Problems with DSTs: The Truth About Delaware Statutory Trusts

November 21, 2024 • 12 min read

A Delaware Statutory Trust (DST) is a structure where multiple investors own portions of a property together. DSTs are often used for 1031 exchanges when selling other properties. However, before investing, it’s crucial to understand the potential challenges and risks involved.

Below, we'll break down Delaware Statutory Trust disadvantages for investors who are interested in what they’re getting into.

The #1 Problem With DSTs Not Being Discussed

The biggest problem with investing in a DST is that the industry is full of those who are beholden to specific sponsors or specific DSTs. Additionally, there are many qualified intermediaries who work directly with others as a way to "capital raise” for their deals. This is not to say they are doing something wrong, but rather to inform you of these relations and protect you from making an uninformed decision.

That being said, trustworthy people recommend trustworthy people so this does not only relate to Delaware Statutory Trust problems but also for investments in general.

Sponsor (Manager) Problems

The quality of the sponsor or manager plays a crucial role in your investment, but not all sponsors are equal:

  • Sponsor Quality Issues: Some sponsors lack the experience or expertise needed to manage a property effectively. Additionally, conflicts of interest may arise if the sponsor prioritizes their own gains over those of the investors. It's hard to verify the sponsor's track record, and if they fail, your investment could suffer significantly. Choosing the right sponsor is crucial for DST investors looking to minimize potential problems with Delaware Statutory Trusts.

  • Management Problems: You cannot replace an underperforming manager or make changes to improve operations. You are entirely reliant on the sponsor's management skills, and if they fail to execute an effective strategy, the property and your returns may suffer. This is a significant risk for passive investment strategies like DSTs.

Illiquidity: Selling Is Not Easy

One of the most significant downsides of DSTs is their illiquidity. If you need to exit your investment, you will face considerable challenges:

  • No Real Market for Selling Shares: There is no established secondary market for DST shares, which makes it extremely difficult to sell your share if you need cash. Unlike stocks or REITs, finding a buyer for a DST share is challenging, and you may have to sell at a significant discount if you can find a buyer at all. The lack of a secondary market is a major disadvantage for DST investors seeking flexibility.

  • Long Investment Lockup: DST investments typically require a commitment of 5-10 years. During this time, you have no early exit options, meaning your money is tied up regardless of personal financial needs or changes in market conditions. This long-term lockup is problematic if you need access to your capital.

  • Hard to Transfer Ownership: Transferring DST shares can be legally complex, with significant costs and a limited pool of eligible buyers. The transfer process is cumbersome, which further limits your liquidity options. For real estate investors looking for more flexibility, this illiquidity is a significant disadvantage of Delaware Statutory Trusts.

Market Risks

DST investments are exposed to market risks, and their structure makes it difficult to mitigate these risks effectively:

  • Single Property Risk: DSTs typically involve a single property, meaning your entire investment is tied to that one asset. If the property underperforms due to management issues or external factors, there are no other assets in the DST to balance out the losses. This lack of diversification makes DSTs riskier compared to other real estate investment options, such as REITs or real estate investment funds.

  • Location Problems: Because a DST property is tied to one location, local economic issues, such as declining neighborhood conditions or unfavorable changes in the local economy, can significantly impact your investment. You can't move the property or diversify away from local risks. This concentration risk is one of the main problems with Delaware Statutory Trust investments.

  • Property Type Problems: If the property type becomes less popular (e.g., retail properties during a shift to online shopping), you are stuck. The DST structure does not allow for adapting the investment to more promising property types, which could leave you with a property type that is underperforming. This rigidity is a key disadvantage for real estate investors looking to adapt to market trends.

Income Risks

The income from DST investments is also subject to various risks, and you have limited tools to address these risks:

  • Tenant Issues: If tenants fail to pay rent or leave, there is limited flexibility to find new tenants or renegotiate lease terms. This can lead to prolonged vacancies and significant income losses, especially if the leases are outdated or not competitive in the current market. Income risks are a common issue for DST investors, particularly in the case of short-term market disruptions.

