No investment is 100 percent risk-free, and DSTs are no different. I’ve witnessed hundreds of clients experience relief, elation, excitement, and a dramatically improved lifestyle after they’ve exchanged their traditional investments for TICs or DSTs, but they do so with full awareness of the attendant risks. We would be doing you a disservice if we didn’t offer you a thoughtful and cogent analysis of the risk factors as well.
There are four main risks associated with DSTs: real estate risk, operator risk, interest rate risk, and liquidity risk. At the end of this section, you will find a list of additional risks involved in DST investing. The most you can lose in a DST is the equity you used to purchase the investment. The loan on your property is non-recourse to you.
Real Estate Risk
While it is regulated and sold as a security, at its core, DSTs are real estate, and the risks of any real estate investment apply. Real estate risk in this context is exactly equivalent to the real estate you presently own, including your own home. The local market can drop, the economy can decline, or a tornado can cut a swath through the town. All of these events will affect the condition, income and expense, and eventual sales price of the property.
While no one has a crystal ball, there are ways to proactively mitigate these kinds of risks. Ensuring you have a well-diversified portfolio in markets that are growing is one way to mitigate real estate risk. And don’t underestimate the importance of spending sufficient time at the outset to ensure the property is a good investment. Is it in the middle of tornado alley? Sitting on a fault line? Perched precariously on the coastline where hurricanes strike regularly? If the answer to any of these questions is “yes,” be certain that the property insurance protects against such catastrophes.
Operator Risk
Poor management is another common risk in all real estate. When the property is not managed at an optimal level, return is always affected. Both a Property Manager and an Asset Manager manage DSTs, and each are assigned to different roles.
A quick review of how management duties are divided: the Property Manager’s job is to implement the business plan, increase income and lower expenses. As a result, net operating income will increase over time. The Asset Manager watches the property as if he owned it himself, managing the Property Manager with the same goal of increasing net operating income as much as possible, which increases your cash flow and appreciation potential. The Asset Manager also watches the market for sales opportunities and decides when it’s time to sell, reports to investors periodically, and is responsible for keeping the investors abreast of what’s going on with the property and answering any questions.
Operator risk spikes if the Property Manager or Asset Manager isn’t doing a good job, or—worst-case scenario—if there is fraud involved. But again, you do have some control over this potential risk. While you can’t account for the idiosyncrasies of human behavior, you can make a point of only working with highly experienced Sponsors, ones with excellent track records and sterling reputations. Have candid conversations with the people who will be in charge of your investment, and determine for yourself whether they have the character and experience to make sound judgments in your best interest.
Interest Rate Risk
We do everything humanly possible to control real estate and operator risk through our due diligence. Interest rate risk is a little different. This type of risk varies, depending on the type of DST you select. It’s easiest to demonstrate in the retail space.
One of the attractive elements of triple net retail investments is having long-term leases in place with major tenants. Turnover will be slight, and the corporation guarantees the lease payments. In such a long lease, the lease payments don’t increase very frequently, perhaps every five years, and they only increase a small amount. The terms of your lease dictate yield and cash flow.
If your retail property has a 10 year lease with a yield of 5 percent, and five years from now all other comparable properties on the marketplace have leases in place that allow for a yield of 7 percent or 8 percent, you’ve lost potential income. The same long-term fixed lease that gives you security and keeps the yield from shifting downward with the market also doesn’t allow the yield to shift upward. It’s entirely possible that you won’t keep up with inflation.
This risk is most often seen in retail and office properties, the ones that lend themselves to longer-term leases. One of the ways to control this risk is to invest in multifamily apartment DSTs or smaller retail units, because rents can be raised or lowered with the market. Of course, if the local marketplace doesn’t allow raising rents, you will remain at the same yield level and length of lease, but you have much more opportunity to make adjustments with shorter-term leases.
