Advantages & Disadvantages of Delaware Statutory Trusts in Real Estate
As with any investment, the decision to deploy various investment strategies and structures may be advantageous or disadvantageous depending on the situation. Let’s explore how DSTs differentiate themselves and look at situations in which they may face challenges. Sponsors and investors alike must remain keen on how to best operate within the structural limitations, especially on how to avoid any red flags from the IRS.
From the real estate sponsor’s perspective, many of the advantages have already been touched on, but let’s look a little deeper. Why should DSTs be widely integrated into sponsors’ business models and offerings?
1. Access to the 1031 exchange Market
With tax law on its side, DSTs have allowed sponsors direct access to a multi-billion dollar market segment, which no prior structure has successfully allowed. Investors of all sizes and experience-levels widely use tax-deferment programs, an investor profile that has historically been left untapped by sponsors.
2. Secondary Market Recapitalization
Creative financial structures have long been leveraged as part of successful real estate deals and the way in which DSTs allow for flexibility in the capital stack is imperative to its popularity.
3. Retain Deal Control
A DSTs managing sponsor retains the final say over decisions. Other structures allow voting rights to be retained by Class B members or mandate unanimous member approval. This, as the case in TIC, can prove a major stumbling block as adverse situations arise and reaching member approval becomes an issue. “Rogue investors” present no threat to DSTs.
4. Equity Contribution Flexibility
Lower dollar contribution minimums, as well as higher individual investor limits, are two benefits enjoyed within a Delaware Statutory Trust. While the sponsor may set their own contribution minimums or investor limits, the IRS allows cash investments as low as $25,000 with no limit on the number of participants, although contributing investors are typically capped at 499.
5. Traditional Deal Fees
While sponsors are not allowed to collect preferred returns under IRS stipulations, typical fees such as property and asset management along with associated deal costs, such as acquisition and disposition fees, are regularly sought by sponsors.
While many of the pitfalls observed in other structures are absent with a DST, the IRS has outlined specific restrictions (“disadvantages”) intended to limit the use and scope made available to Delaware Statutory Trusts. These seven restrictions have been dubbed the “7 Deadly Sins”
1. Future Capital Contributuons
Once the offering is closed, there can be no future capital contributions to the DST by either current or new beneficiaries.
Sponsors combat this issue by baking in heavy reserves on the front-end raise to ensure that a lack of future capital calls does not place undue risk on the investment. Additionally, the last-grasp option of LLC conversion can offer a safety net.
2. Debt Restrictions
The trustee cannot renegotiate the terms of existing loans and cannot borrow new funds from any party unless a loan default exists as a result of a tenant bankruptcy or insolvency.
For this reason, the typical hold period of a DST is 5-7 years. The vast majority of deals will exit prior to loan maturity.
3. Lease Restrictions
The trustee cannot enter into new leases or renegotiate current leases unless there is a need due to a tenant bankruptcy or insolvency.
Net-leased assets are preferred by some in a DST structure to avoid the need to renegotiate. Alternatively, apartments, office buildings, retail centers, and other multi-tenant assets require a master lease structure to circumvent this restriction.
4. Reinvestment of Proceeds Restrictions
The trustee cannot reinvest the proceeds from the sale of its real estate.
The choice is retained by each investor to decide how to handle individual sale proceeds.
5. Limitation of Capital Expenditures
Capital expenditures concerning the property are limited to normal repair and maintenance, nonstructural capital improvements, and those required by law.
Reserves, when underwritten correctly, can handle capital repairs. These reserves are often mandated by the lender. Alternatively, a back-end raise can allow for major capital improvements to be addressed prior to DST ownership transfer. It is important to note, a DST is not an appropriate structure to utilize when seeking a redevelopment.
6. Restrictions on Investing Reserves
Any reserves or cash held between distribution dates can only be invested in short-term debt obligations.
This is to ensure the safety and readiness of the investors’ capital.
7. Distribution Requirements on Cash
All cash, other than necessary reserves, must be distributed on a current basis.
A true pro-rata share is required, and regular cash flows must abide as well.
Now let’s review the reasons Delaware Statutory Trusts are attractive to the individual real estate investor.
1. 1031 exchange-Friendly
As previously mentioned, the single most notable trait of DSTs is its status as a qualified replacement property program. This means that…
2. Passive Income
With major decisions left up to the Managing Sponsor, DSTs offer investors management-free investments – true mailbox money. Because decision making is outlined within the trust agreement, DSTs offer a more centralized, nimble, and decisive ownership structure that effectively mitigates any “rogue investor” risk factor.
3. Real Property Interest
Opposite to REITS, land-leases, and other passive ownership structures, DSTs pass tax benefits of real property interest down to individual investors. Owners receive their proportionate share of all income, tax deductions, and appreciation.
4. Access to Institutional-Quality Assets & Management
DSTs allow individual investors to invest in large, institutional-quality investment properties with professional management otherwise outside of their scope. Additionally, DSTs can be used to invest across an entire portfolio of assets. This type of diversification within direct investments is otherwise difficult and expensive to achieve.
5. Limited Personal Liability
Lenders view the Trust as the sole borrower. There is zero need for the lender to approve individual investors and therefore, no need for personal guarantees or “bad boy carve outs.” This effectively makes the financing process nearly nonexistent for individual investors. This reduces financing costs while allowing for more attractive, non-recourse options.
We set out to answer the following two questions: What is a Delaware Statutory Trust? And, how to form a Delaware Statutory Trust?
Thanks to a comprehensive review of how real estate sponsors, investors, and the IRS view DSTs, you should confidently understand the important role they serve in today’s market and appreciate the niche segment DSTs have evolved to serve. DSTs check a lot of boxes for all participating parties and have proven to be one of the most adaptable solutions present in the market today. It is no surprise DSTs appear primed to continue their dominant share of securitized real estate and replacement property program.