The process of selecting DSTs is substantially different than investing in traditional income properties and we have seen unwary investors take on greater risks than need be due to a lack of understanding of the key differences and potential pitfalls. The following five areas are among the most common that prudent investors need be aware of and consider.
1. Select reps/advisors who have deep real estate management experience and track record
Most investors who are considering DST investments are usually in a tight timeline to meet rigid IRS requirements to identify replacement properties within 45-days of the close of sale on their previous rental property. Due to the large amount of potential information to absorb and evaluate, the services of a competent and experienced advisor can be indispensable. Investors should drill down on the experience and track record of potential advisors and confirm that they have selected a person with deep real estate experience – especially in the asset classes that the investor is seeking. It is not enough for an advisor to have a real estate license – or claim years of experience in real estate. The ideal advisor should have significant and verifiable prior management and ownership experience in the sought-after asset classes. Real estate sales experience is less relevant than actual management experience – so do not put much weight on claims of millions or billions of dollars of deals closed. You should ask prospective advisors for the number of units that they have managed/owned and their direct hands-on experience in overseeing the operation of rental properties. Deep real estate management experience is far more likely to produce the required skill set to better understand financial projections and market trends that are critical to evaluating DSTs than sales skills. Finally, if possible, meet with the advisor at their office to not only size them up, but to also see the depth of their support team and evaluate their ability to not only support the near-term transaction, but to support you longer term.
2. Stick with asset classes that perform best in the worst of times
Regardless of your previous experience in specific asset classes, evaluate DST options with a fresh set of eyes and focus on worst case scenarios. Over the 16-year history of our firm, we have seen many asset classes stressed when tough times occur. Our experience and that of most of our successful investors bears out that well-positioned apartment investments in larger, growing urban markets fair best when times are tough. When the economy slumps, the last dollars that people have to spend will be used to keep a roof over their head. In the deep recession of 2008, all asset classes were negatively impacted, however apartments not only outperformed other asset classes, they were among the first to recover value when the economy improved.
3. Favor high quality assets over higher yields
At any given time, DSTs are typically available that are generally projected to produce first year cash flows ranging from 5% to 7%. We encounter too many investors who weight projected cash flow returns as their primary criteria for selecting DSTs. Do not make this mistake. Newer DST apartments in growing urban markets typically offer first year projected cash flow beginning at or close to 5%. Older apartments and/or those located in secondary and tertiary markets may offer first year cash flow at 6% or even higher. While properties with higher projected yields may provide superior performance, the added risks due to unanticipated maintenance costs, declines in the local economy, etc. can cause overall returns to fall below that of lower yielding newer investments in stronger markets. The saying that “the greater the return, the greater the risk” is heeded by the prudent DST investor.
4. Do your homework on DST portfolio offerings
In general, we favor asset allocation strategies where investors divide their investments among multiple properties rather than invest all their proceeds into one DST. It is not surprising that DSTs that are comprised of multiple properties are popular with investors. A single DST investment in a portfolio of properties can provide desirable asset allocation and perhaps lessen some of the overhead in overseeing multiple separate properties. Investors should be wary however of claims of some DST sponsors that their portfolios may sell at a premium to a large buyer at a future date. We have investigated such claims and have not found sufficient evidence that portfolios are more likely to sell at a premium. In fact, the opposite may be closer to reality. DST portfolio offerings are most often seen among groupings of smaller retail and storage assets – although there are DST apartment offerings that are offered as portfolios as well. DST portfolios comprised of retail or storage assets are more likely to have loans which are cross-collateralized i.e., all properties are tied to the same loan and cannot be sold individually. They are also more likely to contain properties that are in different states. Retail portfolios have an added risk due to the declining lease term in the most common retail properties e.g., drug stores, dollar stores, tractor supply, etc. These factors raise the risk that the exit value of the portfolio may be less that original investment. In considering portfolios and asset allocation strategies, steer towards properties with individual (or no) loans and avoid properties with declining lease terms.
5. Stick with proven DST sponsors with a strong track record
Today there are approximately 30 DST sponsors – and more firms are entering the industry regularly. The history of fractional ownership investments is unfortunately full of companies that no longer exist and who often failed to deliver on the expectations that they set with their investors. Furthermore, some newer DST sponsors are offering their products directly to investors via the internet thereby bypassing the added scrutiny that can be provided with a broker intermediary. Newer sponsors will often advertise higher returns to attract investors or offer other inducements to build a reputation. With rare exceptions, investors are well advised to stick with offerings from sponsors who have the most longevity and best track records. The top sponsors will generally publish an extensive track record of prior results in their offering materials showing actual versus projected performance of each of their offerings over a prior time period. The absence of a published track record or, worse yet, no track record, is a red flag to which all investors should pay careful attention.