Understanding DST Structure & Costs

There comes a time for most investment property owners when actively managing investment property no longer fits their objectives. We write and consult extensively about various options owners have available to them to eliminate active management, each of which has respective strengths and weaknesses. One popular option for individuals, who prioritize preservation of capital and predictable income potential, is to perform a tax-deferred 1031 exchange into a diversified portfolio of high-quality institutional Delaware Statutory Trust (DST) real estate. The are several benefits associated with exchanging into a portfolio of DSTs (for a refresher, see our article entitled, “Why Consider Exchanging into Delaware Statutory Trusts?”). When discussing DSTs with owners, we regularly hear misconceptions about how DSTs are structured, and the costs associated with the exchange. Below is overview of the structuring process and fee structure:

DST real estate qualifies as “like-kind” for 1031 exchange purposes because the property is specifically identifiable and ownership is considered “direct ownership” by the IRS (see IRS Revenue Ruling 2004-86), even though an investor’s ownership is of a “fractional interest”. National real estate firms, referred to as “DST Sponsors”, use their own balance sheet to acquire the property(s) to be structured within the trust. The acquisition process includes analyzing often hundreds of properties before a select, few offers, are submitted. Even fewer properties will ultimately be placed under contract and eventually acquired. Once acquired, the DST Sponsor will structure the actual trust. The structuring includes the following steps:

• Performing an engineering analysis to determine the useful life of all components of the property (e.g. roof, HVAC systems, parking lot, siding, etc.) and any deferred maintenance that the trust must collect reserves for to fund future expenditures.
• Securing long-term debt (generally 10-year fixed rate debt) for the trust, if applicable.
• Commissioning an independent third-party due diligence report to vet the market and property assumptions as well as the rent and expense growth assumptions used in the financial projections.
• Commissioning a legal and tax opinion from a reputable tax law firm to attest to the fact that the trust will qualify for 1031 exchange purposes.
• Construction of the offering memorandum so that the trust complies with applicable securities law as set forth by the Securities and Exchange Commission (SEC).
• Performance of due diligence by the diligence team of a registered broker-dealer.

Naturally there are costs associated with these steps. The result is that investors can access high-quality institutional investment property that has been professionally underwritten, analyzed and acquired and will be professionally managed. Furthermore, investors can combine multiple DSTs together, creating a customized portfolio that is tailored to their specific objectives. The structuring costs are fixed within the offering. There is one variable cost, the compensation paid to the entity that holds the required securities licenses to transact the DSTs on behalf of an investor.

Compensation for DST placement can be structured two different ways. The compensation approach that is best for an investor depends on the investor’s objectives and personal financial situation. Traditionally, representation is compensated through a one-time commission paid by the DST Sponsor to the representative at the time of the exchange. This approach is consistent with the approach most investment property owners are accustomed to when working with commercial real estate brokers. Additionally, the commission amount is consistent with commercial real estate brokerage commissions. The alternative approach is to defer the one-time commission, thus increasing the amount of ownership the investor acquires in the DST property, and instead charging an annual management fee that is taken out of the potential cash flow produced by the DST property. Both options should be available to investors, below is a comparison of each approach.