The use of Delaware Statutory Trusts (DSTs) in net lease investing has started to gain popularity, with creators of DSTs facing the same challenge that’s vexing other net lease buyers: finding adequate product to meet high demand.
DSTs grew to $500 million last year and should continue to upwards of $3 billion within the next three years, according to Steve Meier, a partner with Chicago-based law firm Seyfarth Shaw. And in the third quarter of last year, just a few DST products were on the market, ranging in gross amount from $20 million to $25 million. That number doubled in the fourth quarter.
Several factors are contributing to the growing interest in DST products. The recent hike in the capital gains tax, which affects real estate investors, makes the DST a more appealing investment option because the trusts allow investors to swap properties and defer tax payments.
Banks have become less willing to finance tenant-in-common arrangements, which has also favored DSTs, according to Greg Genovese, president of US Global Realty Capital LLC in San Francisco.
DST creators also anticipate a flow of investors re-entering the market in coming years, as 1031 exchange deals engineered in the boom of 2005 to 2008 come full cycle. “In the coming years, at least two-thirds of those investors will be looking for similar deals,” Meier says.
When they do, they’re under pressure—from the date a taxpayer closes on a 1031 exchange deal, they have up to 180 days to find a replacement property. “There’s pressure to have product, and you have to have it at the right time,” says Louis Rogers, CEO of Capital Square Realty Advisors LLC in Richmond, Va.
That has become increasingly difficult. Cap rates have been low, and shapers of DSTs are in competition with private REIT and private equity funds. The growing demand makes it more difficult for DST creators to find the capital preservation that investors are seeking, pushing them into tertiary markets for opportunities, says Genovese. “That alone tells you how pent-up demand has been,” he says.
At Capital Square, Rogers’ strategy is to locate facilities deemed “mission critical”—factories, warehouses and corporate headquarters with data centers, fiber optics and backup generators that the tenant must keep operational. Drugstores such as Walgreens are more vulnerable to closures, which could disrupt an investor’s holdings.
Rogers also seeks long-term leases with rent increases built in every five years. “That’s how we protect the income stream from the risk of inflation,” he says.
DST advisors are anticipating another change to their business as well: the implementation of the federal JOBS Act, which passed last year but has yet to take effect. One measure of the JOBS Act will make it easier for sponsors of real estate investment programs to solicit for investors. Sponsors now work through broker-dealer networks.
“Those bars to accessing capital that you don’t know yet are going to be largely eliminated,” Meier says, though investors will still need to be accredited to participate. New regulations could take effect within six to 12 months, though it’s difficult to predict, Meier says.
Genovese favors stronger qualifying standards and narrower classes of investors to distinguish among differing levels of net worth. “If everybody that had claimed to be an accredited investor during the heyday of 2005 to 2007 had been accredited and could hold $1 million in net worth, we wouldn’t have a third of the problems we’re having now with some of those programs,” he says.
The JOBS Act provisions “won’t change our business,” Rogers says. “We want to work through broker-dealer relationships.”