While there are countless benefits to owning real estate, being a landlord presents several challenges. Rental income and tax benefits on an investment property can generate considerable wealth for many landlords -- but dealing with the hassle of tenant and property management has deterred some from investing in real estate.
Thankfully, there is another real estate option for investors: the Delaware Statutory Trust (DST). A DST offers the opportunity for an investor to reap the benefits of real estate -- i.e., potential rental income, potential appreciation, and tax benefits -- without having to manage a physical property itself.
I had the opportunity to connect with a leading expert on Delaware Statutory Trusts, Dwight Kay, CEO of Kay Properties & Investments. He walked me through how DSTs are used in real estate and their potential benefits to investors.
What is a Delaware Statutory Trust (DST)?
A Delaware Statutory Trust is a legally recognized trust, similar to a family trust or an LLC, that is used to hold title to a piece of real estate. Despite the name, the property and investors do not need to be in the state of Delaware to participate in this investment option.
A typical DST is owned by several dozen investors who pool their funds into the trust. Depending on the DST's performance, investors may receive a portion of the property's rental income each month. The DST doesn't allow investors to take an active role in making decisions about the property -- those decisions are up to the sponsor (also known as the "operator"), who is the corporate entity that manages the decisions around the property.
A DST can hold title to any form of investment property, from a 300-unit apartment building to an Amazon (NASDAQ: AMZN) warehouse. As of 2004, the Internal Revenue Service (IRS) has ruled that investing in a DST is considered "like kind" property, making DSTs 1031 exchange eligible. In other words, an investor who sells an income property can defer capital gains tax on the sale by reinvesting the net equity into a DST. Here's what that means for an investor:
After several years of property ownership, a landlord may decide they no longer want to deal with the hassle of managing tenants. They prepare to sell the rental properties but soon learn they'll be responsible for paying a considerable amount in capital gains tax. To avoid paying that hefty tax bill, they can enter into a 1031 exchange, sell the rental properties, and put the proceeds from the sale directly into a DST.
"DSTs can be an attractive potential investment option for high-net-worth investors, whether they are coming out of prior property ownership or investing in income-producing real estate for the first time," Kay explained. "A lot of our clients will sell assets and want to do a 1031 exchange to diversify their equity into multiple properties and locations. Through the DST, they can defer capital gains taxes on the prior property sale and diversify their income while stepping away from managing property directly. This is great for property owners who want to travel or spend more time with their children or grandchildren."
Can anyone invest in a DST?
To participate in a DST, an individual must qualify as an accredited investor, meaning they must have a net worth (or joint net worth with a spouse) of more than $1 million, excluding their primary residence. Alternatively, they must have had either an individual income above $200,000 in each of the last two years or a joint income with a spouse of more than $300,000 in those years. Accredited investors are then typically required to invest a minimum of $25,000 into the DST to participate.
What are the benefits of investing in a DST?
Income diversification is one of the most critical components of being a real estate investor. Investors are always advised to create multiple income streams rather than rely on one single property to generate income, which has proven particularly applicable during the COVID-19 pandemic. An investor who only owns retail property may experience a considerable decrease in income right now, whereas an investor who owns retail property, multifamily housing, warehouse space, and medical buildings can rely on income from a wider range of properties.
"The DST allows investors to diversify," Kay explained. "If an investor owns one multifamily property in their town that's worth $5 million and then something like the coronavirus pandemic happens, having all of that capital tied into one property could greatly affect that one individual property. Whereas with the DST, the typical minimum investment is $25,000, so investors can diversify across many different properties, asset classes, tenants, and markets across the country. This diversification doesn't guarantee profits or protection against losses, but it is a prudent thing to do."
Kay went on to explain that, while many DSTs only consist of one property, some may have as many as 10 or 20 properties within a single DST, allowing them to further diversify their income. Some DSTs may even have more properties than that, as there is no limit to the number of properties a DST can own.
"If an investor has $300,000 to put into real estate, the DST is an attractive option because the investor may put, for example, $100,000 into a DST that has a long-term lease with FedEx (NYSE: FDX), an additional $100,000 into a second DST with a 300-unit apartment building, and the remaining funds into a third DST with a 200-unit self-storage facility," Dwight said.
2. Passive income
DSTs are assembled by professional operators called DST sponsors, meaning the investor puts their funds into the trust and allows the operator to make the decisions around what happens to the properties in the trust. This offers the investor a "hands-off" approach, meaning they can benefit from potential monthly income but will not be involved in the day-to-day operations of the properties within the DST.
"Investors like the DST because they can participate in high-quality investment real estate without actually having to be a landlord, do the accounting, collect the rent, put together a business plan, and have the property take up a large amount of their free time," Kay said. "So, they're getting the potential rental distributions, the potential appreciation, and the potential tax benefits from that real estate without having to deal with all of the day-to-day operations."
3. Stabilized assets
DSTs are designed to potentially provide steady, recurring distributions to investors on a monthly basis. With that in mind, although DSTs can include any type of investment property, most DSTs tend to stray away from properties with a repositioning component since those returns may take longer to be realized and are oftentimes higher risk. Instead, DSTs typically consist of properties that have long-term leases and/or a high rate of occupancy.
"A lot of DSTs that we've passed on over the years have included senior care facilities or hospitality-related properties, such as hotels," Dwight explained. "No one is traveling for business or pleasure right now due to shelter-in-place restrictions of COVID 19, so certain DSTs that include those property types have not been performing as well as others. That's why we encourage our clients to stay away from the higher-risk asset classes -- such as hotels and senior care facilities -- and focus on multifamily apartment buildings, industrial properties, triple net leased (NNN) properties, and other essential businesses."
How has COVID-19 impacted DSTs and online real estate investing?
Kay explained that DSTs have seen a considerable increase in investor activity in the first quarter of 2020, although the coronavirus has slowed down the real estate market as a whole. The increase in DST activity is primarily due to investors who are landlords wanting to focus more on online real estate investing and move away from operating physical properties themselves.
"Because of the growth and popularity of DSTs, we could have our biggest year ever at Kay Properties," Dwight explained. "The DSTs offered through our investment platform include both leveraged and debt-free properties. Having our clients invest in debt-free DSTs helps mitigate potential risk in the event of a recession or pandemic. If tenants stop paying rent, the property is owned debt-free. We also like long-term leases with investment-grade tenants such as Amazon, FedEx, Walgreens (NASDAQ: WBA), CVS (NYSE: CVS), and other major businesses."
While any form of real estate investing always comes with risk, the DST is a potential investment option for those seeking to avoid paying capital gains tax on the sale of their current property. Investing in a DST is also a viable option for direct cash investors seeking potential income, tax benefits, and appreciation at a $25,000 minimum investment. Accredited investors with a net worth of $1M or more (excluding their primary residence) are welcome to sign up for an account on Kay Properties' website and review the offerings on their platform.