By Evan Hudson, Stroock & Stroock & Lavan LLP
Qualified Opportunity Funds are receiving a lot of attention right now—and deservedly so. Another way for investors to defer their capital gains, though, is not so new and shiny. A DST syndication, that tried-and-true mainstay of the 1031 exchange industry, might be the hottest asset management tool that many real estate sponsors have never heard of.
In fact, over $2 billion from retail investors will have been raised through DST syndications this year, representing a 10-year high.
Here, we look at why the market for DST syndications is so hot right now, and what real estate asset managers need to know about this business.
What Is a DST Syndication?
A DST syndication is a private placement of interests in a Delaware statutory trust to retail investors, including 1031 exchange investors.
Unlike interests in a corporation, LLC or limited partnership, interests in a DST constitute valid exchange property in a 1031 exchange transaction if certain conditions are met. This represents a big tax benefit for retail investors who have just sold a building and need to redeploy their capital in a tax-efficient manner. Additionally, investors get to enjoy passive participation in a high-quality asset managed by professionals.
Why Is the DST Market So Hot?
DSTs have been treated as valid 1031 vehicles since 2004, when the IRS issued the applicable guidance. So why are they such a hot topic now? One reason is that owners who declined to sell their buildings into the low-liquidity environment of the financial crisis have demonstrated eagerness to sell into today’s strong real estate market.
Hence, proceeds are available to reinvest — and must be reinvested in valid exchange property within 180 days of sale for the investor to take advantage of the nonrecognition-of-gain provisions of §1031.
Who Should Consider Sponsoring a DST?
Candidates for sponsoring a DST include real estate asset managers looking to grow their AUM and diversify their capital sources. Sponsors should have a successful investment track record and be able to tell a compelling story. To succeed, a sponsor must be comfortable with the hard work that it takes to build a reputation in the retail capital markets.
How Does a DST Work?
First, the sponsor identifies an asset appropriate for syndication. For tax and marketing reasons, this is normally either a core or value-add building, or a small portfolio of buildings, whether multifamily, retail, office or industrial, fully leased, with a market value of between $10 million and a $50 million. The sponsor might own the asset already, or might acquire one specifically for syndication.
Next, with the asset financed, fully leased and stabilized, the sponsor sets up a wholly owned DST and contributes the asset to it. Lastly, the sponsor sells interests in the DST to retail investors.
A Win-Win for Investors and the Sponsor
Investors get the benefit of tax deferral and a hands-off, institutional-quality investment. The sponsor is compensated for its efforts as well.
First, when the sponsor sells interests in the DST, it may earn a markup. For example, it might acquire an asset at a 6-cap and sell interests in the DST at an implied 5-cap (net of costs paid by the investor). Recently, targeted all-in returns to investors have been in the range of 5 to 6 percent, so selling an asset to a DST can provide an efficient exit opportunity. Alternatively, as compensation for sharing its pipeline of investments, the sponsor may charge an acquisition fee, a financing fee or a brokerage fee.
Second, during the hold period, which generally lasts from three to 10 years, the sponsor may charge a management fee, and lastly, may earn a fee upon disposition, depending on the deal.
A common aspiration for a sponsor is to become a serial issuer, thereby growing its AUM and serving retail investors more or less permanently. Of course there are costs and issues to navigate, but ideally the structure is a win-win for both sponsors and investors.
So, although Qualified Opportunity Funds are getting lots of attention at the moment, they’re not the only tax deferral product — and that’s one of the reasons that DSTs are so successful right now.