Delaware Statutory Trusts (DSTs) have become a popular investment vehicle for real estate investors, particularly those utilizing 1031 exchanges. They offer the allure of passive income potential, tax deferral, and access to institutional-grade properties. However, like any investment, DSTs come with their own set of risks. Two significant concerns are 1) concentration risk in a single asset class or single sponsor 2) temptation of chasing claims of high distribution yields. This blog delves into these issues and provides strategies to attempt to mitigate them.
Understanding Concentration Risk in DSTs
Concentration risk arises when a significant portion of an investment portfolio is allocated to a single asset class or to single DST sponsor – especially those sponsors who lack a significant track record of full cycle DSTs i.e., DSTs that have consistently met distribution projections during the holding period and resulted in profitable gains for investors upon sale. In the context of DSTs, this means avoiding investing heavily in one property type, geographic location, or sponsor. While DSTs allow for fractional ownership of large properties, investors may be tempted to invest in a single property or a limited number of properties. This lack of diversification can expose investors to localized risks such as economic downturns, natural disasters, or tenant defaults in a specific area, or sponsor management issues.
Risks of Claims of Potential High Distribution Yields
DSTs typically offer the potential for predictable annual distributions, with the potential for additional appreciation. However, some DSTs advertise the potential for high distribution yields exceeding the rate that sponsors typically target. While these yields can be attractive, they often come with increased risk. High yields may be indicative of investments in lower-quality properties, such as Class B or C assets, properties in less desirable locations, or asset classes such as hospitality, student housing, or raw land that can experience more volatility during economic downturns. Additionally, these high yields if achieved at all, may not be sustainable over the long term and could decrease over the holding period.
Diversification Strategies to Attempt to Mitigate Risks
Asset Class DiversificationInvesting across different property types can reduce exposure to sector-specific risks. DSTs offer opportunities to invest in various asset classes, including multifamily, retail, office, senior care, industrial, and hospitality properties. By spreading investments across these sectors with a focus on DST sponsors with significant track records and in asset classes that have historically been less impacted by economic downturns, investors can strive to buffer against downturns in any single market segment.
Geographic DiversificationEconomic conditions and real estate markets can vary significantly across regions. By investing in DSTs located in different geographic areas, investors can mitigate risks associated with local economic downturns, natural disasters, or regulatory changes. Geographic diversification helps improve the chances that a downturn in one area does not disproportionately affect the entire portfolio.
Sponsor DiversificationThe performance of a DST is heavily influenced by the sponsor's expertise and track record. Relying on a single sponsor can expose investors to risks if that sponsor encounters financial difficulties or operational challenges. Diversifying investments across multiple reputable sponsors is intended to help reduce this risk and provide access to a broader range of investment opportunities.
Evaluating Distribution Yields CarefullyWhile claims of high distribution yields can be appealing, they should be scrutinized carefully. Investors should assess the sustainability of these yields by examining the property's location, tenant quality, lease terms, and the sponsor's track record. It's essential to understand that higher yields if achieved at all, often come with increased risk, and a balanced approach may be more prudent.
Understanding Fee StructuresDSTs can have various fees, including acquisition, management, and disposition fees. These fees can impact the net returns and should be considered when evaluating an investment. It's crucial to understand the fee structure outlined in the Private Placement Memorandum (PPM) and how it affects the overall investment performance.
Conclusion
While DSTs offer the potential for attractive benefits such as passive income and tax deferral, it's essential for investors to be aware of the risks associated with concentration and claims of high distribution yields. By implementing diversification strategies across asset classes, geographic locations, and sponsors, and by carefully evaluating targeted distribution yields and fee structures, investors can strive to mitigate these risks and build a more resilient real estate portfolio.
As with any investment, thorough due diligence and a clear understanding of the associated risks are paramount to your efforts to achieve long-term financial success.
Please contact the specialists at First Guardian Group at to learn more about risk mitigation strategies before committing funds to a DST or other real estate investments. You can email us at info@firstguardiangroup.com or schedule a no-obligation consultation today!
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