Delaware Statutory Trust vs. 506B Syndication

12 Replies

Could anyone tell me if a Delaware Statutory Trust is better than a 506B when setting up a real estate syndication? Pros/cons to either?

Thanks a bunch!

I think what you are asking is whether a DST is better than an LLC. 506(b) just refers to the exemption from registration of your securities for public sale. Even a DST can utilize the 506(b) exemption.

So if my interpretation of your question is correct, it's hard to say that one is "better" than the other because they each have a use case.  

Most syndicates use an LLC structure because it allows flexibility in how you structure the offering. Most importantly you can get carried interest which in the simplest terms means that you, as the investment sponsor, can receive a percentage of the profits disproportionate to your capital contribution (even if you contribute no capital at all). You also have ultimate flexibility in how you execute the business plan. You can refinance whenever you want, you can do a value-add or heavy rehab, heck you can completely reconstruct the property if that's what is needed. But, most importantly, you can receive a share of the net profits from cash flow and appreciation.

The downside to the LLC structure is that you cannot accept 1031 funds into the LLC because units of an LLC are not like-kind property to real estate.

To solve the problem of accepting 1031 investors, sponsors started accepting money from their investors and putting them on the deed as fractional fee title owners. This was called a TIC structure because each owner was a Tenant In Common on the deed. This created all sorts of problems, mostly because there was no centralized control over the asset, and also because there was a lack of alignment of interest on the part of the sponsors--and even some corruption--so the TIC industry earned itself a very bad reputation after the market collapse a decade or so ago.

The DST concept was a response to the downsides of the TIC structure. It solved the issue of decentralized control by holding the property in a trust (the Delaware Statutory Trust, specifically) and the investment sponsor (or an affiliate) was the trustee of the trust. So now you have a structure where, similar to the LLC concept, the sponsor has control of the asset and the investors own beneficial interests in the trust, just like investors own units in an LLC. But the upside is the IRS ruled that beneficial interests in a DST were like-kind to real estate and thus qualify as replacement property in an exchange.

But just like everything else in real estate, there is no perfect solution to solve every problem and the DST is no exception--it comes with its own limitations and downsides. The primary limitations are what is called "the seven deadly sins". I'll just focus on the ones most important to you as a sponsor.

First, you cannot raise any additional capital.  Now if you raise enough in the beginning (which you always should anyways), you should be fine.  But you need to be aware of it.  Once the offering is filled, that's it.  No capital calls, no new investors.

Second, you cannot refinance the property and take out cash.  Nor can you renegotiate the terms of any existing loans. 

Third, and I think this is one of the most limiting factors--you are limited to making capital expenditures only to the extent as required for normal repair and maintenance and minor non-structural capital improvements.  So this means no heavy value-add projects and major rehabs.  

Finally, the DST structure is complex and this is not the same as an LLC syndication. You have to create multiple entities, one to be the trustee, one to be the master lease tenant and in some structures other entities as well.

And...in a DST you can't receive a promoted interest. In other words, you can't get a share of the profits in the same way as you do in an LLC structure. Instead, this is primarily a fee-based venture where you earn an acquisition fee, asset management, property management, and other fees. You can get some of the rental income via the way you structure the master lease, but you don't get a split of the property's appreciation.

So to sum it all up, it's not a matter of which is better. First you must ask yourself the question of what is the problem you are trying to solve? If it is that you have a lot of investors that want to invest in a value-add multifamily deal, LLC is your answer. But if you have a bunch of 1031 investors looking to trade into something, DST is the answer. You just have to be aware that from the lens of the sponsor these are two very different businesses.

@Brian Burke , as always, reading your response to someone else's question is illuminating and extremely educational. I think I'll have to set up an Alert just to trigger on your responses. :)

Thanks for your contribution.

Ditto that...incredibly insightful, Brian. I would anticipate the cost to setup and maintain a DST in quite a bit more expensive than the LLC structure as well.

Originally posted by @Sean Morrisey :

Ditto that...incredibly insightful, Brian. I would anticipate the cost to setup and maintain a DST in quite a bit more expensive than the LLC structure as well.

 Yep, but like all service providers, depends on who you hire.

I tend to agree with Brian.

From what I have seen and heard over the years the TIC model had a very high failure rate. As mentioned trying to get many people with a voting share to agree on what to do with a property can be a nightmare. Now there are some TIC's out there where you might have 5 and under investors and sometimes those can be manageable but even then there can be fall out over time. I saw some properties go into a serious state of decline while the infighting was ongoing and the original seller bought it back from the TIC investors for a reduced value. After awhile the TIC investors just wanted out even if they took a loss to move on.

I was not involved in that deal I have just talked to thousands of investors over the years and have heard various situations they or their friends have come across.

I have another friend that is a mortgage broker but also has their securities license. They do capital raises for the DST's. DST's are heavily laden with fees. The structure of a DST dictates the fees model so for a lot of those companies it is about the volume to make profit. Many DST's have the same value or a loss of value upon exit. The other sponsors I know specifically stay away from the DST or TIC models when syndicating. The costs to do them can be high and as like Brian mentioned there are many, many limiting factors.

DST's or small group of investors for TIC's can make sense in certain situations. An example would be someone has 300k to put into something and wants commercial real estate for 1031 exchange. Unless they want to put in more money anything around 900k or so in price will tend to be not that high quality. The high quality stuff in strong suburban markets is generally about 2 million bucks and up and lot's of times 3 million and up in price. In those situations the 1031 investor might not exchange into anything or might want to go into a DST or TIC and own a fractional interest in a much more higher quality asset than they could own themselves.

It is all situational. When someone approaches me I will help them buy direct with 1031 exchange where I am a commercial buyers broker but I am not interested in setting up a DST or TIC just to take their 1031 money on a project as a sponsor. I like investor money that is liquid and ready to go that doesn't have to be a DST or TIC model to invest with me as a sponsor.

This is a very good thread on the topic of DSTs. Currently, I'm invested in several syndicatons that are either in year 1 or 2 of the business plan, thus I stilll have ample time to plan my exit strategy. Can anyone provide advice and/or strategies to rollover non-IRA funds on syndication disposition?

Many thanks in advance!

Originally posted by @Sean Morrisey :

Could anyone tell me if a Delaware Statutory Trust is better than a 506B when setting up a real estate syndication? Pros/cons to either?

Thanks a bunch!

This is not legal or tax advice. A DST usually is used for 1031 investors and a group of them. Below is a great breakdown of 506 b and 506c. Please make sure you speak to a securities attorney if you need one or recommendations please shoot me a message.

https://www.wealthforge.com/insights/506b-or-506c-that-is-the-question

@Roni Elias , Thanks for the mention of my article on the difference between 506(b) and 506(c) on Wealthforge’s website.

As for the original question, DST v 506(b), this is like comparing apples to oranges. For every syndicate, there are 2 parts; one is what business structure you will use (LLC, LP, TIC, DST, promissory notes, etc) and the other is what Securities exemption you will use to legally raise private money.

There are intrastate exemptions (where all investors, you and the property are in one state), and federal exemptions to choose from (Rules 504, 506(b) and 506(c)). Each exemption has its own set of rules. A Syndication Attorney will ask you a series of questions about you, the deal, and your anticipated investors and then make a recommendation on both your structure and the appropriate exemption, as well as sharing their knowledge on how you might split money with investors.

@Brian Burke - extremely well articulated! Another challenge for DST's to add to what you've said here is the fact that you cannot renegotiate the leases. That's why you will commonly assets in DST's with long term single tenant leases.