In recent years, Delaware Statutory Trusts (DSTs) have become popular investment vehicles. Benefits like tax deferral and hands-off involvement appealed to many types of investors. However, even with these advantages, DSTs are not without risks. Some emerge from the structure of the trust itself, while others are inherent to real estate investing. Whatever the case, it’s important for you to understand DST risk factors to better prepare for the possibilities.
In this article, Realized 1031 shares what you need to know about managing risk in DSTs. Let’s take a closer look.
Illiquid Investment
One of the biggest risks inherent in DSTs is the fact that your investment becomes illiquid. DSTs have a set holding period. Until the full-cycle event is over, it’s extremely challenging to liquidate your investment. It is possible by selling your beneficial interests to the secondary market, but there’s no guarantee you can find a willing buyer. As such, it’s better to accept the reality that your capital will be locked in. If you need cash, you’ll need to find other sources.
Market and Economic Risks
The DST’s income is directly tied to the performance of the underlying assets. As various economic and market factors make an impact on the asset’s revenue, monthly income distributions will also be affected. Here are a few examples unique to real estate investing.
- Lower location demand or foot traffic
- Declining property values
- Lower occupancy rates or rising vacancy rates
- Inflation and rising interest rates
- Broader economic downturns
Lack of Investor Control
For many investors, the hands-off involvement in DSTs is a feature. However, the passive nature of the investment may become a risk. The sponsor can make decisions that would harm the DST’s profitability, but investors cannot intervene or exert control over the properties to follow Revenue Ruling 2004-86 and maintain 1031 Exchange eligibility. As such, your returns depend heavily on the sponsor’s expertise, integrity, and strategic execution.
Sensitivity to Interest Rates
DSTs have fixed loan terms and are restricted from refinancing, so interest rate fluctuations may not make an immediately apparent impact. However, rising interest rates are headwinds for DST investments. This risk can decrease property value due to higher cap rates. If the DST is about to begin property disposition during periods of rising interest rates, then the proceeds you earn might be lower than expected.
Sponsor and Management Risk
We’ve mentioned how investors are reliant on the sponsor’s capabilities to ensure the profitability of the DST. This dependence presents another unique risk with DSTs. Mismanagement, inaccurate financial projections, or uninformed market assumptions from them could lead to disappointing returns or even losses. As such, mitigating this risk means choosing sponsors with strong industry credentials and transparent reporting practices.
Property-Specific and Tenant Risks
There’s also the unique risks associated with the DST property and its occupant. The age of the asset, its current condition, and location all affect the profitability of the DST, especially if there’s only one asset under the trust. Furthermore, the tenant’s creditworthiness, industry, and business strategies also play a role in the performance of the investment.
Regulatory Risks
Changing rules regarding the DSTs also present a risk to the investment. Any changes in IRS regulations regarding the eligibility of DSTs for 1031 Exchanges could alter how these investments are treated. As such, it’s important to consult with tax advisors and other professionals to gain an in-depth understanding of emerging laws or trends.
DST Investor Awareness: General Tips To Help Minimize the Effects of These Risks
Given the passive nature of DSTs, there isn’t much an investor can do to minimize the effects of these challenges once they enter the trust. As such, the most effective strategy is to vet and choose DSTs carefully. Evaluating the sponsor’s track record and the condition of the property are paramount to reducing risk and maintaining your tax deferral status.
Beyond evaluating each DST offering, it’s also best practice to spread your capital across multiple DSTs instead of just one. This practice enhances your diversification, ensuring that even if one investment underperforms, you have a cushion to weather the losses. Following the 200% rule in 1031 Exchanges allows you to invest in multiple DSTs.
Final Thoughts on Delaware Statutory Trust Investment Risks
When entering a DST, part of the 1031 Exchange due diligence is understanding the associated risks of this investment, such as illiquidity, sponsor risk, and regulatory changes. Knowing how these challenges can affect the investment helps you implement strategies that can mitigate the effects and increase the chances of a successful investment.
Sources:
https://calawyers.org/real-property-law/what-is-a-1031-exchange/
