It should come as no surprise that Delaware Statutory Trusts (DSTs) carry many of the same risks as a direct property investment. After all, the underlying asset driving the investment's performance is some type of real estate asset. From illiquidity to macroeconomic risks, such as rising interest rates, DSTs are exposed to various similar factors that may spell trouble for any real estate investment.
Unfortunately, due to their structure, DSTs are subject to further risks that may not exist in direct property or REIT investments. Because they are tax-heavy, financial products, DSTs are exposed to a variety of additional forces that include regulatory and execution risk, as well as financial risk due to the fees that are baked into most DST offerings.
This article will explore the various risks and fees that DSTs are subject to and the impact that they may have on an investment. Although DSTs are costly, there are several misconceptions about the price of investing in a direct property versus a DST that this article will explore as well.
In a prior article we wrote titled “Disadvantages of Delaware Statutory Trust (DST) 1031 Exchange Replacement Properties”, we discuss several risks associated with owning a beneficial interest in a DST: illiquidity, lack of control, and capital restrictions. Although important and perhaps the most evident to new investors, one must not forget other key risks involved:
A major concern about DSTs we hear from investors is fees. This is understandable, considering your hard-earned money is going directly into the pockets of another instead of getting put to work for you. The unfortunate truth, however, is that the companies involved in a DST transaction won't work for free and can sometimes be expensive.
DST fees encompass a variety of real estate-related expenses that are integral to the process of investing in a Delaware Statutory Trust. These include escrow fees, title charges, appraisals, environmental reports, property condition assessments, legal services, and closing costs. Essentially mirroring the costs an individual investor would face when purchasing real estate independently, DST fees are integral to acquiring and managing the trust's properties. It's important for investors to understand these fees as part of their overall risk assessment, as they influence both the immediate cost of investment and potential returns, thereby playing a vital role in investment decisions within the DST structure.
Fees are typically taken at three levels in the DST structure: upfront, operating, and disposition. Although acquisition costs are typical in most real estate investments, such as legal costs, loan and lender expenses (when debt is being acquired), and other miscellaneous closing costs, some upfront costs in a DST are not as typical. These fees include:
Selling Commissions |
Due to most sponsors not being licensed to broker DST investment sales through their platform, most of the selling efforts are done on behalf of third-party selling groups. These groups include registered representatives and registered investment advisors (RIA). Because RIA’s are compensated by their clients, typically based on assets under management, selling commissions are typically re-allowed to registered representatives that execute the sale of a DST interest in a given offering. |
Broker-Dealer Allowance |
Managing broker-dealers are often reimbursed for marketing expenses and due diligence efforts. This allowance can be in addition to managing broker-dealer fees, and is used to cover costs of obtaining third-party reports, marketing materials, or other relevant items. |
Wholesaling Fees |
Sponsors often utilize an in-house selling team, known as wholesalers, that works with registered representatives and RIAs to ensure they have all the information and documents they need to sell an offering effectively. These individuals are typically responsible for a geographical area and are compensated a commission for sales in their region. |
Managing Broker-Dealer Fee |
Because DSTs are recognized as securities, offerings are often issued through entities known as 'managing broker-dealers.' If a broker-dealer is involved, they will assist in due diligence, document preparation, and securities compliance and are compensated for their efforts. |
Offering & Organization Expenses |
Any overhead costs associated with establishing and running the DST. This can include printing costs, expenses related to the registration of securities, or other miscellaneous costs that don't fit another bucket. This line item could be described as a "catch-all," for which the trust reimburses the sponsor. |
Acquisition Fees |
Sometimes referred to as a Sponsor's "finder's fee," an acquisition fee is a payment to the sponsor for identifying, negotiating, and acquiring the asset in the trust. In addition, a sponsor may take an additional loan fee for obtaining financing for the acquisition. |
The amount of capital going towards fees and reserve accounts above the purchase price of the underlying property is known as the "load." It is an important consideration when returning 100% of your capital at the time of sale. While no returns are assured, the higher the load, the more the underlying property in the DST must sell to return an investor's original invested equity.
Fees don’t end there, however. Over the DST’s life, sponsors will often take asset management fees as additional compensation. In some cases, sponsors will structure cash flows to where investor returns are capped, leaving the sponsor to receive the upside cash flow. Lastly, sponsors will often take a disposition fee upon the sale of the property, which may or may not be subordinate to investors returning all of their original investment.
One of the things we always hear is that DSTs are too expensive. The reality is you are not wrong. In 2018, the median load-to-equity on a DST was 19.82%1, meaning that this percentage of each investment was being allocated towards expenses related to Sponsor compensation, selling commissions, and the establishment of the trust.
On its surface, the DST load-on-equity figure creates sticker shock for many potential investors. However, it needs to be taken in context.
All in all, one should consider the benefits of investing in a passive investment with fees against the benefits of direct property without fees. Let’s take a look at some of the differences:
Although there are a lot of similar fees in both direct property and DSTs, extraneous costs and factors must be considered before entering into either. While DSTs may incorporate more tangible expenses related to the syndication of the investment, such as fees to the Sponsor and various selling and due diligence groups involved in the offering, direct investment expenses may relate to the opportunity cost of time loss spent performing one's own due diligence, or the inability to obtain as favorable of financing terms as an established real estate operator could obtain. It really comes down to how much you value the benefits of a hands-free DST investment versus buying, operating, and selling a property in your own right.