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DST Due Diligence in a Hot Market

by Brandon Raatikka

After major tax reform spared the 1031 exchange tax deferral treatment for like-kind real estate, the syndicated 1031 market is poised to extend its growth streak. Equity sales of Delaware statutory trust (DST) offerings were nearly $2 billion last year, a 10-year high. According to Mountain Dell Consulting, equity raised during the first quarter of 2018 was up 50% from the same quarter last year, and the market could be on track for a $2.5 billion year.

It should be noted that broker dealers have primarily driven these sales figures. FactRight is unaware of any studies quantifying the potential untapped demand for 1031 solutions from clients of RIAs and wirehouses, but on some level, substantial demand is likely to exist from those sources. As retail alternative investment sponsors make headway into these channels, it’s not hard to imagine the 1031 syndication market becoming larger than ever, provided that real estate retains its value.

FactRight is just starting to see innovations emerge in the syndicated 1031 landscape that appear to address client-specific situations and are likely to appeal to RIAs, who typically work directly with clients. In fact, some of these new features have already resonated with our RIA clients. Some sponsors are now offering DSTs that purport to allow investors to “park” their equity for a time before informal liquidity options enable subsequent exchange opportunities. Other structures envision the roll-up of DST properties into more diversified, more liquid investments via section 721 exchanges, through purchase options on properties or intended execution of aggregation strategies. And then there are offerings with so-called cash-out transactions, which theoretically allow investors to access a significant amount of tax-deferred gain as a return of equity shortly after investment. We discussed cash-out transactions at length in this blog post

There are reasons to be cautious 

As rising real estate prices drive investor demand for securitized 1031s, we’ve heard from several sponsors that it’s becoming increasingly difficult to acquire quality properties at current values and make DST economics work. We’re somewhat concerned about current pricing, and the relatively inflexible DST structure has not yet been tested by a real estate downturn. (If and when that occurs, we may learn about the viability of springing in and out of LLCs.) Many deals we review have tentative breakeven prospects, and a downturn is likely to create pain for these DST investors and sponsors.

FactRight does not formally track equity raising, but we sense that deals are selling out at an accelerating pace. For some time now, we’ve been hearing concerns from clients regarding the diminishing timeframes to perform adequate due diligence on these offerings before they are fully reserved. Things haven’t gotten nearly as compressed as in TIC days of the 2000s, when TIC deals would often sell out so quickly that almost no due diligence could be considered “best practice.” But that now is even somewhat similar to then should cause a bit of discomfort. Remember, in those days, real estate values were climbing to unprecedented levels, too.

Questions that are more critical than ever to ask

Thankfully (albeit painfully), the industry has learned a lot in the past decade about how to assess 1031 offerings. But given the emerging confluence of factors—growing demand for 1031 solutions (and numerous sponsors entering the market to meet that demand), the opening up of new distribution channels, program innovations, heightened real estate pricing, and the increasing challenges of reviewing programs—it’s more important than ever to grasp and undertake prudent due diligence for DSTs.  

Although no investment program is without risk, the following considerations should help you separate the good DST deals from the ones that may cause you and your clients headaches down the road. 

  • Who is the sponsor? Experience with investment programs in multiple real estate cycles is important. The sponsor (or its executives) should have a track record of doing right by investors, through performance of managed programs or otherwise. A robust investor servicing and communication platform is critical.
  • Who is the operator of the real estate? Either the sponsor or an aligned joint venture partner needs to have deep knowledge of and success in the asset class and markets in which the syndicated real estate is located. Access to an attractive pipeline, especially as pricing gets tighter, is critical.
  • Is the fee profile competitive? While the fees of the established sponsors who stuck around through the recession have continued to come down, competition is increasing as new sponsors enter the market. FactRight tracks fee data on available DST programs in order to put individual deals under review within the context of the market. But the fee assessment is a qualitative as it is quantitative. For instance, pay attention to whether disposition fees and expenses are capped and whether the sponsor’s fee is subordinated to full return of investor principal out of net sales proceeds.
  • How is the master lease structured? The more a master lease aligns the interests of the investors and the sponsor, the better. Virtually all master lease structures in the market generally do this, but some accomplish it more effectively than others. See a fuller discussion on master leases from this blog here.
  • Are the projections conservative and defensible? Rent growth and other assumptions need to be grounded in market fundamentals. Projected returns may be enhanced by, but cannot be fundamentally based on, the value-add components or anticipated operational efficiency.
  • Identify any harmful financial engineering. Regardless of whether such engineering makes the deal more “marketable,” we think it’s bad form to exchange even a little bit of total return for “smooth” or enhanced annual cash flows through use of up-front reserves or interest rate buydowns.
  • Assess the reasonableness of the asset class and business plan. Multifamily is currently getting the most traction in the DST space. Depending on the market, newly developed Class A multifamily could prove to be problematic down the road, or else will offer lackluster total returns. Class B value-add is much more supportable to grow NOI (although many sponsors are jumping in—do they have experience doing value-add?).
  • Understand the underwriting. Terms of leases with investment-grade tenants (which generally don’t provide for significant rent growth during a hold period) may make it difficult to overcome the load without cap rate compression. One potential solution for sponsors in the net lease context is to underwrite and identify strong, creditworthy tenants and leases not completely priced efficiently by the market due to lack of an investment-grade rating.
  • Look hard at the loan terms. Many trust managers are handcuffed by loans that require significant prepayment fees until near the maturity of the loan. The optimal time to sell may not always overlap with a three-month window at the end of the projected hold period, and we don’t like to see a prepayment fee or lockout being a major impediment to exit. Terms defining cash sweep triggers and events of default under the loan also need to be carefully assessed.
  • Scrutinize conflicts of interest. Acquisitions from affiliated programs are not ideal. They can be done if supported by a reasonable, independent valuation, if seller governance mechanisms were observed, and if compensation to the sponsor is minimized or waived. Even then, you need to be careful.
  • Don’t accept any markups. If the sponsor has only recently purchased the property or has not put significant value into it, no independent appraisal will justify a markup.
  • Pay attention how stated exit strategies will impact your clients. For instance, investment in a property encumbered by a purchase option held by a diversified entity may only be suitable for investors who desire to eventually invest in that entity. It is helpful if investors have the option to take cash (for a subsequent 1031) in lieu of a 721. Either way, the transactional mechanics must be structured carefully to mitigate conflicts of interest, or else the sponsor has too much discretion in determining the sales price or cash consideration.

Of course, this list cannot be exhaustive in helping you identify and mitigate all risks. Macroeconomics can frustrate the objectives of even the best designed programs. On the positive side, even in down markets, as long as section 1031 remains in the tax code, 1031 solutions should be theoretically suitable for real estate owners that want to defer taxes. And we’ll be here to help you identify risks and meet your clients’ needs in selecting the strongest DST investment programs.

 

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Filed Under: Due Diligence, DSTs, Real Estate