If you seek to provide your clients with DST investment opportunities, I don’t have to tell you how much of a challenge it can be to identify and properly assess a program before it is fully reserved.
Regardless of how quickly DST products are moving, you still need to perform thorough due diligence to ensure you make the best recommendations to your clients and protect yourself from a compliance perspective. While due diligence takes time and effort, this post will examine various strategies that will help give you an extra edge in making effective and efficient DST investment decisions under today’s conditions.
1. Gain a time advantage by getting to know the sponsor, their capabilities, and their structure before looking at a particular offeringThe most fundamental way to assess a DST program is to start by focusing on something other than the program itself.
Independent of the actual investment opportunity, it is of primary importance to thoroughly vet the sponsor to develop a comfort level before you do anything else. After all, you and your clients are entering into a long-term relationship with whom you do business. A third-party sponsor due diligence review can help you get up to speed quickly on the sponsor’s organization, resources, and track record. But also to talk to the executives yourself to get a sense of their character and the company’s culture. Pay particular attention to the things that successful sponsors have in common.
There are several DST sponsors that consistently have offerings in the market for when client need arises. To gain the most efficiency from your sponsor underwriting down the road, prioritize these firms for an ongoing partnership. Review the PPMs and offering structures of their recently offered deals. Master lease structures, governance provisions, and purchase agreement terms most often do not significantly vary from offering to offering of a particular sponsor. Foundational due diligence on the sponsor’s approach gives you a time advantage on deals going forward once you’ve already generally vetted the offering structure.
2. Compare the deal to other programs, including prior DSTs of that sponsorOne of the primary determinations you’ll make in a due diligence investigation is whether the program’s probable return is worth the risk required to potentially achieve it. Benchmarking the program against comparable programs could help you assess the reasonableness of the risks swiftly. For some time in our industry, there has been a growing emphasis on product comparisons. For example, Reg BI requires broker-dealers to consider “reasonably available alternatives” to the investments they ultimately recommend to clients.
The most obvious basis of comparison are fees and expenses, given that costs directly impact total returns. Maintaining or consulting a database of other programs reviewed will help you put the fees of any given program into context. (Our own due diligence reports contain comparable fee data from all of the DST programs we’ve reviewed.) Comparables should give you a good idea of the reasonableness of fees, or whether programs with similar risk profiles may come at lower costs and perhaps higher potential returns.
But fees aren’t the only attribute for comparison. Other program and property features, such as leverage level, asset class, and income profile, should be considered and compared to what else may be available in the DST market to ensure the best fit for your client. Note that each asset class has its own nuances, so some features are best compared to other deals of that asset class only.
And comparing a current offering to past offerings of that same sponsor that you’ve reviewed can be insightful too. Such an examination can help identify program differences that you should focus on in your final analysis and illustrate changing market conditions over time.
3. Assess how the deal will perform in different market conditions
One of the best ways to quickly grasp how a DST program works, and the likely obstacles that could stand in the way of investment objectives, is to assess how it would perform under different future scenarios. That’s because this exercise forces you to develop a good understanding of the projection model and probably the master lease structure. (In addition, it’s also part of Reg BI’s care obligation.)
It may be hard to predict where commercial real estate is headed given the very strange market conditions we find ourselves in. Still, at least you can determine approximate outcomes for investors under different, high-level future scenarios to see how well the bases are covered.
Real estate is complex, but don’t overcomplicate your scenarios. To determine sensitivity to certain major factors, modify just one variable and leave the rest of the sponsor’s base case as the control in your stress testing experiments. Think critically about what factors in this program may have the biggest impacts and test those. For instance, increased vacancies, reduced rent growth, and higher expenses will typically be appropriate, but does the loan have a rate reset five years down the road that you can model? What happens if a tenant doesn’t renew a lease in 2025? You may also want to model outperformance of sponsor projections to see how a master lease structure would allocate excess revenues between the investors and the master tenant.
From there, you want to determine whether you are reasonably comfortable with the outcomes in these various scenarios. Are returns to investors decreased, but not to an end-of-the-world extent and nothing more? Or could underperformance threaten the viability of the master lease structure or result in a technical loan default? These are the questions we focus on in our own third-party DST reviews.
4. Document that you’ve followed your procedures consistentlySeveral distinct elements are contained in that short statement:
Due diligence review efficiency comes through following a process that helps to remove ambiguity. Consistently documented files show that you didn’t give in to the temptation to cut corners on due diligence under pressure. We’ve seen time and again that wealth advisors being able to demonstrate they adhered to their processes is the best defense against regulatory and litigation risk. And most importantly, following robust processes will help you make the best investment decisions and recommendations for your clients.
5. Leverage third partiesLast, there are significant benefits to consulting third-party due diligence reports on DST offerings as a part of your review process:
And these types of things help save you time and money.
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