Mastering the Art of Evaluating DST Properties: Expert Tips and Insights
Carl E. Sera, CMT
May 9, 2023
How to Evaluate Potential DST Properties: Key Metrics to Consider and Questions to Ask.
There are certain things to think about before investing in a Delaware Statutory Trust (DST). Because of the DST's legal and financial structure as a pre-packaged investment, knowing how to evaluate potential DSTs is key.
First and foremost, each DST offering under consideration should have a Private Placement Memorandum (PPM). The PPM may appear overwhelming at first, but it contains critical information that should not be overlooked.
Here are a few essential factors/questions to consider when determining whether a DST is appropriate for your investment needs.
What do you think you should know before investing?
Since DST offerings move through numerous hands before reaching investors, it is critical to understand what you're getting into. Understanding and examining the terms of a potential DST investment may save you from investing in an overly risky offering. Here are some questions to ask when assessing a DST offering:
Who is the Sponsor, and what is their track record?
Do you know if the Sponsor is familiar with this type of investment? Does the sponsor specialize in a particular asset class? How has the Sponsor managed its investments at various stages of the real estate cycle? Although the internet is helpful in investigating a Sponsor's background, every offering memorandum contains information about the Sponsor's previous performance. But, past results do not guarantee future outcomes.
Are the financial projections reasonable?
Returns are estimated using a Sponsor's models and assumptions about a specific property's performance. These estimates attempt to forecast rent increases and occupancy levels, and their underwriting is generally devoid of context. Turning to market reports and appraisals is an excellent place to start when analyzing whether the financial estimates for a deal are reasonable.
What are the fees?
Almost every Sponsor will charge fees such as an acquisition fee, a disposition fee, and an asset management fee. Could you look over the competitiveness of these fees to see if they will detract from your return? DSTs are some of the most fee-heavy investments real estate investors can buy. We've only ever recommended DSTs for 1031 exchange investors. With a fee-only fiduciary, like Sera Capital, if there is any commission in the DST, that gets credited to our clients' accounts at closing. We want to be completely agnostic about our recommendations and always operate in our client's best interest.
What is the intended exit strategy?
Sponsors have devised various strategies to exit an investment as DSTs have gained prominence in the 1031 arena. Sponsors use both third-party sales and UPREIT exit plans. Evaluating your long-term goals might help you assess if the exit strategy corresponds with your objectives.
What is the liquidity?
The typical "Traditional DST" is designed to sell or "roll" every 5-10 years, and many of the proformas you'll see project a 7-10 year hold. Many companies say there is a secondary market for DSTs, but we've only seen this a handful of times. This means that when you buy a Traditional DST, the investment is illiquid until the investment sells. However, with a 721 DST, a major REIT usually purchases DST after a 2-3 year safe-harbor period. After one additional year of a cooling-off period, clients have monthly liquidity. Considering that it is real estate, many investors are used to illiquidity.
What is the property type?
DSTs can come in many shapes and forms. The most common type of DST that you'll see is usually a single-property multifamily apartment property. Other types include Industrial, NNN, Manufactured Housing Communities, Self-Storage, Hospitality, Retail, Senior Independent Living, Assisted Living, Memory Care, Build for Rent, and Student-Housing, to name a few. We usually recommend investments that have the strong ability to increase rents in an inflationary environment.
What are the geographic risk factors for the location of this property?
Analyzing the property's surrounding metro to assess demand and employment drivers is beneficial, as these ultimately drive a project's long-term prospectus. Investors should also study submarket trends such as occupancy rates and median household income in the neighborhood.
How do I diversify my portfolio?
Over the years, the industry has evolved. While many brokers may take a $1mm sale and recommend that you purchase ten different DSTs in 100k increments, this can be a nightmare for many landlords looking to retire as they run the risk of doing several 1031 exchanges per year and the risk of "di-worsification" as time goes on. The DST industry has since grown. Many institutional multibillion-dollar publicly traded companies have entered the space by allowing investors to purchase a DST later purchased by a major REIT. This represented 30-40% of all DSTs purchased in 2022 and continues to grow.
How could broad market risks impact performance?
Another set of elements to examine are typical market risks linked with real estate investments, such as the level of appreciation an investor can anticipate. Furthermore, how can existing market debts affect the deal's long-term prospects?
What is the overall loan-to-value ratio (LTV)?
As an investor, you should assess the LTV ratio to ensure it is appropriate for your debt replacement requirements. Investors will generally want to look at the loan-to-value (LTV) and payment schedule to see if the predicted net operating income (NOI) and prospective appreciation will cover the loan payoff obligations and investment returns.
What is the debt-service coverage ratio (DSCR)?
While the lender is likely to have a reasonable belief that the property would generate enough cash on cash return to support the loan payments, as an investor, you may want to confirm that the DSCR is at a level where the property would not be at risk of foreclosure, thus putting the investor's portion at risk.
How much cash has been reserved?
Because the seven deadly sins restrict DST programs from borrowing additional cash or accepting other equity contributions, DSTs must keep a reserve of cash that can be used if the property requires repairs or faces unexpected expenses. As an investor, you must determine that a reasonable amount of money has been reserved to protect the investment.
There are numerous aspects to consider before making an investment decision. The DST's due diligence process includes reviewing the DST offering and investigating where the investment is located.
With the extra unpredictability of rising interest rates and inflation, engaging a professional can help you better understand the risks of an investment and if a DST offering is likely to achieve your long-term goals and objectives.
Sera Capital helps clients by acting as a fee-only fiduciary focusing on tax-efficient exit planning. We offer DST 1031 exchange services through special situations where investors could put 1031 real estate into a securitized property while deferring taxes. Schedule a free 30-minute call today.