A Delaware Statutory Trust (DST) is a passive investment. However, passive doesn’t mean risk-free. There are still many potential pitfalls that investors need to be aware of before investing in a DST. This article will review several DST-related risks and how to help manage them.
Liquidity Risk
DSTs have holding periods of several years and some up to 10 or more, making them illiquid. Funds invested in a DST will be tied up for a while. Trying to retrieve those funds before the holding period ends can result in a large discount on the original investment.
Any investor liquidity needs that may arise during the DST holding period will need to be satisfied with other funds. This is why investing in a DST makes thorough long-term planning essential.
For potential liquidity, investors might consider the 721 exchange. This exchange may allow investors to exchange like-kind property into Operating Partnership (OP) Units owned by a Real Estate Investment Trust (REIT) while retaining their tax-deferred status on gains. A 721 transaction may allow for shorter holding periods for your DST, which may provide the opportunity for liquidity, at the discretion of the sponsor.
Some conditions can trigger a taxable event in a 721 exchange. But until that happens, investors can simply retain their OP units while tax deferring gains.
Diversification Risk
Some DSTs invest in only one property. Investors with a large real estate portfolio may not need further diversification from a DST and are fine with a single-property DST.
Investors who do not have a large real estate portfolio may benefit from diversification, as it can help manage risk. Seeking out DSTs that hold multiple properties is one way to manage risk through diversification.
Although the investor is putting their money into a single instrument (i.e., the DST), that instrument diversifies funds by spreading them across different properties held within the single DST.
Sponsor Risk
Sponsors or management companies can significantly impact the success of a DST investment. Because DSTs are passive, investors have no say in the management of the DST. That is completely left to the discretion of the sponsor.
Finding sponsors with a great track record, reputation, experience, and knowledge will go a long way to improving the odds of a DST investment. A lot of responsibility is put on the investor to do thorough due diligence when investigating sponsors. Note, even if you do find a sponsor with a great track record, be aware that past performance is no guarantee of future results.
Interest Rate Risk
As interest rates rise, so will the cost of debt. This can negatively impact returns since financing, leasing, and appreciation will all be affected.
Understanding and monitoring the interest rate environment is critical for investors considering DSTs.
Regulatory Risk
The IRS makes the 1031 exchange and its tax-deferred benefits possible. Should the IRS decide to change the tax code, it can impact the tax-deferred status of investments.
Staying on top of potential and pending tax code changes should be part of every investor’s research.
While an investment in a DST is passive, the upfront research is not. While the research is very time consuming, it’s time well spent as it can increase your odds of a successful DST 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.
Costs associated with a 1031 transaction may impact investor’s returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
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.
A REIT is a security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mortgages.
REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of investing in real estate.
There are risks associated with these types of investments and include but are not limited to the following:
- Typically, no secondary market exists for the security listed above.
- Potential difficulty discerning between routine interest payments and principal repayment.
- Redemption price of a REIT may be worth more or less than the original price paid.
- Value of the shares in the trust will fluctuate with the portfolio of underlying real estate.
- There is no guarantee you will receive any income.
- Involves risks such as refinancing in the real estate industry, interest rates, availability of
mortgage funds, operating expenses, cost of insurance, lease terminations, potential economic and regulatory changes.
This is neither an offer to sell nor a solicitation or an offer to buy the securities described herein. The offering is made only by the Prospectus.
Investors who have sold real estate and executed a 1031 Exchange into a DST may execute future 1031 Exchanges and continue to defer taxable gains. Alternatively, a client may enter into a transaction pursuant to IRS Code Section 721 (also known as an UPREIT transaction). In an UPREIT transaction, Clients will receive, at the REIT Sponsor’s option, cash or OP units. OP units are units of an operating partnership that is wholly owned by a REIT. If the client receives OP units, he or she has exchanged into a security and therefore no longer owns real estate and cannot execute another 1031 Exchange out of the OP units and into other real estate. However, pursuant to IRS Code Section 721, the UPREIT transaction into the OP units may qualify as a tax-deferred exchange. The disposition of their interest in OP units will result in a taxable transaction, including the recognition of their deferred capital gain and any depreciation recapture. The client’s gain will only be recognized upon sale or disposition of the OP units.
There is no guarantee that an UPREIT transaction will occur. The option for this transaction is at the discretion of the REIT Sponsor. Some DSTs allow the client to choose whether to take OP Units or cash. Clients should consult the prospectus and their advisor regarding the specifics.
