I had a conversation with a friend about real estate DST investments. We invested recently into DST-s as part of 1031 exchange. I educated myself on the risks and read the PPM-s. I am comfortable and I think it was a good choice for 1031 exchange funds. But for new money to be invested the consideration is slightly different. (Deferring of taxes is a significant motivator.)

One particular risk that came up has to do with the fact that the multifamily DST-s we looked at typically have 45%-55% loan to value ratios with 10 year fixed rates. Most DST sponsors indicate that they will sell in 7-10 years. I assume the main reason for that is so that the investors could get out. Those who want continued real estate exposure can reinvest into another DST etc. The loan term seems to be engineered accordingly.

The concern that was raised is that what if there is a recession or a credit crisis and so it is hard to get loans. That would reduce the market for the properties since fewer investors can get loans. The fact that the DST has to sell is a liability in that case. It seems that the consequence is that the market would set a lower price. On the other hand if you invest into a multifamily property via say a partnership, there is no similar pressure to sell within a time period. The partners can and probably will decide to try to hold until the crisis eases and sell when they can get the proper market price.

Do you agree that the limited holding period is a concern?

The PPM-s talk about the option of turning the DST into a Springing LLC when things do not go according to plan. I assumed that such conversion would enable a refinancing of the loan (say if sale is not possible or unattractive and the loan terms are such that extension is not possible).

I know that there are many other risks. The above was something I did not consider myself until I talked to my friend.

@Matyas A. S. Lack of liquidity is the number one risk I explain to investors considering DST. The LLC option would place the investor in a taxable situation upon sale. A few sponsors have taken DST into an LLC and back again into the DST structure, however this is extremely rare.

There are some business popping up to support liquidity in the DST space (i.e. purchase your interest in DST prior to the deal going full cycle). An active and liquid secondary market would go a long way in growing the DST space.

@Matyas A. S. Yes i do agree with your analysis.

It is important to underwrite a DST for it break even point. The difference between the purchase price (price the sponsor paid) and the offer price ( the price investors pay). There are two tools that are needed to accelerate the process. The first NOI growth of 2.5% to 3% a year, the second is principal pay down sooner then later.

NOI growth increases the value of the property and principal pay down builds your equity. This will allows for the selling of the asset sooner then later knowing that there is a high probability that the principal is protected.

Most Multifamily DST's use agency debt (Freddie or Fanni) that allows for 10 years of interest only. These DST's only have NOI growth. Right there you are losing one of the two tools. Other DST's have flat NOI but are paying down principal, again one of the two tools being used. And there are DST' that have no NOI growth and use IO for 10 years, those DST's are the kiss of death.

I hope this helps!!

@Matyas A. S. Great question / comments! One question we continuously receive from our clients is "How can I defer my taxes and take advantage of 1031 exchange?". To your point, one advantage of partnerships is the ability to hold on to your investment through a crisis, but you can't defer the capital gains. In my experience, the only options for passive investors that want to invest in real estate and be 1031 eligible are syndicated TICs or DSTs. 

Here are a few thoughts on your post:

Diversification - In addition to diversifying real estate assets classes or geographic locations, I have client's diversify between investing cash in DSTs and cash in partnerships. Our goal is to create different buckets of money with different timelines, goals, and tax advantages.

DST holding period - Most multifamily DSTs have 10 year mortgages. The average business cycle lasts 7-10 years. Lets look at 2008 to now. In that decade, investors survived the Great Recession and prospered in one of the longest bull markets ever. I think a 10 year holding period, gives a DST sponsor more than enough time to exit the investment in an orderly fashion; especially, with an asset class like multifamily. I see some net lease retail / healthcare DSTs being held for 10-15 years, but those deals aren't designed like multifamily ones.

DST sponsors - Know your sponsors. It's great that the PPMs say the sponsor can convert the DST into a Springing LLC (which allows more financing flexibility), but has the sponsor ever done it before? I always recommend my clients work with reputable sponsors, who have been in business for years, with a track record of results.

Originally posted by @Matyas A. S. :

I had a conversation with a friend about real estate DST investments. We invested recently into DST-s as part of 1031 exchange. I educated myself on the risks and read the PPM-s. I am comfortable and I think it was a good choice for 1031 exchange funds. But for new money to be invested the consideration is slightly different. (Deferring of taxes is a significant motivator.)

One particular risk that came up has to do with the fact that the multifamily DST-s we looked at typically have 45%-55% loan to value ratios with 10 year fixed rates. Most DST sponsors indicate that they will sell in 7-10 years. I assume the main reason for that is so that the investors could get out. Those who want continued real estate exposure can reinvest into another DST etc. The loan term seems to be engineered accordingly.

The concern that was raised is that what if there is a recession or a credit crisis and so it is hard to get loans. That would reduce the market for the properties since fewer investors can get loans. The fact that the DST has to sell is a liability in that case. It seems that the consequence is that the market would set a lower price. On the other hand if you invest into a multifamily property via say a partnership, there is no similar pressure to sell within a time period. The partners can and probably will decide to try to hold until the crisis eases and sell when they can get the proper market price.

Do you agree that the limited holding period is a concern?

The PPM-s talk about the option of turning the DST into a Springing LLC when things do not go according to plan. I assumed that such conversion would enable a refinancing of the loan (say if sale is not possible or unattractive and the loan terms are such that extension is not possible).

I know that there are many other risks. The above was something I did not consider myself until I talked to my friend.

