Leading Delaware Statutory Trust (DST) sponsor Capital Square Realty Advisors is coming off of a big year of capital raising. The company raised $356 million in equity and 2021 could be even bigger.
The amount of activity the firm has seen during the first three months has been “off the charts”, according to Capital Square Founder and CEO Louis Rogers. “We were aiming for $400 million in equity in 2021, which is over $1 billion in real estate, and I think we underestimated,” he says. “I think it is going to be the strongest year ever.”
DSTs are a form of fractional real estate ownership that have become increasingly popular among accredited investors as a replacement property used to complete 1031 exchange transactions. The syndicated 1031/DST market is coming off of two robust years with $3.4 billion in equity raised in 2019 and $3.1 raised in 2020, according to Mountain Dell Consulting. The research firm is forecasting an increase to $4 billion in total equity raised for 2021.
Part of that growth is due to the fact that its main target market, individual accredited investors, is growing. In particular, aging baby boomers are selling investment properties or businesses that own real estate. They are looking for a replacement property to complete a 1031 exchange and defer capital gains taxes, and they also want a passive investment that will generate stable cash flow. “A DST fits that to a T,” says Rogers.
The syndicated 1031 market dates back to the mid-90s. What started as tenant in common (TIC) programs, evolved into the DST structure in the early 2000s. Unlike TICs, DSTs are able to accept a large number of investors and benefit from a streamlined management process, notes Allan Swaringen, president and CEO of JLL Income Property Trust, a non-traded daily NAV REIT. The REIT launched its own 1031 tax-deferred exchange program, the JLL Exchange, in December 2019. The company recently announced that it had fully subscribed its fourth DST, JLLX Penfield. The Penfield, is a 254-unit apartment community in St. Paul, Minn.
In addition to Capital Square and JLL Income Property Trust, the DST industry currently includes about 40 active sponsors. Inland Private Capital Corp. is the largest, grabbing 19 percent of the market share in 2020, according to Mountain Dell Consulting.
Historically, expansion of the DST market has been significantly hampered by lower quality properties, high fees charged by sponsors, and a lack of price transparency,” says Swaringen. Institutional platforms, including JLLX and others, are giving financial professionals and high net worth taxpayers the ability to invest in higher quality assets at substantially lower fees and expenses, he adds.
Growing appetite for DSTs
A number of factors are fueling the growing DST industry. Property sales have a direct correlation, and an active investment sales market in 2019 and early 2020 created demand for 1031 exchanges. Although sales did slow during the height of the pandemic, DST investing has accelerated in 2021 as sellers look to get out ahead of potential tax law changes.
DSTs are an attractive solution for investors who are trading out of actively managed assets, such as the “tenants, toilets and trash” of multifamily and single-family rental real estate, and looking for passive real estate investment alternatives, notes Jason Salmon, senior vice president, managing director of real estate analytics at Kay properties & Investments LLC. The fractional ownership of DSTs also allows investors to diversify the capital they need to invest across multiple DST offerings. “When you dig down a little deeper, there is greater understanding of the space and word of mouth has created more knowledge and awareness of this subsector,” he says.
The pre-packaged convenience of DSTs is another big draw for 1031 exchange investors. DSTs offer speed and certainty of close, both of which are key to successfully completing a 1031 exchange. IRS guidelines require a detailed process for reinvesting both the equity and debt from a relinquished property. Investors must identify a short list of possible replacement properties within a 45-day window and close on the replacement asset or assets within 180 days. Make a mistake on any one of those and it would blow up an entire 1031 exchange, resulting in a big tax liability for a seller.
That specific 1031 timeline can be challenging for investors who have to go out and find real estate they want to buy, conduct due diligence, negotiate terms for the purchase, line up financing if a loan is needed and then close on the purchase, says Salmon. “There are all sorts of factors that weigh into that timeline, which can be somewhat tricky for 1031 investors,” he says.
A 1031 exchange also requires an investor to replace an equal or greater amount of debt and equity into the replacement property. DSTs have already been packaged by sponsors and investors can mix and match shares and calculate 1031 debt and equity reinvestment amounts, almost down to the penny, says Salmon. “On our platform, there are dozens of deals to consider, and we work directly with the investor to help figure out what works for them and their situation, so there are a lot of options,” he adds.
Tax reform could derail growth
The 1031 exchange market is facing a looming threat of tax law changes under the Biden administration. Early in the presidential campaign, Biden’s tax proposal called for modifications to the 1031 exchange that would make it available only to exchange investors with taxable gains of $400,000 or less. Such changes could be a big blow to the DST industry in significantly limiting capital that needs to be reinvested as part of a 1031 exchange.
The 1031 tax breaks have been on the chopping block numerous times before, and yet have remained intact for real estate transactions since the law was first introduced nearly 100 years ago. However, the industry is definitely concerned about proposed changes, and several real estate groups have banded together to lobby and educate Congress on the positive impact 1031s have on the economy, as well as potential negatives, including a stagnant industry with people more inclined to hold properties rather than sell. “A large part of our vibrant real estate economy would come to a screeching halt,” says Rogers.
When it comes to 1031 investors in particular, many are not large institutions or corporations, they are everyday people who happen to own investment real estate for one reason or another, adds Salmon. Being able to do a 1031 exchange and defer capital gains taxes is really helpful for where they are in life, such as planning for retirement. In some cases, military people that move around might have a house and decide to keep it as a rental. Business owners also might own the building where their business operates, and when they sell or exit that business, they also need to sell the real estate. “I really hope that all of these people have the ability to continue to do a 1031 exchange for their investment real estate, because if they weren’t able to it would have a tangible impact on their lifestyle and their net worth and their future,” he says.