Navigating Hard to Reach Markets with DST 1031 Exchange: Expert Insights
Carl E. Sera, CMT
June 11, 2023
Using a DST 1031 Exchange to Access Hard-to-Reach Real Estate Markets: Strategies for Investing in Properties Outside Your Local Area.
Owners of investment properties typically own only one sort of property in one geographic area. The reasoning behind this strategy is understandable: owners develop expertise in acquiring and managing a specific property type, such as residential rentals or multi-family properties, and want the properties to be within commuting distance of their house. The problem with this strategy is that it introduces "concentration risk."
Most owners' goals eventually move toward capital protection and stable, predictable income potential. When this objective shift occurs, transitioning concentrated assets into a widely diversified replacement property portfolio is worth considering. While diversification does not ensure returns, it can provide downside protection as various property types and geographic markets trend differently throughout market cycles.
And one of the surefire ways to achieve real estate portfolio diversification and access to diverse real estate markets is through investment in the DST 1031 Exchange.
What is a DST 1031 Exchange?
A DST 1031 Exchange enables savvy investors to do 1031 exchange into “fractional ownership” of high-quality institutional real estate. One of the primary advantages of DSTs is the comparatively low minimum investment requirement, typically $100,000 of equity for each offering.
The cheap minimums provide exchangers with unprecedented access to diversification. An exchanger can effectively design a portfolio of replacement properties across various property types and markets - a REIT if you will. Did you know some DSTs operate as stepping-stones into multi-billion dollar REITs with hundreds of properties?
What are the Benefits of a DST 1031 Exchange?
A DST 1031 Exchange offers a range of benefits for real estate investors. Here are some of the key benefits to consider:
1. Tax Deferral: One of the main benefits of a DST 1031 Exchange is the ability to defer capital gains taxes on the sale of an investment property. This means that the investor can reinvest their proceeds into a new property without paying taxes on the gain from the sale. This can help to increase the investor’s purchasing power and provide a higher return on investment over time.
2. Diversification: Another benefit of a DST 1031 Exchange is the ability to diversify your real estate holdings. Rather than owning a single property, investors can purchase fractional interests in multiple properties. This can spread the risk and potentially increase returns over time.
3. Professional Management: When investing in a DST, the property is typically managed by a professional asset management company. This can help to mitigate the day-to-day responsibilities of property ownership, including maintenance, leasing, and tenant management. As a result, investors can enjoy passive income without the stress of managing the property themselves.
4. Access to Institutional-Grade Properties: DSTs typically invest in larger, institutional-grade properties that may be out of reach for individual investors. This can provide access to high-quality assets that may generate higher returns over time.
5. Estate Planning: DSTs can also be used as part of an estate planning strategy. By exchanging a property into a DST, investors can defer capital gains, receive non-recourse debt replacement, and a step-up in basis.
How DST 1031 Exchange Allows for Access to Hard-to-Reach Markets
The DST 1031 Exchange is a solution for accredited investors who want to hedge against market volatility by exchanging a single property for a diversified collection of passive real estate. DSTs enable investors to control concentration risk by purchasing high-quality real estate across the United States.
A 1031 Exchange investor, for example, could diversify by selling a single property and then buying a portion of a Walgreens in Dallas, a piece of a 200-unit apartment building in Raleigh, and a piece of a $50 million medical facility in Phoenix. Regarding your stock portfolio, advisors always promote diversification; why should real estate be any different?
So, while you may currently own a residential rental property and be thinking of exchanging it for a similar property, DST sponsors offer you the ability to have fractional ownership in many different property types, including:
- Multi-Family Apartment Buildings
- Single-Tenant Net Lease Retail Properties
- Medical Office Buildings
- Self-Storage Properties
- Student Housing Properties
- Industrial Distribution Centers
- Commercial Property
- Hospitality Properties
Since DST investors own a ‘fractional interest’ in a property, you may be able to invest in much larger, institutional-quality property than you would with a 1031 Exchange. And finally, DST sponsors offer properties throughout the United States, giving you options to own in areas that may have more robust economic fundamentals than others at this moment in time.
Also, most DST investments are more substantial institutional-grade properties with long-term leases and higher occupancy rates. These assets' size, value, and quality also garnish lower loan interest rates for major banks, lenders, and agencies. In today’s market, it is common to see returns on equity invested in the 5% range.
However, it is essential to understand that every real estate investment presents uncertainty. Net lease properties tend to be susceptible to interest rate risk as they behave much more like bonds because they are primarily valued on the competitiveness of their remaining income stream compared to other income-focused investments. Likewise, annual lease properties, such as apartment buildings, may be much quicker to react to economic slow-downs due to the properties’ shorter lease duration.
Significant diversification is a unique feature of Delaware Statutory Trusts, but there is no “one-size fits all” portfolio for all investors considering an exchange. If you want to learn more about whether DSTs are a suitable replacement property option based on your objectives, please get in touch with us at Sera Capital for a complimentary 30-minute consultation. We'll discuss the pros and cons, guide you through the timing of your exit, and coordinate DST 1031 Exchanges into your financial planning.