Hi Matyas,

You make the comparison to multi-family syndications which is an excellent way to put things in perspective. Let me start off by saying that I am not a big fan of DST's. However, I must say that your comparison is making things pretty unfair on the DST side. Non-DST multi-family syndications are subject to the same type of refinance risk and exit strategy risk as DST's. Also, you will find that most multi-family syndications generally leverage more than 45-55% and have shorter terms than 10 years. To me, one of the greatest risks of syndications (and DST's for that matter) is refinance risk, which can concievably lead to a 100% loss of capital. If a deal is able to secure a 10 year term loan, then that is actually a pretty attractive component of the deal. Most multi-families do not start with 10 year terms. If a multi-family is able to secure a 7 year term, then that is considered to be pretty good. Also, as stated in your original post, the plan is to exit in 7-10 years. DST's can also plan an exit strategy based on how the economy is performing and do not have a strict time-table on when they need to sell the property.

I guess my point is that DST's are in general a very safe investment. They have to be safe because their goal is to "break even".

Hi Tony,

I apologise if I was not clear. The comparison was meant to single family home investments.

Regarding the exit before the 10 year loan is up. Almost all ppm-s list a prepayment penalty for the loan. They often list an explicit risk of this making it harder (make it financially less profitable) for the trust to sell.

Even when sold just 6 months before the 10 years is up the penalty is 1% of the payoff amount per loan docs.

Originally posted by @Matyas Sustik :

Hi Tony,

I apologise if I was not clear. The comparison was meant to single family home investments.

Regarding the exit before the 10 year loan is up. Almost all ppm-s list a prepayment penalty for the loan. They often list an explicit risk of this making it harder (make it financially less profitable) for the trust to sell.

Even when sold just 6 months before the 10 years is up the penalty is 1% of the payoff amount per loan docs.

I don't agree with that at all. Usually there are a few years between the permitted prepayment date and the stated maturity date of the loan. If a DST sponsor agreed to a prepayment penalty even within a 6 month window before the term is up, then he/she agreed to very poor financing terms. I did a 1031 exchange last year and was researching potential DST's. Luckily I was able to find an excellent local property for the exchange. But if I HAD to resort to a DST, I would have had many to choose from......and I would have never invested in a deal with financing terms that you describe above as it puts the sponsor in a position of weakness when negotiating the sale of the property.

@Tony Kim

I checked several PPM-s, but I do not have the time to be able to look at enough of them to confirm our contradict what you say.

However, the 5 I had time to check today, one has no prepayment penalty at all, the others all have the terms I described above. The sponsors are Inland, Bluerock, Passco, Capital Square, well known players.

@Matyas Sustik

The DSTs you are mentioning are getting CMBS financing. CMBS usually has defeasance or yield maintenance as a pre-payment penalty. This pre-payment is one of the risks with this debt structure. It can also be substantially higher than 1%.

Mark

Originally posted by @Matyas Sustik :

@Tony Kim

I checked several PPM-s, but I do not have the time to be able to look at enough of them to confirm our contradict what you say.

However, the 5 I had time to check today, one has no prepayment penalty at all, the others all have the terms I described above. The sponsors are Inland, Bluerock, Passco, Capital Square, well known players.

Interesting. You may have a point. 

I did check a few more PPM's on the DST site that I used in the past.... one provided for an 18 month window, another 24 months, but others had short windows....similar to what you were describing. In looking into it a bit deeper, it looks like it's pretty standard to have these prepayment penalties in exchange for the safety of locking in long-term debt at a fixed rate. So in order to reduce refinancing risk that can accompany shorter term loans, this prepayment premium can be added to negotiate a longer term period. The DST's I saw that had these premiums had very long term periods....most of them were 10 years.

And I would assume that any good sponsor will incorporate this prepayment penalty into their proformas and projected equity multiples.

The ones I checked were all 1%.

My personal syndicated investments are all relatively shorter term (3-5 years) and so I couldn't find anything about prepayments in the PPMs. My HML syndication does not utilize any leverage and so it wouldn't apply.

Most of my clients choose to own the asset directly so they take 1031 money and I find the property to buy.

A DST can make sense if say someone had 300k down and looking at 1 million property. If that's the case not likely to find a good commercial property in strong suburban to urban core area in that range. They could instead take the 300k and own a small slice of a higher quality 10 or 20 million property they might could not afford on their own.

Additionally you can have excess funds from a 1031 where you took 1.2 million proceeds and only needed 1 million for one property so put 200k more into a DST. It's not just capital gains. Often investors do not think of potential depreciation recapture that has built up, any Medicare tax, any state income tax. You add all of that up and it can sometimes be close to 50% of your equity total you would lose in a failed exchange!

In DST you do not control the timing or the exit you are basically in the back seat.

With TIC (tenant in common) it can work sometimes with a few investors. Generally though when lots of investors are involved and each has an opinion and a voter share right it can become a nightmare with lots of infighting with what to do with a property if a problem arises.

So whether people find DST's favorable is really situational on what the investors deems important considerations.

Most regular syndicators do not take 1031 money as they have to run the TIC or DST models.

   

I has just experienced my first DST round trip.  The defeasance cost caught me by surprise.  The sale occurred at the end of year 5 causing five years of early payoff penalty interest.  The cost was added to our debt and this grew our debt allocation by almost 9%.  Now the next rollover must include the higher loan to value ratio.  If this keeps up, one day an ill timed recession might wipe me out.  I could go back and take the defeasance as an expense that would lover my capital return from 58% to 39%.  If I rollover with the higher debt I increase my monthly cash flow by 25%, but if I take out the fees as an expense (reducing both my debt and equity) my increase in cash flow is only 5%.  Should I worry about the increase in debt and take the lower return or is it safe to go forward with the proposed rollover?