Gregory Hill, Prime 1031 Exchanges

As baby boomers enter retirement, many tend to shift away from the active management of investment properties. In this market, securitized real estate has found a new and growing niche. In 2015, for the first time in six years, securitized real estate sponsors raised more than $1 billion in equity, a significant increase from the $229 million raised in 2009. This influx has given rise to several new real estate sponsors. As a result, the current real estate investment options are quite diverse. Portfolios specializing in assets ranging from student housing, health clubs, medical facilities, and beyond are no longer uncommon.

DST Basics: Delaware Statutory Trusts, more commonly known as ‘DSTs’, were codified by the IRS on August 16, 2004, via Revenue Ruling 2004-86. The ruling confirmed that this form of securitized real estate was acceptable as a replacement property under IRC 1031 – a watershed moment for real estate investors. Exchangers were no longer constrained by location, property type or investment size, and no longer limited to a 100% fee simple ownership profile property. The ruling allowed exchangers to buy a fraction of one or more properties to perfect their exchange. The line between traditional real estate investing and purchasing a Delaware Statutory Trust became nearly indistinguishable.

DSTs are fully constructed portfolios of commercial real estate, usually $5 million to $50 million in size. These portfolios often focus on a specific sector. Triple net retail, medical office, and multi-family housing are three popular areas. This form of securitized real estate is very well suited for investors looking for passive management, monthly income, non-recourse debt, and potentially investment-grade tenants. 

Management Responsibilities: Properties in Delaware Statutory Trusts are usually acquired by established real estate sponsors and packaged to suit the needs of fractional interest investors. Depending on the types of properties in the Trust, sponsors may handle management of a given portfolio themselves, or hire a qualified third-party to service the properties. The investor, by design, has no management responsibilities when purchasing a DST. This resonates with many Exchangers who are ready to escape the “Three T’s”-- toilets, trash and tenants.

Financing – Non-Recourse to Investors: Individual investors often have difficulty obtaining financing. Many lenders require high interest rates, cross-collateralization, or even a personal guarantee. This hurdle is negated when purchasing securitized real estate. DST sponsors generally enjoy better financing terms, such as lower rates and faster amortization. Additionally, financing used in a DST is secured solely by the properties themselves. It is non-recourse to fractional interest investors, limiting liability to their initial investment.

Employing leverage allows the Trust to acquire more properties and thus increase cash flow. Compare two similarly structured portfolios:

• DST-A has $10 million in equity and purchases properties on an all-cash basis.

• DST-B also has $10 million in equity but uses 50% leverage, allowing it to purchase $15 million of real estate.

Both portfolios have national retail tenants, with strong credit ratings, signed to long-term NNN leases.

The all-cash portfolio will likely have a starting cash flow of approximately 5%, while the leveraged portfolio is likely to start around 6.5%. On a hypothetical $500k investment, the difference amounts to approximately $7,500 annually.

We have been here before, whenever dollars begin pouring into an asset class look for plump fees, inflated mark-ups, and overly optimistic projections. Financial engineering in the form of ploys like interest-only loans rather than amortizing debt should be cause for further scrutiny. Remember, investors will need to sell these assets at a profit in the future. Too many, upfront fees, limited debt reduction, or choosing an asset class that falls short of projections, are a few of the potential pitfalls.

This is a billion dollar plus industry…and growing. There are countless opportunities that can potentially provide viable solutions for investors looking to unburden themselves from some or all of the rigors of active real estate ownership. If diversification with professional management is attractive to you, and the burden of active management has become tiresome, this ownership format might well be worth exploring. Happy investing.

Gregory Hill is managing partner at Prime 1031 Exchanges, Pittsburgh, PA.