Examining Sponsor Payments and Yield Manipulation Tactics

Delaware Statutory Trusts (DSTs) can offer many advantages to investors. One possible benefit of DSTs is they provide the opportunity to invest in quality real estate in smaller increments due to the fractional ownership structure. 

While it’s essential to research the trust’s real estate holdings, it’s also important to investigate the DST’s sponsor. It can be easy for sponsors to manipulate or overinflate projected yields (and corresponding fees) to seek out additional equity and increase their earnings. 

If you’re considering a DST investment, understand that a deep dive into the numbers is essential to protect yourself. Here is some information to consider when evaluating a potential DST Sponsor. 

An Overview of Sponsors and How They Earn Their Profit

A Delaware Statutory Trust is a legal entity created as a trust under Delaware state laws. DST investors own what’s known as a beneficial interest in this trust. The trust, in turn, owns underlying real estate. As a DST investor, you’re a beneficiary of the trust.

The DST sponsor is the person or company that creates and manages the trust. The sponsor identifies, buys, holds, and manages the trust’s properties and oversees distributions to investors.

As the trust’s beneficiary, you could benefit from cash distributions and potential appreciation when properties are sold. However, per the IRS, the DST sponsor doesn’t benefit from potential gains when those properties sell. So DST sponsors earn their keep in other ways like the following:

Upfront fees

Through this method, the sponsor charges fees for activities connected with buying, financing, and maintaining the properties. These might include “finder’s fees” for finding and acquiring assets in a trust. This could also include fees connected to finance negotiations and securing debt. 

Percentage of AUM and/or cash flow

Under this arrangement, sponsors may earn a revenue percentage based on the value or the performance of assets in the trust or even cash flow distributions. In some cases, the sponsor could have a hands-on role as manager of the property or properties. This isn’t necessarily a profit generator for the sponsor, as the properties still carry operating expenses.

Exit fee

While sponsors cannot benefit directly from property appreciation upon sale, they aren’t prohibited from taking a percentage of the property’s gross sale as an exit fee. Remember that if the sponsor acts in good faith, none of these fees or costs are out of the ordinary. For example, there’s nothing wrong with a sponsor taking a percentage of a property’s cash flow as long as the sponsor generates a higher value through performance-based incentives.

The takeaway here is that all DST sponsors have fees included in their offerings. However, it’s crucial to understand those costs and when they occur. A sponsor that is cagey or dishonest about its fees must be avoided.

Understanding Yield Manipulation

Most DST sponsors are trustworthy and act as fiduciaries – in other words, they act in the best interest of their beneficiaries. They don’t deliberately inflate returns or hide issues. However, problems can occur with sponsors who might not be trustworthy or willing to work in the best interest of their beneficiaries.

Here are some yield manipulation tricks to be wary of while conducting DST research.

Paying out from reserves

Through this method, a sponsor acquires property with a smaller current cash flow and then uses reserves funded with investors’ capital to boost one-year returns. This can make the property appear to generate a higher cash flow (thus potentially attracting more equity) than it actually does.

Additionally, paying out from reserves can cover the fact that the real estate was more expensive to purchase. This, in turn, means the property will need a higher amount of appreciation to make it a worthwhile investment.

Not all reserve payments should be regarded as deal-killers. It’s more important to assess whether a DST sponsor hides such information from potential investors and beneficiaries. 

Buying into aggressive assumptions

Sometimes, a DST sponsor bases a pro forma or revenue assumption on previous solid rent growth and an economy firing on all cylinders. But if the current (and forecasted) reality suggests sluggish rent growth and a slowing economy, robust rent growth assumptions should be called into question.

Aggressive assumptions also can impact lower-quality assets located in less-than-desirable markets. On the surface, these properties can carry higher cap rates due to their higher risk. The investor mantra is that higher risk can mean higher reward.

But this isn’t always the case for properties driven by poor fundamentals. Under this scenario, a higher rent forecast is likely not feasible. An inability to push rents can lead to less cash flow and little property value appreciation. 

