is produced by the structure of the deal?

Ten ways a yield gets enhanced

1. Expenses prepaid or reserved in year one

   Property taxes, insurance, interest or lender reserves are funded at closing, so they barely register in the first-year operating statement. Compare each year-one expense line in the pro forma with years two and three. A line that is zero, or far below the years that follow, is being paid with investor capital.

2. Fees waived or deferred

   A sponsor may forgo its asset management fee for the first year or two. This is one of the more benign enhancements, because the fee sits outside the property's operations. Read the PPM closely: a waived fee is gone, while a deferred fee is usually collected at sale, out of your proceeds. If property management fees are also reduced, add them back before judging the purchase cap rate.

3. Higher cap rates, weaker properties

   A high cap rate is the market's price for risk: an older building, a secondary location, a local economy with weak job or income growth, or too much new supply. The starting yield looks attractive, but growing rents enough to sell at a profit after the load is harder. Sometimes the premium is worth it. It should be a deliberate choice, not a surprise.

4. Thin reserves

   The years after 2008 taught me that a syndicated property needs real reserves, both for the repairs in the property condition report and for the upgrades a building needs to stay competitive over a long hold. Because a DST cannot raise new capital later, every dollar not reserved at the start raises the yield today and the risk tomorrow.

5. Tax abatements

   A property with a tax abatement produces more income now, and the sponsor pays for it in the purchase price. The abatement expires, usually before the next buyer arrives, so the property has to overcome both the syndication load and the premium paid for a benefit it cannot pass on at sale.

6. Interest-rate buy-downs

   Paying the lender to lower the rate lifts the distribution, but the cost is added to the load and raises the price the property must fetch at sale.

7. Short-term or floating-rate debt

   A five-year loan or a variable rate is cheaper than ten-year fixed debt, and cheaper debt means a higher distribution. It also means less time to grow income before the loan matures, and because the trust cannot refinance, maturity effectively forces a sale in whatever market exists that year. Variable-rate debt adds full exposure to rising rates. Long-term fixed-rate debt removes one of the few real estate risks an investor can actually control, and I want a good reason before giving that up.

8. Net lease: less term, weaker tenant

   In single-tenant deals, a higher cap rate usually comes from a shorter remaining lease or a weaker credit. Less term means fewer years of contracted rent and a lower sale price when little term remains. A weaker tenant raises the odds of default, and on a leveraged single-tenant DST a default can end in foreclosure.

9. Aggressive assumptions

   In multifamily, self-storage, senior housing and hospitality, the pro forma rests on projected rent growth. It is tempting to extend a strong recent run, and to grow expenses more slowly than revenue. If you expect inflation to lift rents, expect it to lift costs too.

10. Distributions paid from reserves

    This is the one I object to most. The sponsor raises more equity than the property needs and uses the surplus to top up distributions. There is no economic substance to it: investors receive their own capital back, after it has already carried the offering's load, and are told it is yield. There is also no natural limit, which is how a property with little current income can be marketed at a competitive rate. When the reserve runs out, the distribution falls to what the property actually earns.

How I underwrite around it

The enhancements are almost always disclosed. They are rarely added up. My starting point is to rebuild the first year as if none of them existed: every expense at a normal run rate, every fee paid, no reserves used for distributions. From that normalized net operating income I subtract debt service at the actual loan terms and compare the result with the projected distribution. The difference is the enhancement, and it tells me how much the property has to grow before operations alone cover the distribution.

Then I look at the exit. Starting from the total load, including selling commissions, sponsor fees, financing costs and any abatement or buy-down premium, I work out what income and what exit cap rate are needed simply to return investors' capital, and how that compares with the sponsor's own record and with the market.

A sponsor that enhances yield is betting that the property will grow into its distribution. Sometimes it does. When it does not, because of a recession, new competition or a tenant problem, the distribution is cut, and that is often the first time investors learn the property was never producing it. The time to find out is before you invest, not when the quarterly letter arrives.

The ten techniques above draw on a 2022 piece by Tim Witt of DAI Securities, "Yield-Enhancement Strategies for DSTs." The commentary and underwriting approach are my own.