Hidden UPREIT Fees Added By DST Brokers – How To Avoid Them

Carl E. Sera, CMT
Carl E. Sera, CMT
Managing Principal, Sera Capital
Carl Sera is a Chartered Market Technician and the Managing Principal at Sera Capital Management, LLC. He has over 16 years of experience in the financial services industry with a focus on investment management.

Make Sure to Dot Your I’s and Cross Your T’s

Are you asking your 721 DST Broker which share class you’re getting? Not knowing the answer could cost you a fortune.

As readers of our blog and posts know, we are big fans of Delaware Statutory Trusts (DSTs) for real estate investors looking to retire from active management and transition to passive management in a tax efficient manner.  Our readers also know we think the DST that converts to a REIT after a short period of time is especially attractive. We’ve written extensively about it, and it seems the trend, as of January 2023, has caught fire in the industry as evidenced by the fact that the largest market share in the industry in 2022 was captured by a firm that only sponsors DSTs that convert to their REIT.

For those that may not appreciate the implications, it’s major to say the least and what we at Sera Capital have been predicting for several years.  We anticipate the trend towards this type of DST will continue to grow.  This does not mean that the traditional DST is dead or yesterday’s news.  It just means that investors must now understand the choices available to them and one of the most important aspects of developing an understanding is determining the type of REIT you will end up owning as well as the share class you will own once you own it.

At Sera Capital we never recommend DSTs that can convert to publicly listed REITs because of the future volatility of their shares.  We can’t imagine seeing someone’s capital drop, even if temporary, as much as 70% during a severe stock market downturn and 30-50% during routine stock market downturns.  Let’s repeat, publicly listed REITs are not in our repertoire and so when selecting a DST that converts to a REIT, avoid these at all costs.

This brings us to the subtitle of this post which is to make sure to

Dot your I’s and Cross your T’s.

What does this even mean, you may ask? It means make sure the share class you end up owning once you own the REIT is the lowest cost, highest yielding share class at the REIT you end up owning.  At Sera Capital, we work on a fee-only basis and act as fiduciaries, which means you will end up with the I share of the REIT, the lowest cost highest yielding shares, instead of the T shares which pay commission-based brokers a trailing commission. When/if and you need to read the fine print, you will see that often these trailing commissions are so large that you end up paying the commission-based broker as much as 20-25% of your total annual income. Don’t let this happen to you.

So, a little history is in order.  When Sera Capital first got into the exit planning business the only viable option if someone wanted to 1031 from active management to passive management was the traditional DST. Since then, many more non-DST options have appeared, but this article only focuses on the DST landscape. So, in the old days, as late as 2020, DSTs were traditional and sold almost exclusively by full commission brokers and the average sales commission plus broker dealer fee was approximately 7% of your initial investment. We came along, looked at the industry and said, 7% is insane, we would never pay that, and you shouldn’t either. The world started paying attention and the phone hasn’t stopped ringing since.

What happened next? By the late summer of 2021, Sera Capital had identified 3 viable options for investors to invest in DSTs that convert to REITs. We were uncomfortable when there was only 1 option, more comfortable when there were 2 and very comfortable when there was 3.  There are 5 viable options today and more high-quality firms are developing their platform and will enter the space as they recognize the limitations of the traditional DST.

So, what’s the full commissioned broker to do when they can see their world crumbling around them? What are they to do when the 7% gravy train is leaving the station? Let’s see and let’s not forget that these folks are experts at transferring money from your pocket to theirs and so the following is a typical example and the latest deception.

We love stories, tales, anecdotes and believe people learn best this way.  So, we are going to describe a situation we witnessed. Please note, when you read the following, there is a part of us that experienced sour grapes, a part that feels bad for the investor and the actions they took and a part that is in awe of the sheer salesmanship of the fully commissioned broker and the extent they will go to make a sale.

We received a call from John and he had $1,000,000 or so he wanted to invest in DSTs.  We spoke several times, explaining the differences between the traditional DST and the DST that converts to a REIT and after much deliberation he agrees the DST that converts to a REIT is the right one for him and we identify one.  So far so good.

A few days later we get a call from him saying that he has decided to purchase the exact same investment we agreed upon from a full commissioned broker because “they are cheaper than we are.” We are stunned, not because he is talking with someone else, but because we know one of two things.  We know the broker is deceiving John or that the industry has changed, and brokers are actually willing to work at greatly reduced margins. We can’t determine which one it is until we end up doing some digging.

What happened and how did the broker deceptive practice capture John’s imagination?  Remember, we are a fee only advisor that credits our clients with 100% of any sales fees or commissions inside of traditional DST as well as DST that convert to REITs. We only get paid by the client and never get paid by the sponsor, while brokers only get paid by the sponsor and never by the client.  That’s how you can tell with whom you are dealing.

The broker simply told John that he would match us and waive 100% of their sales commission and that it was stupid for John to pay our fee when he would charge him zero.  This is a red flag.  What John heard was that he could get into the identified DST at $0 fee and receive 100% of the credit, or that the full commissioned broker was essentially working for free.  We all know that’s not possible.  So, how did the broker deceive John?  The answer is found in the share class of the REIT that John will ultimately end up owning. With Sera Capital, John will receive the I share while with the broker, John will end up receiving the T shares—thus the subtitle of this post.

What’s the difference between these two share classes? The exact answer varies depending on the REIT sponsor, but a good and average approximation is 85 basis points per year. What does this mean specifically?  It means that on $1,000,000 investment if the REIT pays 4% annually to John if he owns the I class, it only pays him 3.15% instead since he owns the T shares.  John would receive $40,000 per year had he transacted through a fiduciary such as Sera Capital but only receives $31,500 since he transacted through the fully commissioned broker.  Why? Because $8,500 is sent from the sponsor to the broker every year. Please note-this is paid every year, so it is a permanent and ongoing back-end commission that I suspect was not disclosed.

You gotta hand it to these folks for creating innovative ways to make money.  The good news is there are firms like ours and others that are in the business of providing reasonable advice at a reasonable price and have the attitude that an educated customer is our best customer.  These types of unsavory broker practices will go the way of the dinosaur and we will all be playing in a better place once they cycle through this phase.

So, don’t forget to Dot your I’s and Cross your T’s.  What’s the easiest way to know?  Ask the broker if the sponsor at any time pays them or their firm.  They can’t be true fee-only fiduciaries if they are compensated by anyone other than you.

Lastly, while we feel for John, we realize that people are responsible for their actions.

If you’d like to learn more about Traditional DSTs and 721 DSTs, schedule your call today.

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