Mastering Due Diligence: Understanding DSTs
Carl E. Sera, CMT
May 12, 2023
The Role of Due Diligence in DST 1031 Exchanges: Best Practices for Investigating Potential Investments.
Due diligence is a crucial part of DST 1031 exchanges. Learn everything you need to know about ensuring a successful exchange, from conducting property inspections to scrutinizing investment offerings.
Delaware Statutory Trusts, or DSTs, can provide passive income without the headache of full-time property management. But how can you be sure you're investing with a trustworthy Sponsor? When committing to a DST, it is critical to assess potential offers properly.
At Sera Capital, we pride ourselves on our comprehensive knowledge of DST investments and our experience helping investors manage a DST transaction. A big part of this process is our responsibility to conduct thorough due diligence for every investor and on every potential transaction BEFORE we present a DST investment opportunity to clients.
To help you better understand the different variables to analyze before making a decision, such as risk factors and economic trends, we’re breaking down the data we use in our due diligence analysis.
Why Is Due Diligence So Important?
Although DSTs have been positively regarded by investors as a potential replacement property alternative for 1031 exchanges, this form of investment should be more than a "plug-and-play" scenario.
Due to the high velocity of deals and the ever-increasing number of Sponsors trying to enter the market, due diligence is more vital than ever to ensure that you are not exposing yourself to an unreasonable level of risk. Also, conducting due diligence can assist you as an investor in distinguishing between excellent and bad deals.
Our Due Diligence Process
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 headaches down the road.
1. Sponsor Review
A Sponsor is a person or institution who discovers and purchases properties to be held in a DST and often arranges for the assets to be leased by a master tenant. They subsequently make these investments available to accredited investors through financial advisors and/or registered representatives via beneficial interests. While considering a Sponsor, we consider the following factors:
• Sponsor history and performance
• Extensive executive team experience
• Fees and markups
• Local market expertise
Choosing the correct sponsor is the first step in completing a successful securitized real estate transaction. Once the sponsor has been selected, we evaluate the opportunity, including the deal structure and property information.
2. Deal Structure Diligence
The following due diligence stage analyzes the deal's structure, including all DST-related agreements. They include purchase agreements, financing paperwork, and tax structures. This information comprises disclosures for each offering and can be found in a Private Placement Memorandum (PPM), a legal document created by the real estate sponsor.
The PPM includes a full explanation of the property, the sponsor, the financial facts of the investment, the estimated return on investment, and the specifications of the DST structure. It also includes third-party due diligence reports and all relevant leases, agreements, and contracts.
3. DST Property Diligence
During the last due diligence phase, we analyze the individual properties within the deal portfolio. Some of the areas we evaluate are:
• Number of Buildings in the Portfolio
• Percent (%) occupancy
• Cost per square foot
• Length of Lease Term
4. Economic & Market Diligence
Fee analysis is integral to the Deal Structure Evaluation and the Property Review. Besides fee sources and uses, we examine a variety of economic variables to determine whether a property is a good investment. Here are just a few examples:
Net Operating Income (NOI)
Investors interested in commercial real estate must consider the property's net income. The NOI is the value that remains after calculating and deducting operating expenses (i.e., taxes, management expenses, and repairs costs). When income exceeds operating expenses, the NOI is deemed accretive.
Assessing the NOI will assist in determining whether the property is a "good" investment. A positive NOI indicates that the property is well-positioned to continue producing a consistent income stream.
Exit Capitalization Rate (CAP Rate)
The exit capitalization rate, or terminal capitalization rate, assesses a property's resale value by capitalizing the predicted Net Operating Income (NOI) after the scheduled holding period.
The cap rate is calculated by dividing the NOI by the property's sales price. This determines your return if you pay for everything in cash with no mortgage (debt). The cap rate is sometimes used to calculate the value of a property. It considers vacancies, credit losses, operating expenses, and other income streams.
As a result, we recommend that the breakeven exit cap rate exceed the sponsor's acquisition price. This allows for cap rate compression throughout the holding time. Remembering that the breakeven exit cap and disposition analysis is contingent on the sponsor meeting their financial expectations is critical.
Cash-on-cash return is a rate of return in real estate transactions that estimates the cash income produced on the cash invested. It is determined by dividing the annual pre-tax dollar revenue by the total investment.
Simply put, investors must ensure they receive their money quickly to invest in other properties. Assessing the cash-on-cash return may be one component in determining whether a property has the potential to be an excellent long-term investment.
A replacement cost is the cost of replacing a property with the same or comparable value. When performing a property study, it is critical always to compare the sales price to the expected replacement costs.
Advisor or Broker
When purchasing a DST, you can buy it through an advisor or a broker. During your investigation of DST ownership solutions, you'll find that no matter what amount of money you have, working with a Registered Investment Advisor will give you the edge over our commission-based broker competition.
As with any real estate investment, DSTs have potential risks. It is always essential to hire a team of professionals – in addition to advisors – that includes a Qualified Intermediary, a CPA, and a Real Estate Attorney to help facilitate the process.
At Sera Capital, we make it our job to vet every offering on our marketplace. Regardless of the property type or business strategy, we're ready to help you with any questions about a particular DST offering.