By Evan Hudson, Stroock & Stroock & Lavan LLP
Qualified Opportunity Funds are receiving a lot of attention right now from sponsors and investors, but they’re not for everyone. Many investors seek a more traditional and practical approach to deferring their capital gains.
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. It represents a way for real estate asset managers to buy low, sell high and gather AUM from friendly capital sources.
The term “friendly” is apt because retail investors are generally less demanding in their return requirements and are willing to cede almost total management control to the sponsor.
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 the benefit of passive (hands-off) investment 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 investors who declined to sell their buildings into the low-liquidity environment of the financial crisis have demonstrated eagerness to sell into the strong CRE market of 2018.
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 $100 million.
The sponsor might own the asset already, or might acquire a new asset 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.
What’s in It for the Sponsor?
When the sponsor sells interests in the DST, it often earns a markup. For example, the sponsor might acquire an asset at a 7-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 sponsors with an immediate arbitrage opportunity. Alternatively, the sponsor might charge an acquisition fee, a financing fee or a brokerage fee. No matter what, the sponsor receives compensation up front.
During the hold period, which generally lasts from three to 10 years, the sponsor charges an asset management fee. Finally, the sponsor pays itself a fee upon disposition.
A common aspiration for a sponsor is to become a serial issuer, thereby gathering substantial AUM and a durable stream of fees from a friendly capital source. Of course there are costs and issues to navigate, but the benefit to sponsors can be significant, with a DST serving as a practical way to reach retail investors looking to defer their capital gains while benefiting from hands-off real estate ownership.
So, although Qualified Opportunity Funds are getting lots of attention at the moment, they’re not for everyone — and that’s one of the reasons that DSTs are so successful right now.