Prepaying normal expenses

A sponsor might reduce expenses on paper by prepaying them, especially in the early years of ownership. This would come from fees included in the upfront offering amounts, meaning investors are paying these costs as opposed to using the property’s cash flow for that purpose. 

In another situation, the sponsor might defer its fees or costs until the property’s sale.

In the beginning, reduced expenses can suggest a higher cash flow and property value. However, carefully analyzing a property’s costs (going beyond years one and two, for example) can provide a more realistic viewpoint. 

There isn’t anything wrong with prepaying expenses. It can become a problem when the sponsor fails to tell investors or beneficiaries that this is taking place. You might choose to invest in a particular DST because cash-on-cash returns are generated through property operations rather than expense prepayments. Without more careful research, you could find that the actual yield is lower than you anticipated.

Caveat Investor

Now that you know some items to avoid when evaluating DST Sponsors, here are steps to protect yourself when it comes to making the right investment decisions:

Go beyond cash flow

Certainly, cash flow is an important metric. But as mentioned, it’s relatively easy to manipulate it. Because of this, be sure to examine other information for an honest assessment of yield and appreciation. Other good metrics examples include appreciation/total return potential and net operating income. 

Also, research the assets and locations to determine if a DST sponsor’s assumptions and forecasts are spot on. Due diligence can uncover a poorly performing asset in an undesirable geographic area. It’s also a good idea to know the overall economic outlook and understand how this might impact cash flow and/or property appreciation.

Look past year one

It’s easy to inflate cash flow or decrease expenses over a single year. It’s much harder to artificially boost cash flow over several years. When performing due diligence, look at all years during the hold period. Question anything that looks suspicious. If it seems a DST sponsor is being cagey with answers or responses, finding another investment might be a good idea.

Examine the track record

Under the category of “researching the DST sponsor,” take note of the individual’s or company’s previous track record of real estate ownership. Pay attention to how many economic cycles the sponsor has been through. Also, keep an eye on whether the sponsor has a history of underperforming project returns or smaller investor distributions.

Most reputable sponsors will be happy to provide you with information about previous investments and their performance. Also, remember that a poor previous performance isn’t a deal-killer. Many factors go into a real estate investment's success (or failure). Ask the right questions to ensure the sponsor is honest about any problems.

Know Your DST Sponsor

DSTs can be ideal investments. But as with any investment type, due diligence is essential. In addition to researching a DST’s real estate assets, it’s important to understand the sponsor’s behavior and actions. 

Fees are a normal part of DST investments; they compensate the sponsor for sourcing quality properties, negotiating attractive financing, and structuring the DST offering to facilitate investments. The sponsor also manages and operates properties to potentially maximize their performance. But be wary of hidden fees. 

By the same token, yield manipulation activities aren’t always harmful. There can be good strategic reasons for them. But when yield manipulation is coupled with a lack of transparency, this could spell trouble. 

Understand that nothing is guaranteed

After conducting your research, you might find that the DST looks good on paper. It’s run by a seasoned sponsor who embraces transparency and eschews yield manipulation tactics. You’re confident that the properties’ forecasts are realistic.

Even with all of this, there’s no guarantee that the DST will perform as indicated. You might not receive any distributions. Nor will the properties appreciate as high as you hoped. This is the reality of investments. They don’t always pan out. To that end, your research should include the risk of losing your entire investment principal and whether you’re okay with that scenario.

To help you navigate the world of sponsors and DST due diligence, find a reputable wealth manager who is dedicated to working toward your long-term lifestyle goals. By partnering with a wealth manager like Realized, we can help you better understand the world of Sponsor and DST due diligence so you don't have to research sponsors and potential deals on your own. Sponsor due diligence is the first part of our rigorous due diligence process and includes evaluating financial statements, regulatory disclosures or actions taken by regulatory agencies, cybersecurity policies, and more. 

Contact us if you're interested in learning more about our due diligence process or what makes us different than other DST advisors.