Investment diversification combines different financial products into a single portfolio. This, in turn, spreads the potential negative impact of specific risk across the portfolio. In plain English, this means that owning several assets, that are impacted differently by certain economic forces, ensures that a portfolio is not overly exposed to one type of risk.
A recently published Realized blog focuses on why diversification strategies can be highly effective with Delaware Statutory Trusts (DSTs). This article will offer a deeper dive into types of diversification approaches. Understanding these tactics can help you reach your financial goals more effectively.
Single Concept, Different Strategies
DSTs are investment entities, overseen by sponsors with experience in buying, selling, and managing real estate. You, meanwhile, are the passive investor, who acquires undivided fractional interests in the trust. Ideally, you receive ongoing distributions from this investment, while the sponsor maintains the quality of the asset or assets.
Beyond this basic overview of DSTs, here are some diversification strategies to consider when it comes to investing in them.
Property Types. The real estate investment world offers a plethora of properties, which provide dissimilar attributes. A net-lease retail asset will have different target rates of returns, cash flows, tenant lease terms, and operating costs, versus a 300-unit luxury apartment complex. Further, certain property types may respond differently in certain economies. During recessionary periods, office space may see higher vacancies, whereas a self-storage investment may perform more even keel, given its demand is based on lifestyle changes rather than job growth. Being aware of the current economic trends is important as well. Thanks to e-commerce, industrial assets have become more desirable to both buyers and sellers, which drives liquidity and value in that particular market.
Geography. In addition to being highly diversified when it comes to property type, the real estate sector is also highly locational. Let me put it this way: A net-lease Dollar General store in Joshua, TX will provide different returns than a net-lease Dollar General store in Brooklyn, NY. The Joshua store is situated in a rural, small-town area, while the Brooklyn location caters to a large-city population. This means both stores will deliver varied cash flow, operating expenses, and tenant lease terms; all of which are important to consider before investing.
Diversification. Net-lease properties seek to provide predictable, stable income streams. They are generally considered a more conservative property type to include in a DST portfolio. Multi-family properties, on the other hand, offer earnings based on net-operating income — which means feast or famine. Lots of revenue if the earnings are high, and limited to no revenue if the property is not generating a revenue. Investment diversification decisions might focus on whether your goal is income preservation or income growth, with a higher amount of risk.
Leverage. Leverage is a fancy term for “borrowed capital on a property,” or, more basically, “mortgage.” As a DST investor, you can invest in debt-free assets, which carry no mortgage, or leveraged properties, which do. Debt-free properties offer no financing risk, nor would you have to take on equal or greater debt in future 1031 exchanges. On the other hand, leveraged DSTs work well for 1031 exchanges that do require debt replacement to satisfy tax-deferred exchange requirements. Leveraged DSTs also present additional tax benefits that have the potential to drive higher after-tax cash flow, which includes mortgage interest deductions from taxable income.
Maturity, or Hold. “Hold” describes how long the DST will hang on to the property before selling or exchanging it. While most typical hold periods are five to seven years, some trusts can hold on to the assets for up to 10 years. Laddering DST maturities provide a degree of liquidity for the investor as investments rollover in intervals over time, rather than all at once. This strategy also ensures that each investment exit isn’t betting on the economic climate at one particular moment in time.
Sponsor. It’s very important to ensure that your sponsor is experienced, has a good track record, and is trustworthy. Remember that it’s also a good idea to consider investing across multiple sponsors. Sponsors differ in approach and market knowledge and may perform better or worse in certain geographic regions, property types, or parts of the economic or real estate cycle. In addition, situations like fraud and bankruptcy are always a possibility, and investing with multiple groups ensures you are not overly exposed to the business risk of one particular sponsor. It’s perfectly acceptable to place capital with different DST sponsors as part of a diversification strategy, but be sure that the entities in question fit your financial goals and match your risk tolerance.
Risk and Income Considerations
Diversification requires more than simply throwing money at a bunch of different DSTs. In line with the above suggestions, a bottom-up approach, that examines your risk appetite and lifestyle goals, should be part of the decision process.
If, for example, you have a higher risk tolerance, DSTs focused on value-add properties with greater leverage, or located in secondary markets, might work for you. However, if your goal is passive income, DSTs with investment-grade net lease properties could be a better fit for your portfolio.
Regardless of how you and your financial professional. proceed, a DST diversification strategy can help balance your finances, allowing you to nicely manage returns in a way that makes sense for your current investment situation.
Realized’s professionals can help with many areas of your real estate investment strategy, from wealth management, to 1031 exchanges, to DST selections. For more information, log on to realized1031.com, or call 877.797.1031.
The actual amount and timing of distributions paid by programs is not guaranteed and may vary. There is no guarantee that investors will receive distributions or a return of their capital. These programs can give no assurance that it will be able to pay or maintain distributions, or that distributions will increase over time.
No public market currently exists, and one may never exist, for the interests of any DST program. The purchase of interests in any DST program is speculative and is suitable only for persons who have no need for liquidity in their investment and who can afford to lose their entire investment.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk.