Many elements in Delaware Statutory Trusts (DSTs) work together to provide investors with benefits like steady cash flow, enhanced diversification, and tax-deferral benefits. One of the lesser-discussed aspects is the DST reserve, which plays a crucial part in ensuring the longevity and stability of the investment.
For investors, knowing how Delaware Statutory Trust reserves work is crucial as part of overall due diligence. This knowledge helps you gauge the trust’s financial health, set cash flow expectations, and appreciate the long-term protections these funds provide. Below, Realized 1031 shares a comprehensive guide to shed light on this aspect of the investment. Let’s take a closer look.
Defining DST Reserves
Many real estate investment structures maintain reserves as part of their long-term financial planning and preparation for unexpected expenses. These are funds appropriated from the gross revenue of the underlying properties to cover costs of repairs, maintenance, and other unforeseen operational needs.
DST reserves aren’t distributed at first to the beneficial interest holders, but are held by the sponsor until the end of the holding period. These reserves are typically held in dedicated accounts controlled by the signatory trustee or asset manager, depending on the DST structure. Only during the DST’s dissolution can you receive the withheld income as part of the full-cycle event proceeds.
Common Types of DST Reserves
DST reserves cover a wide range of expenses, so they can be divided into several types. These distinctions help DST sponsors properly assign funds for specific contingencies.
1. Operational Reserves
The operational reserves cover the most ground, serving as funds for day-to-day expenses, net operating costs, and utilities in case rental income dips. DST sponsors often maintain operational reserves at a level equivalent to several months of projected expenses.
2. Capital Expenditure (CapEx)
While operations reserves are for daily expenses, capital expenditures are dedicated to major repairs or replacements that help maintain the property’s value and functionality. Examples of CapEx include the following.
- HVAC Repairs
- Parking Lot Resurfacing
- Renovations for New Zoning Regulations
- Roof Replacements
CapEx is a crucial reserve, considering how the DST is not allowed to raise new capital, per Revenue Ruling 2004-86. Having these funds allows the DST to handle bigger expenses without disrupting beneficial interest owner distributions.
3. Tenant Improvement and Leasing Reserves
Some DSTs create reserve funds for tenant improvements. These buffers are particularly helpful for DSTs that hold properties with multiple tenants, covering new move-ins or leasing commissions.
4. Debt Service Reserves
Given how DSTs usually acquire properties through financing, any dip in income could result in delinquencies. The debt service reserve serves as a contingency fund should the DST have less than enough to cover the mortgage dues, ensuring that nothing escalates into a foreclosure.
How Sponsors Fund DST Reserves
Where does the DST sponsor take the funds from? How does it build up the reserves? The cash comes primarily from the operating income of the underlying assets, particularly rental income. Each month or quarter, the DST appropriates a portion of the revenue and holds it in the reserve account. The appropriation occurs before any cash distributions take place. However, there is no set percentage. As such, it’s important to examine the private placement memorandum (PPM) to see how much of the income will be held back for reserves.
Some DSTs create reserves at the time of acquisition or before the DST closes its offering. The sponsor would fund the reserve accounts upfront using proceeds from the original capital raise, which includes the capital you contributed. This approach ensures that the DST has a financial cushion at the start.
The Importance of DST Reserves for Investors
While DST reserves are beyond the control of investors, understanding how they work and which types the DST holds is crucial for long-term planning and financial management. Here’s why:
- Reserves protect the DST by covering unexpected costs, ensuring that income won’t be reduced immediately.
- Reserves can provide steady and regular distributions, even when the rent collections decline or if capital repairs are underway.
- Some lenders require DSTs to maintain minimum reserve levels as a condition of financing, and having the debt service reserve helps the trust comply with this requirement.
Wrapping Up: DST Reserves and Their Importance
DST reserves are an integral part of DSTs, providing the financial cushion that ensures the stability and long-term profitability of the assets, even when unforeseen expenses arise. The funds are taken from the income of the properties, and if left unused, will be distributed to the beneficial interest owners by the end of the DST’s holding period. By understanding how reserves work and evaluating how each sponsor manages them, you can make more informed decisions and enjoy greater confidence in your DST investments.
Sources:
https://www.investopedia.com/terms/c/capitalexpenditure.asp
https://www.loansjagat.com/blog/what-is-a-capital-reserve
https://mf.freddiemac.com/docs/multifamily_legal_fyi_delaware_statutory_trust_august_2014.pdf
