Key Takeaways
Understanding DST Fee Structures
Front-end fees can significantly impact investment returns and must be carefully evaluated before investing
Balloon Loans Force Sales
DSTs cannot refinance, so balloon payments often require property sales at potentially unfavorable times
Cash Sweeps Reduce Distributions
Lenders can trap cash flows when properties underperform, significantly impacting investor returns
Debt-Free vs Leveraged Trade-offs
Debt-free DSTs offer stability but may struggle to overcome fees; leveraged DSTs provide higher returns with added risks
Understanding DST Fee Structures
Fees are essential to any investment. Investors must be willing to pay for convenience, due diligence, risk mitigation, regulation/accountability, and access. The cheapest way to 1031 exchange is to sell your property without an agent/broker and then purchase a property without third party reports or debt. Obviously, this strategy is vulnerable to a high degree of financial risk and potentially a significant amount of risk to personal time and labor. While DSTs offer passive income and professional management, it's essential to understand these fee structures before investing. Additionally, having an exit strategy is crucial since DST interests cannot be sold individually.
On the other side of the spectrum, you have a turn-key product, such as a DST, with property management in place, third party reports on hand, little-to-no closing risk, and a regulatory body who exists to enforce ethical business practices. This all requires human labor, which comes at a price. Though it mitigates risk, fees may also challenge overall returns and therefore must be considered.
In this section we will highlight the fees in a DST. This is because DSTs are typically accessed via regulated markets where the fees structures are relatively uniform when compared to Tenants-In-Common or real estate purchased outright. Typically, due diligence, third party reports, and regulation is relatively similar when accessed through formal channels such as Broker Dealers and Financial Advisors.
Important Note: Fee Variations
Before diving into the specifics, it's important to recognize that not all DSTs have the same fee structure. The fees described here are common across the industry, but they may not be present in every DST, and the amounts can vary widely. For investors, understanding these fees is crucial for assessing the risks and potential returns of an investment.
One-Time and Front-End Fees
Acquisition Fees
One of the primary profit centers for DST sponsors are acquisition fees, which are charged for sourcing, evaluating, and purchasing the property. DST sponsors are prohibited from taking a "promote" or "waterfall" fee, which means they cannot receive a percentage of the profits. As a result, acquisition fees and disposition fees (charged when the property is sold) are the main avenues for them to generate revenue. Typically, acquisition fees amount to around 2% of the equity invested in the property.
Note: To reduce upfront costs, sponsors may choose to defer the asset management fee, spreading it out over the lifecycle of the DST, or deferring it until the property is sold.
Financing Fees
Financing fees cover the costs associated with securing financing for the property, including loan origination fees, broker fees, and other related expenses. These fees usually range from 0.5% to 2% of the loan amount and are factored into the overall project costs, adding to the initial investment burden.
Note: Even debt-free DSTs may incur financing fees if a bridge loan was used by the sponsor to acquire the property. This loan is often paid off over time as investors buy into the DST.
Organizational and Offering Fees
These fees encompass the costs of setting up the DST and offering the investment to potential investors, covering legal, accounting, and marketing expenses. Organizational and offering fees typically range from 2% to 3% of the total equity raised.
Sales Commission
Similar to the commission paid to a real estate agent, sales commissions are paid to the selling group and usually amount to 5-6% of the equity raised. For properties with debt, the commission might be 2.5-3% of the total property value.
Marketing and Due Diligence Fee
Paid to the broker-dealer, this fee covers the cost of conducting research on the sponsor and the investment, typically around 1% of the equity offering.
Note: This fee might be shared with the selling group, particularly if they assist the broker-dealer in researching the properties or sponsor.
Ongoing Fees
Asset Management Fees
The asset management fee is an ongoing fee paid to the sponsor or asset manager for managing the DST. This fee covers activities such as managing the master tenant lease, overseeing the property management team, handling investor relations, and preparing DST accounting and tax reports.
Typical Range: 0.5% to 1% of gross rental income
Property Management Fees
Paid to a third-party property management company, this fee covers the day-to-day operations of the property. It usually ranges from 3% to 6% of the gross rental income and is deducted from the Net Operating Income (NOI).
Typical Range: 3% to 6% of gross rental income
Essential Considerations Before Investing in a DST With Debt
Interest in Delaware Statutory Trusts (DSTs) continues to grow among 1031 exchange investors, driven largely by the turnkey, non-recourse debt that satisfies 1031 requirements without requiring the investor to apply or sign for the loan. DSTs are particularly attractive to investors seeking passive real estate investments with leverage.
