When a commercial property is sold, the difference between the investor’s cost basis and the sales price is classified as a “capital gain” and it is taxable. Fortunately, real estate investors have options to reduce or defer this tax bill. One such option is to take the sales proceeds and reinvest them into a “Delaware Statutory Trust” (DST).
In this article, we will define what a Delaware Statutory Trust is, describe the tax benefits of investing in one, and review the potential returns that they offer. By the end, readers will have the information needed to determine if a DST investment is a good fit for their real estate investment objectives.
At First National Realty Partners, we actively work with our investors to minimize tax liability whenever possible. To learn more about our current investment opportunities, click here.
What is a Delaware Statutory Trust?
As its name implies, a Delaware Statutory Trust is a trust, organized under Delaware law, and set up for the purpose of conducting business. They are formed with private trust agreements under which real property is “…held, managed, administered, invested, and/or operated.”
In a commercial real estate investment context, the trust is set up by a “sponsor” which is usually a large, experienced real estate firm who finds an investment property, performs the due diligence on it, arranges the debt, and places it under contract. Then, they will find individual investors to fill the equity portion of the DST Offering’s capital stack.
There are many reasons why an equity investor would be interested in a DST property, but one of the most common is for tax purposes. This is because IRS Revenue Ruling 2004-86 states that a DST investment qualifies as a “like kind replacement property” in a 1031 Exchange. Practically, this means that individual investors can defer capital gains tax liability by reinvesting the proceeds from a profitable sale into a DST.
NOTE: DST investments are only available to accredited investors, who meet certain income and net worth requirements.
Pros and Cons of Investing in a DST
Like any real estate investment opportunity, there are pros and cons to making a DST investment. The pros include:
- Taxes: The primary benefit of the DST investment option is the tax deferral associated with using it as a replacement property in a 1031 Exchange.
- Property Quality: DST investors gain fractional ownership of institutional quality commercial properties.
- Cash Flow: DSTs are a passive investment, which means that the sponsor handles day to day management of the property. As such, they earn passive income from regular distributions.
- Diversification: Given their relatively low minimum investment amounts, DST investors can purchase an interest in multiple properties, which can diversify their portfolio across property type, location, market, and size.
- Liability: DST investors benefit from limited liability on a personal level because the property is held in a separate legal entity with a defined ownership structure. In addition, many DST transactions are financed with non-recourse debt, which further limits individual investor liability.
- Estate Planning: As an investment vehicle DSTs can be passed to beneficiaries upon death.
But, there are potential downsides too. They include:
- Illiquidity: DST investments often require that real estate investors make a five to ten year commitment. During that time, there is no liquidity.
- Fees: DST sponsors do not work for free. They charge DST fees to pay for the administrative overhead required to find, finance and manage the investment property.
- Involvement: Individual investors have no say in the day to day management decisions of a DST property. All management responsibilities are handled by the DST sponsor and if there are any disagreements, the sponsor will prevail.
- Additional Capital: Once the deal is closed. DSTs are not allowed to raise additional capital. Major repair and maintenance costs must be paid from reserves. If there are not enough funds in reserves, they will be paid from operating profits. In a worst case scenario, a big ticket cost can wipe out months or years of operating profits.
Potential DST investors should weigh the pros and cons of a DST investment to determine if they are a good fit for their own objectives. But, DST rules can be complex so it is always a best practice to speak with a real estate investment advisor or CPA to ensure there is proper understanding of DST tax benefits and the rules that must be followed to realize them.
DST Investment Returns Explained
Like any commercial real estate asset, DST returns come from two sources, income and appreciation.
Income is generated from the rental property’s leases. Per the lease agreement, each tenant pays a certain amount of rent each month in return for the right to occupy a certain space in the property. That income is first used to pay for the property’s operating expenses like property management, taxes, insurance, depreciation, maintenance, and debt service. If there is any money left over, it is distributed to investors. In most cases, this creates a consistent, steady source of passive income for real estate investors, but this is not where the large gains come from.
Commercial properties are valued based on the amount of net operating income they produce (income less expenses). Over a long period of time, income tends to increase faster than expenses, which means that the net operating income (NOI), and the property’s value appreciates. Over time, property appreciation can be significant and typically makes up the bulk of returns. However, it is not realized until the investment property is sold at the end of the planned holding period, which is why many DST sponsors require a 5-10 year commitment.
Combined, these two sources can offer DST investors a healthy annual return, which can be measured using a variety of methods.
Measuring DST Returns
DST Returns are measured the same way as those for a traditional commercial real estate asset. Of note, there are three metrics that deserve special attention:
Cash on Cash Return
The ratio of the cash received in a given year to the total cash invested represents the property’s annual cash on cash return. For example, if a real estate investor receives $10 in the first year of a $100 investment, the cash on cash return is 10%. Cash on cash returns can vary widely by deal, but 6% – 10% annually is generally considered to be good.
Internal Rate of Return
A property’s internal rate of return is the discount rate that sets the net present value of all future cash flows equal to zero. The formula used to calculate it manually is complex. Instead, it is most frequently calculated using a property’s pro forma cash flows and the IRR function in a spreadsheet program. Again, the IRR can be dramatically different from one deal to another, but 10% – 15% is generally considered to be good.
The equity multiple is the ratio of total cash received from a real estate investment to the total cash invested. For example, if an individual received $200 from a $100 investment, the equity multiple would be 2.0X, which means that the investor doubled their money. An equity multiple above 2.0X is generally considered to be good.
It is important to note that individual real estate investor needs and return requirements can vary. The return ranges described above are for reference only. In reality, one investor may view a deal as favorable while another may demand a higher return. For this reason, each individual should consider their own real estate investment objectives and look for DST opportunities that are a good fit with them.
DST Returns & Private Equity Real Estate
Because of the operational complexity associated with DSTs, they are organized by a sponsor who has expertise needed to stand up the investment. DST sponsors may or may not be a private equity firm. If they are, it is important to note that private equity firms have specific operational expertise and can leverage real estate industry relationships to drive returns for the property.
Again, this is a general range, but DST investments offered by private equity firms tend to have returns in the range of 10% – 20% annually.
Summary of Delaware Statutory Trust Returns
A Delaware Statutory Trust is a specialized type of entity that is formed specifically for the purpose of real estate investment.
Investors like DSTs because they qualify as a like kind replacement property in a 1031 Exchange, which means that funds from the profitable sale of a property can be invested in a DST to defer tax liability.
DST returns can vary widely by property type and location, but they are typically measured using three key metrics: Cash on Cash Return, IRR, and Equity Multiple.
Given their operational complexity, DSTs are typically offered by a real estate investment sponsor, which may or may not be a private equity firm. If they are, they may be able to drive higher returns through their operational expertise and industry relationships.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.