  • Vacancy Problems: Restrictions on making property changes can make it difficult to fill vacant space. You can't adapt the property to make it more attractive to new tenants, which can lead to long periods of vacancy and loss of income while fixed costs continue. This lack of flexibility to manage vacant properties is a significant disadvantage of DSTs.

  • Cost Increases: Operating costs, such as maintenance, property taxes, and utilities, may increase over time. However, the rent collected may be fixed or insufficient to keep up with these rising costs, putting pressure on the investment's cash flow. The inability to adjust rents to match rising costs is one of the major problems with Delaware Statutory Trust investments.

Debt Problems

Debt is often a key component of DST investments, and it comes with its own set of risks:

  • High Debt Levels: Many DSTs rely heavily on debt to finance property purchases. This leverage increases the risk, as high mortgage payments can eat into the income generated by the property, especially during times of reduced occupancy. High debt levels are a significant DST problem, particularly when market conditions are unfavorable.

  • Interest Rate Risk: Since refinancing is not an option, you are stuck with the original interest rate. If interest rates drop, you cannot take advantage of lower rates, which could result in paying more than necessary on the mortgage, reducing overall returns. This lack of refinancing flexibility is a key disadvantage for DST investors.

  • High Fees: DSTs often have significant fees, including upfront fees (sometimes 8-15% of your investment), ongoing management fees, and fees at the time of property sale. These fees can significantly reduce your returns and make the investment less attractive. The costs associated with a private placement memorandum can further eat into your returns, making DST investments more expensive than initially expected.

Lack of Control

When you invest in a DST, you give up almost all control over the property:

  • No Decision-Making Power: You have no say in decisions regarding property management, leasing, financing, or selling. All decisions are made by the sponsor, and you must accept their strategy and choices, even if you disagree. This lack of control is one of the biggest disadvantages of Delaware Statutory Trust investments.

  • Limited Transparency: You receive limited information about the property and its operations. You are dependent on the sponsor for updates, and it may be challenging to verify their claims or get a clear picture of how the property is performing. The limited transparency is a common complaint among real estate investors considering DST investments.

Tax Problems

While DSTs are often used for 1031 exchanges, they come with specific tax-related risks:

  • 1031 Exchange Requirements: To successfully complete a 1031 exchange, you must meet strict timing rules, invest the correct amount, and take on enough debt. These requirements can be challenging to meet, and failure to do so can result in significant tax liabilities. For real estate investors looking to defer capital gains tax, the complexities involved in a DST 1031 exchange can be daunting.

  • Potential Tax Rule Changes: Tax laws are subject to change, and there's always a risk that new regulations could negatively impact DST investments. Changes in state tax laws or challenges to the DST structure by the IRS could create unforeseen tax burdens. These tax risks are a major concern for long-term DST investors.

Legal Problems

DST investments are also complicated from a legal perspective:

  • Securities Law Issues: DSTs are considered securities, which means they are subject to strict regulations. Investors must be accredited, which limits the pool of eligible participants. There are also many regulatory requirements, which can make investing in a DST complex. Legal complexities are a significant disadvantage of Delaware Statutory Trust investments.

  • Structural Concerns: The legal structure of a DST carries liability risks, including the potential for bankruptcy or disputes among owners. The legal documents are often complex, and navigating these issues without a legal expert can be challenging. Investors should carefully review the private placement memorandum to understand these risks fully.

Research Problems

DSTs are not as transparent as other types of investments due to regulations, making research challenging:

  • Limited Access to Information: The details of the property, sponsor, and overall structure can be hard to come by. Without access to critical information, it can be difficult to make an informed investment decision or verify the claims made by the sponsor. This is one of the biggest problems with Delaware Statutory Trust investments.

  • Hard to Value: Determining the true value of a DST investment is complicated due to the lack of comparable sales and transparency in the market. This makes it hard to know if the price is fair or if the investment is worth pursuing. Valuation challenges are a common concern for real estate investors interested in DST properties.