However, it is crucial to understand both the common real estate risks and those unique to DSTs before committing to such an investment. Several key aspects of the mortgage, such as loan amortization schedules, the timing of balloon payments, the presence of cash traps, and whether properties are cross-collateralized, can significantly impact the performance and returns of the investment.
Does the Loan Amortize? If So, When?
Loan amortization is the process of gradually repaying a loan through regular, scheduled payments over a set period. Each payment is divided between paying the interest on the loan and reducing the principal. Typically, a larger portion of each payment goes toward interest early in the term, with the balance shifting toward principal reduction as the loan matures.
With a DST, loan amortization allows investors to build equity in the property over time. However, paying down the principal can also reduce cash flow to investors, as there is typically no tax benefit associated with repaying a loan. To balance these considerations, many DST sponsors structure mortgages with interest-only payments for the entirety of the loan or with a period of interest-only payments followed by amortization after a few years.
When Does the Balloon Payment Occur?
Critical Risk: Forced Sales
A balloon loan is a type of financing where the borrower makes regular payments for a predetermined period, often with lower or interest-only installments, followed by a large "balloon" payment due at the end of the loan term. However, DSTs are not permitted to refinance. As a result, balloon loans typically necessitate the sale of the property when the balloon payment becomes due, which could force a sale at an inopportune time.
Balloon payments commonly occur around the tenth year of the loan term, though some may occur sooner. Investors should be aware of when the balloon payment is scheduled to assess whether there is enough time for the property to appreciate and meet their return criteria.
Are There Any Cash Traps Built into the Loan?
A cash trap, also known as a cash flow sweep, is a financial mechanism where cash flows generated by an asset are retained by the lender rather than distributed to investors. This typically occurs when specific financial covenants or conditions in loan agreements are not met, triggering the lender's right to withhold cash distributions.
Common Cash Trap Triggers:
- A drop in the property's net operating income (NOI) below a certain threshold related to the debt service coverage ratio (DSCR)
- A tenant in a net lease property ceases operations on the premises, even if they continue to pay the lease
- The approach of a lease term ends without confirmation from the tenant about renewal
- Pre-determined triggers in loan agreements that activate cash traps after a certain number of years
- Issues in a multi-property portfolio where cross-collateralization leads to cash sweeps from performing properties
Are the Properties Cross-Collateralized?
Cross-collateralization is a lending arrangement where a single loan or group of loans is secured by multiple assets. In a DST, this means that if the borrower defaults on any of the loans, the lender can seize and sell any of the collateralized assets to recover the debt.
Diversification Risk
For DST investors seeking diversification, cross-collateralization can be a double-edged sword. If investors place money into a DST with multiple properties, they may not be as diversified as they believe. If one property in the portfolio underperforms, the lender could sweep the cash flow or even foreclose on the entire portfolio, affecting all of the properties and, consequently, the investor's returns.
A Critical Look at Debt-Free DSTs
Investing in real estate through Delaware Statutory Trusts (DSTs) has gained significant traction, particularly among investors looking to defer taxes via a 1031 exchange. Debt-free DSTs, in particular, offer a unique set of benefits that can make them an attractive alternative for those seeking a more conservative approach.
Benefits of Debt-Free DSTs
No Balloon Loan Risk
Eliminates the pressure of securing refinancing under potentially unfavorable terms or being forced to sell the property in a down market, providing a more stable and predictable investment environment.
No Cash Flow Sweeps
All rental income generated by the property is available for distribution to investors, ensuring a more consistent and predictable income stream without lender-imposed restrictions.
No Cross-Collateralization
If one property underperforms, it does not impact the income generated by other properties in the portfolio, offering true diversification and greater protection against portfolio-wide risks.
Simpler Future Exchanges
Eliminates the need to replace debt in future 1031 exchanges, allowing investors to focus solely on finding suitable replacement properties without financing complications.
Potential Drawbacks of Debt-Free DSTs
Difficulty Overcoming DST Fees
While debt-free DSTs offer stability, they can also present challenges in overcoming the substantial fees associated with DST investments. Without the leverage of debt to amplify returns, the income generated by the property must be sufficient to cover these fees and still provide a desirable return to investors.
For example, single-tenant net-lease or "NNN" DSTs may struggle to overcome these fees in a typical market. If the tenant goes out of business or does not renew the lease, it could take well beyond a decade to recover the initial investment.
Considerations When Purchasing a Net Lease or NNN Syndication
Many investors are drawn to net lease real estate assets due to their allure of predictable income and minimal management requirements. When thinking of net lease properties, one might envision Walgreens, FedEx distribution centers, Amazon fulfillment centers, Chipotle restaurants, Albertson grocery stores, or other large, single-tenant commercial buildings.
