Despite a record year of capital inflows into the DST market in 2022, a sharp drop in demand is creating headaches for sponsors now stuck holding properties longer than planned.
One of the selling points of DSTs is that they are often “pre-packaged” real estate deals ready and waiting for time-sensitive 1031 exchange investors to buy a fractional ownership interest. Rising interest rates that have stalled investment sales activity is contributing to an imbalance in supply and demand for DSTs, and impeding what had been a booming trajectory for the marketplace.
On paper, the DSTs market had a great year in 2022 with $9 billion in fundraising, up nearly 27 percent compared to the $7.2 billion in fundraising from 2021, according to data from Robert A. Stanger & Company and Mountain Dell Consulting.
“Reflecting on 2022, it was very much a tale of two halves,” says Keith Lampi, president & CEO at Inland Private Capital Corp., an active DST sponsor. The first six months were a bonanza of new fundraising, and in the second half of the year, investors were settling into the realities of higher interest rates and friction between buyers and sellers on pricing. Rolling into 2023, new capital flowing into DSTs is solid relative to historical levels, but certainly more muted compared to the robust pace of activity over the prior two years, he says.
DST investment is driven largely by 1031 exchange activity, and a slowdown in investment sales activity has a direct correlation on the decline in capital flowing into DSTs. According to MSCI Real Assets, sales activity dropped 62 percent in the fourth quarter of 2022. Early industry data for January suggests that the DST market is on pace for a $5.5 billion run rate in 2023. Although it is early days, if current levels continue, it would still represent the third-greatest year of DST fundraising on record. “Our expectations are for a slower, but healthy fundraise for the DST market,” says Jay Frank, president of Cantor Fitzgerald Asset Management.
DST sponsors have been reacting to shifting market conditions accordingly by buying fewer assets and bringing fewer DST offerings to the market. However, there is still a massive amount of DST inventory built up from past offerings. As of Jan. 15, there were $3.5 billion in DST offerings across 82 products from 39 different sponsors. Based on the fundraising rate seen in the first half of January, that amounts to about 7.5 months of inventory, notes Frank. Another issue that has offerings sitting on the shelf longer is that some legacy DSTs have first-year cash-on-cash yields that are below 4 percent—a tough sell in the current interest rate environment.
Sponsors tap the brakes
One concern of the slowing demand, even if it is relatively short-lived, is that it could create some shake-out among weaker sponsors. “We have seen this movie before. There are market cycles, and our securitized industry has been through several of them over the last 20 years,” says Lampi. At the top of the cycle, there is a rush of new entrants that jump in, and then those companies exit by choice or are flushed out when the cycle turns the other way. On the flip side, there are those firms that take a longer-term view and are better positioned to weather market challenges, he adds.
Slowing demand is forcing sponsors to rethink strategies. How long is that offering likely to sit on the shelf before it is sold? What is the cost of capital, and how does that financing now impact profitability? What if a sponsor gets stuck with a property that they can’t sell? Those are all questions that are more top-of-mind now than they were a year ago when investor capital was flowing into the sector at a more robust pace, notes Frank.
Cantor Fitzgerald hit the brakes on buying new assets in August of last year and hasn’t acquired any assets since. That pause is also due to higher interest rates and sellers that have been reluctant to lower prices. “We have pulled back significantly across all real estate verticals, and we’re waiting for the real estate market to reset because we’re not willing to use dilutive leverage,” says Frank. Effectively, that means that Cantor Fitzgerald is turning away potentially hundreds of millions of dollars of DST capital. “It’s frustrating because you’re leaving money on the table,” he says. However, the firm believes there will be better buying opportunities later in 2023, which means they will be able to deliver better outcomes to investors over the hold periods for DST products.
Industry inventory levels of DST product provide a snapshot into the imbalance in the supply and demand that exists. The DST industry ended 2022 with $3.2 billion in available DST equity offerings available, and that number climbed to $3.5 billion at the end of January. From an inventory standpoint, the data shows that the industry is going in the wrong direction, notes Lampi. “What that is telling me as an industry sponsor is that it would be healthy for the industry to sell down some of its inventory before it continues to pile on new inventory,” he says. For example, as of early February, Inland is in the market with an inventory of about $350 million in DST equity offerings compared to $500 million a year ago.
Flight to quality
It remains to be seen how long the disruption in the real estate investment sales market will last. “I think you will see the friction between buyers and sellers open up as we make our way through the year, but you can’t bet on that with absolute conviction, and you have to take a measured and thoughtful approach with respect to asset selection and determining how much more inventory you put on your balance sheet,” says Lampi.
One factor that bodes well for continued demand is that many DST investors are motivated by lifestyle changes versus real estate market conditions. DSTs appeal to property owners that are transitioning out of active real estate investment or business ownership, and moving into more passive ownership, usually due to retirement or some other life event.
“We’re still in the front end of that baby boomer wealth transfer. So, I think the demographics are going to lead into a longer term movement into the DST space,” says Drew Reynolds, chief investment officer and head of the research group at Realized, a firm that provides wealth management solutions for investors that include DSTs. Other factors that are favorable to long-term industry growth are greater market awareness of DSTs as a 1031 exchange option and investors who are more educated on DSTs.
“I actually think the slowing velocity in the market is a huge benefit for the investor,” says Reynolds. Investors are often investing a large portion of their net worth into long-term, illiquid holdings. At one point, demand was so heated that investors were feeling pressure to make these huge investment decisions, sometimes in a matter of days, he says. “We now have a more reasonable time period for investors to go through a proper planning process to evaluate their options, and that bodes well for the industry also,” he adds.
And investors should be proceeding cautiously in a more challenging market. Some DST sponsors have relied on short-term bridge debt to finance acquisitions while they work to sell fractional ownership in the DST to investors. The cost of floating rate debt has spiked with SOFR that is now hovering at roughly 4.5 percent. That presents a material risk to sponsors who are holding assets longer than expected, as well as the investors who are investing in these programs. Investors face risk in properties not performing up to projected returns, and potentially loss of principal. “Flight to quality is critical right now,” says Frank. “And I would define quality as well capitalized, dry powder, access to capital, good liquidity, the ability to manage through tough economic environments.”