[Webinar Recap] Understanding Due Diligence: Risks to Consider

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Posted Aug 23, 2022

If you’re considering investing in a Delaware Statutory Trust, or DST, it’s important to evaluate risk the same way you would for any investment. At Realized, a critical component of our due diligence process is risk assessment. Risks can include general market conditions, the precise location of the property, and an array of other factors.

Let’s take a look at some of the risks we evaluate when performing due diligence on a Delaware Statutory Trust.

Market Risks

The three key indicators we evaluate when considering market risks are as follows:

1) Pricing

Acquisition price plays a significant role in determining the expected appreciation for a given project. If a Sponsor paid above-market value for a property, it may limit profitability on the backend, especially if sold in a down market.

Pricing is of particular concern right now since we’re still seeing a lot of real estate markets with limited supply. Limited supply leads to inflated prices and the potential risk of overpaying for an investment.

2) Inflation

The second risk we consider is whether or not a property provides a hedge against inflation. More often than not, this is a risk to net-lease projects with rental escalations that lag behind the pace of inflation. If landlords aren’t raising rents in accordance with rising costs or other market triggers, then an investor could be vulnerable to losses. One hedge against this risk is targeting projects with rent bumps that are tied to the Consumer Price Index or using net lease as part of a greater portfolio construction.

3) Debt market conditions

Debt market conditions can have a significant effect on supply, projected distribution, and exit. With recent rapid fluctuations in the debt market, we’ve found it critical to dig into the terms of debt on leveraged offerings. If interest rates continue to rise, that will increase the cost of debt, meaning, as an investor, you’ll want to pay a lower price for assets.

Geographical Risks

When we look at geographic risk for DST offerings, we drill into two main areas: metro risk and submarket risk. Metro risk means comparing one metro area to another. Submarket risk refers to evaluating different neighborhoods in a metropolitan area.

  • Metro risk means evaluating demand and employment drivers for a given area since those factors are what typically determine long-term prospects for a project. For example, we’ve seen large population and income growth in Charlotte, North Carolina, which bodes well for apartment deals in that metro area.
  • Submarket risk, or neighborhood-specific risk, involves consideration of supply and demand dynamics to determine how many units we expect to be delivered and what percentage of those will be occupied or absorbed. We also look at demographic trends such as median household income.

Property-Specific Risks

Realized’s due diligence analysis generally involves two types of properties: multifamily and triple-net (NNN). Multifamily includes typical apartment complexes ranging from high-rise to garden-style, while triple-net offerings refer to commercial properties like retail, office, or industrial spaces where the tenant pays the taxes, insurance, and maintenance costs of the building as well as, potentially, roof and structural repairs.

In evaluating multi-family offerings, we ask the following questions:

  • What is the average tenant household income, and what is the income-to-rent ratio?
  • In what industries do residents work?
  • What are the local employment drivers?

When assessing profitability for triple-net offerings, we assess the following:

  • How are the tenants’ financials?
  • Do the tenants have investment-grade credit?
  • What are the property’s historical sales?
  • What is the lease structure and remaining term?
  • Are the leases guaranteed? If so, by whom?

Before you invest in a DST, make sure you have thoroughly evaluated the risk or are working with a company that has a solid understanding of 1031 exchanges and experience in performing due diligence on potential offerings.

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.

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