Disposition Strategy
Investors should ask, "How will the property generate profit beyond covering fees?"
Net lease properties are favored for their predictability, but they typically offer limited returns beyond cash flow. Unlike residential properties, the value of net lease properties often declines as the lease term diminishes, complicating profitable sales. Potential appreciation largely depends on the tenant renewing the lease or the sponsor securing a new tenant with equal or better credit.
Tenant Risk
What happens if the tenant leaves or stops paying rent?
Sponsors often assume tenants will renew leases without considering the challenges of re-tenanting a vacant property. Finding new tenants for large, high-quality properties can be timely and costly. From a practical point of view, sometimes companies decide just not to pay.
In a DST, once the capital raise is complete, no additional funds can be contributed, necessitating substantial reserves. In contrast, a TIC can request additional funds from the investors as needed therefore requiring less of a reserve fund.
Adequate Reserves
Re-tenanting can be timely and expensive. If sponsors use investor principal to maintain reserves, this money can be taxable as "boot." Alternatively, building reserves from net operating income might reduce cash flow to unattractive levels.
If a tenant indicates that they plan to vacate, cash flow may stop for years. DSTs are not allowed to invest reserves. Therefore, by keeping more money in the investor's pocket, it empowers the investor to seek additional returns elsewhere, or keep the cash as a personal safety net for unforeseen life events.
Frequently Asked Questions
Assessing the Impact of Fees
When evaluating a DST investment, it is crucial to consider the cumulative impact of all fees. Here are some key tips for investors:
Compare Fees Across Offerings
Not all DSTs have the same fee structure. By comparing multiple offerings, investors can identify those with more favorable terms. Our vetted DST opportunities provide transparent fee disclosures to help with your analysis.
Understand Sponsor Underwriting
A sponsor with a strong track record for underwriting conservatively may justify higher fees if they consistently deliver on their proforma.
Review PPM and Third-Party Reports
Carefully review the Private Placement Memorandum (PPM) and third-party reports to understand the fees, risks, and financials.
Consult with Advisors
Engaging with financial and tax advisors is always a wise move. They can provide an independent assessment of the DST offering and its fee structure.
Conclusion
Fees in a DST are a critical factor that can significantly influence the overall profitability of an investment. By understanding the different types of fees and their implications, investors can make more informed decisions and better assess the potential returns of a DST investment.
However, fees should not be the only consideration. Investors should also evaluate how their investment could potentially overcome these fees through a sound disposition strategy and the likelihood that the sponsor will successfully execute the plan. As with any investment, due diligence and a comprehensive understanding of all associated market factors are key to developing a holistic investment strategy.
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Tax Complexity and Investment Risk
Tax laws and regulations, including but not limited to Internal Revenue Code Section 1031, bonus depreciation rules, cost segregation studies, and other tax strategies, contain complex concepts that may vary depending on individual circumstances. Tax consequences related to real estate investments, depreciation benefits, and other tax strategies discussed herein may vary significantly based on each investor's specific situation and current tax legislation. Anchor1031, LLC and Great Point Capital, LLC make no representation or warranty of any kind with respect to the tax consequences of your investment or that the IRS will not challenge any such treatment. You should consult with and rely on your own tax advisor about all tax aspects with respect to your particular circumstances. Please note that Anchor1031 and Great Point Capital, LLC do not provide tax advice.
The information contained in this article is for general educational purposes only and does not constitute legal, tax, investment, or financial advice. This content is not a recommendation or offer to buy or sell securities. The content is provided as general information and should not be relied upon as a substitute for professional consultation with qualified legal, tax, or financial advisors.
Tax laws, regulations, and IRS guidance regarding 1031 exchanges are complex and subject to change. Information herein may include forward-looking statements, hypothetical information, calculations, or financial estimates that are inherently uncertain. Past performance is never indicative of future performance. The information presented may not reflect the most current legal developments, regulatory changes, or interpretations. Individual circumstances vary significantly, and strategies that may be appropriate for one investor may not be suitable for another.
All real estate investments, including 1031 exchanges, are speculative and involve substantial risk. There can be no assurance that any investor will not suffer significant losses, and a loss of part or all of the principal value may occur. Before making any investment decisions or implementing any 1031 exchange strategies, readers should consult with their own qualified legal, tax, and financial professionals who can provide advice tailored to their specific circumstances. Prospective investors should not proceed unless they can readily bear the consequences of potential losses.
While the author is a partner at Anchor1031, the views expressed are educational in nature and do not guarantee any particular outcome or create any obligations on behalf of the firm or author. Neither Anchor1031 nor the author assumes any liability for actions taken based on the information provided herein.
