It is very common for investors who are first learning about DSTs to be initially attracted to properties that offer the highest current distribution rate or cash flow. While distribution rates are an important consideration in selecting investments, more experienced risk-averse investors tend to consider other factors ahead of the reported current cash flow.
Among them are the following:
Sponsor Track Record
When DSTs were first made available to investors in 2004, as active managers of real estate nationwide, we were skeptical over giving up full management control to DST sponsors that had not yet established a track record of successfully managing and ultimately selling DSTs. It was not until we saw how certain sponsors were able to successfully navigate the deep 2008 – 2009 recession that we began to develop confidence that this form of investment might be appropriate for certain of our clients.
Today we have over 30 firms in the US that sponsor and manage DSTs – and most of them have limited track records. Fortunately, we have access to the full track records of most DST sponsors and can evaluate and compare their prior performance with other sponsors.
We encourage our clients to be wary of new industry entrants since managing a DST can be more complex than managing traditional real estate due to limitations on raising capital if unexpected conditions develop. As an example, a DST sponsor is not allowed to obtain additional funds from DST investors, nor can they obtain additional financing from a lender if a cash crunch develops. DSTs must be managed in a way that all expenses can be funded either from operations or reserves that were set aside when the DST was created. Also, if there is a loan on the property, the DST sponsor is the sole guarantor of the loan and the lender may have recourse against them in the event the DST fails to meet loan obligations.
Fortunately, there are now a number of DST sponsors who have excellent track records spanning multiple years of operating DSTs and these more experienced sponsors are most often selected by our clients even if the distribution rates for their offerings may be less than that of a newer DST sponsor who may be offering a higher yielding DST in order to establish a track record.
Most DST investors have a preference to invest in asset types that perform well in tough times. Residential properties such as apartments and single-family rentals fare better in recessionary periods since tenants are generally highly motivated to pay rent to keep a roof over their head. Select storage, necessity retail e.g., supermarkets, and industrial warehouses e.g., Amazon warehouses also have performed well in tough times. By contrast income from hotels, conventional retail, commercial office, and discretionary service providers e.g., elective surgery centers are more negatively impacted when the economy is not doing well.
Due to the relatively higher demand for recession resistant properties, distribution rates will generally be lower for less volatile properties than for properties whose income streams may be reduced during recessions.
Location, Location, Location
I owned my first rental properties where I grew up in the Midwest. While I was able to obtain good cash flow, I discovered that properties in the area where I lived did not increase in value at anywhere near the rate of properties located in warmer coastal locations such as California. By contrast, when moving to California, our first rentals had negative cash flow that required that we invest additional capital until we could sufficiently raise rents to cover expenses. Even today, those of us that invest in California rental properties typically are investing for appreciation and not income.
DST investors are generally looking for a balance of acceptable income with at least a return of their original capital at time of sale or, better yet, with appreciation of their property over the holding period.
Fortunately, there are many areas in the US where select rental properties can provide investors with both attractive cash flow and appreciation. At the top of the list are growing cities offering multiple employment options in low-tax landlord friendly states such as Texas, Colorado, Tennessee, and the Southeast portion of the US from Florida up through Georgia, the Carolinas, and Virginia. The vast majority of DSTs are found in these areas.
Impact of Depreciation Write-offs
As the old saying goes, it is not how much you make, but how much you keep. One of the largest potential tax write-offs currently available to real estate investors is the depreciation deduction on their property. There are important differences in comparing DST distributions which become more apparent in looking at after-tax income.
Per IRS rules, residential real estate e.g., apartments can be depreciated over 27.5 years. The allowed depreciation schedule for commercial properties such as office and retail buildings is generally 39 years. Due to differences in allowed depreciation, a commercial building that has a reported distribution of 6% may deliver after tax income which may be comparable to an apartment property distributing 5%.
If you are comparing different asset classes, be sure to ask your advisor to assist you in comparing potential after-tax income.
As I wrote in a previous blog, many investors are growing increasingly nervous over concerns about the possible impact of inflation on their investments. During extended periods of higher inflation, investors will tend to reallocate funds into assets that allow rents to be quickly raised to market rates. Properties that are perpetually leased such as apartments, single-family rentals, storage, and senior living are generally preferred over properties with long term fixed leases that limit rent increases such as commercial office, retail, industrial, and healthcare.
Real estate investors should also take personal considerations into account when deciding which properties to acquire. Investing in a property near where a relative or friend lives or in an area that you wish to occasionally visit is a valid factor to consider – and might help increase your after-tax income since the business-related portion of cost incurred to visit your investment properties can be a legitimate tax write-off.
While it is natural that most first-time DST investors will be initially attracted to those properties offering the highest current yields, several factors including those discussed in this blog should be considered before making any final investment decisions. As many of us learned when making our first investments, the adage that “the higher the reward, the higher the risk” is more often correct than not.
In working with thousands of real estate investors over our many years in business, we have found that no two investors are exactly alike, and that each investor will weigh factors related to investment decisions differently. We strive to expose our clients to all pertinent facts that have in hand and help them understand trade-offs in making final investment decisions.
For more information on how to select suitable real estate investments, please contact us at 408 392-8822 or info@FirstGuardianGroup.com.