Liquidity Risk
DSTs are illiquid investments. When you consider that you likely have held your current investment real estate for more than seven years, an anticipated hold period for DSTs of five to seven years on average doesn’t seem so long. The hold period could be shorter or longer, depending on market conditions. There is currently no secondary market for DST ownership shares. The industry has no “multiple listing service” as in traditional fee simple real estate ownership. It is possible to sell your shares back to the Sponsor or to another investor in the DST, however, it is likely the shares would sell at a discount, not a premium to the purchase price you originally paid. We inform our investors that this is a long-term investment, just like their relinquished property in their 1031 exchange.
Navigating real estate risk, operator risk, interest rate risk and liquidity risk can be tricky, but less so when you’re armed with the appropriate experience and expertise. It’s essential to have an experienced professional guide you through the process. With a proper understanding of all the variables at play, these risks can be greatly reduced.
Additional Risks…
Suitability
DST investments may not suitable for all investors.
Fees and Expenses
There are fees associated with acquiring DSTs. Making the property available to multiple owners incurs expenses—including but not limited to brokerage fees and marketing, for example. In some cases these fees might even outweigh the benefits of tax deferral.
Conflicts
Registered Investment Advisors have a fiduciary duty to act in the best interests of their clients. However, brokers are not required to abide by such fiduciary standard and do not have to place a client’s interests above their own.
Past Performance
Past performance doesn’t ensure future performance. Property appreciation and projected income are not guaranteed. You may lose equity in this investment.
Tax Status
According to the IRS and Revenue Ruling 2004-86, 1031 exchanges completed through a DST are structured investments. This revenue procedure includes guidelines for taxpayers preparing ruling requests. They are only guidelines, however, and are not intended for audit purposes. Also, laws change, which means that different tax provisions may come into play, creating liabilities and penalties.
The Seven Deadly Sins
DST trustees are prohibited from committing any of the following actions:
- Accept contributions to the DST after the period for soliciting investments is over.
- Renegotiate the terms of existing loans or borrow new funds.
- Reinvest proceeds from real property sale or acquire new real property.
- Invest any cash to profit from market fluctuations.
- Make any unnecessary property modifications unless required by law.
- Renegotiate any master lease or enter into a new lease on the property.
- Fail to distribute cash profits regularly.
Conclusion
Risks are inherent in any type of investment. Please keep these points in mind when making investment decisions. This material is also not intended as legal or tax advice. Please consult with your accountant and attorney to ensure you are making the best decision for your circumstances.
This is neither an offer to sell nor a solicitation of an offer to buy any security which can only be made by prospectus. Investing in real estate and 1031 exchange replacement properties may not be suitable for all investors and may involve significant risks. These risks include, but are not limited to, lack of liquidity, loss of principal, limited transferability, conflicts of interest and real estate fluctuations based upon a number of factors, which may include changes in interest rates, laws, operating expenses, insurance costs and tenant turnover. Investors should also understand all fees associated with a particular investment and how those fees could affect the overall performance of the investment. Employees of Archer and LightPath Capital, Inc. do not provide tax or legal advice, as such advice can only be provided by a qualified tax or legal professional, who all investors should consult prior to making any investment decision. Archer is a branch office of LightPath Capital, Inc. Securities offered through LightPath Capital, Inc. Member FINRA/SIPC.
Risks of 1031 Exchange
Section 1031 of the Internal Revenue Code allows an investor to defer the payment of capital gains taxes that may arise from the sale of a business or investment property. By using the proceeds of the sale to purchase “like-kind” real estate, taxes may be deferred, as long as the investor satisfies certain conditions.
If the strict timeline and procedural rules are not followed, the 1031 exchange may be disqualified. Also, there is no guarantee that the IRS will approve each individual exchange, nor that tax law will not be altered in the future, nor that the IRS will not change their application of present law to future cases. Finally, the full scope of tax related risks can only be determined in counsel with the client’s personal tax advisor, taking into account all the facts and circumstances of that client’s tax situation and the specific laws of the state where they reside. The acquisition of interests in a DST may not qualify under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”) for tax-deferred exchange treatment.