Selling Problems

When it comes time to sell, you face additional challenges:

  • No Control Over Sale Timing: The decision to sell is made by the sponsor, not the investors. This means you have no say in whether the timing is optimal for the market, which could result in selling under less-than-ideal conditions. Lack of control over sale timing is one of the major disadvantages of DSTs.

  • Value Concerns: High transaction costs, limited buyers, and potential issues with property condition can all impact the value you receive upon sale. The market may not be favorable, and you might end up with a lower return than expected. These value concerns can affect the capital gains tax deferral benefits that many investors seek when investing in a DST.

Property Management Problems

Managing a property through a DST presents its own set of difficulties:

  • Limited Repair Options: The restrictions on adding funds mean that only basic repairs are allowed. This can prevent improvements that would otherwise increase the property's value or attractiveness to tenants. This limitation is a common problem with DST investments, particularly when trying to enhance the property's competitive position.

  • Money Problems: With limited reserves and strict funding rules, handling emergencies or making necessary repairs can be difficult. These financial constraints could impact the long-term viability and profitability of the property. Money issues are a significant concern for DST investors relying on stable cash flow.

How to Protect Yourself

To mitigate the risks involved with DSTs:

  • Before Investing: Conduct thorough research on the sponsor's track record, study the property and its market, and consult with professional advisors who understand DSTs and 1031 exchanges. Understanding the pros and cons of DST investments is essential before making any decisions.

  • Diversify: Avoid putting too much into DSTs. Diversify by investing in multiple properties, different types of properties, and working with various sponsors to spread your risk. Diversification can help mitigate the specific disadvantages of Delaware Statutory Trust investments.

Other Options to Consider

DSTs are not the only way to invest in real estate or complete a 1031 exchange.

Consider these alternatives:

  • Buy Property Directly: By purchasing property directly, you maintain full control and can make decisions that maximize the investment's value. Direct ownership offers more flexibility and the ability to actively manage the property to suit market conditions.

  • Invest in Public Real Estate Investment Trusts (REITs): REITs are more liquid than DSTs, allowing you to buy and sell shares more easily while still gaining exposure to real estate. They also provide diversification benefits that help reduce single property risk.

  • Join Real Estate Investment Funds: Private real estate funds offer another way to diversify your investment and maintain more flexibility compared to DSTs. These funds often have more flexible investment strategies, which can adapt to market changes.

  • Use Traditional Investments: If real estate isn't a priority, consider traditional investments such as stocks, bonds, or mutual funds, which provide more liquidity and fewer restrictions. These alternatives offer a simpler way to invest without the complications associated with DST investments.

Final Thoughts

DSTs can be a viable option for some 1031 exchanges, especially for investors looking for a passive, hands-off investment. However, they come with many challenges and downsides that need to be carefully considered. Lack of control, illiquidity, and the risks associated with debt and market changes are significant factors that could impact your returns. Before investing, evaluate your options thoroughly, understand all the potential risks, and consult with professionals to ensure that a DST aligns with your investment goals and risk tolerance. For real estate investors looking to defer capital gains tax through a DST 1031 exchange, it's crucial to weigh the pros and cons and consider the long-term implications for your portfolio and cash flow.

SEMPER

- “Always Grow”

S: Sell your property in a seamless way using an investosemperr-friendly real estate agent. Or, just talk to a 1031 exchange expert for help.

E: 1031 Exchange your newfound equity with a savvy qualified intermediary (your 1031 exchange expert).

M: Match your equity with a DST or other replacement property that fits your investment goals. This requires a DST sponsor or broker.

P: Pocket cash flow from your investment property and work with tax specialists to maximize your in-pocket returns.

E: Expand your DST property’s equity with time. It's important to choose your DST wisely so it appreciates well.

R: Repeat this process to grow your real estate portfolio and your returns. Once the DST term is complete, you can 1031 into the next one.

Would you like to talk about DST's and learn more?

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Jeffrey Lemoine

Jeffrey is a real estate advisor focused on finding creative ways to solve problems.

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