Guest Contributor: Overturning “Caveat Emptor” – How to Diminish Risk in a DST Acquisition
By: Paul Moore, Managing Partner at Wellings Capital
By: Paul Moore, Managing Partner at Wellings Capital
You know that sick dreadful feeling, don’t you?
If you’ve invested in real estate, you probably do. But if you have purchased many cars or almost anything else of significant value, you’ve probably had this unfortunate experience.
I’m talking about discovering a significant flaw in a purchase… after it is in my possession.
I recall the time I acquired a pricey waterfront investment home for cash. It was early in my real estate career, and I was closing quickly to get a reduced price. No inspections, no contingencies.
I didn’t realize the bowed shape in the basement’s front wall was the result of a serious situation that needed immediate attention. (Construction just wasn’t my thing.)
Knowledgeable advisors say, “Caveat emptor…Buyer beware!” for a reason. We all know this is true. And real estate investors go to great lengths doing inspections to learn all they can about a property.
But some things don’t turn up in inspections. And even if the inspection is accurate, some un-inspectable surprises still come to light after closing.
Like the time our firm invested millions in an almost new self-storage facility in Florida. After operations commenced, we learned about some local market dynamics that caused the asset to struggle for years to get to breakeven.
Or the asset in South Carolina that relied on a building permit that was “a simple administrative matter…should be wrapped up in a few weeks.” That few weeks turned into over a year.
We dealt with these painful issues. But it cost time and money to resolve them.
And that’s exactly what Delaware statutory trusts can’t afford.
The structure and rules around a Delaware statutory trust don’t leave much room for error. And investors who place their capital in these vehicles are trading their past management headaches and more robust returns for the alleviation of headaches. But they often accept lower returns in the process. They expect the yields to be as advertised, and they expect a stress-free experience.
Errors or unforeseen problems in the DST realm can be deadly. They can even lead to the dissolution of the DST and the transition to a springing LLC. This could cause the loss of investors’ 1031 exchange capital gains deferral and a host of other expenses and hassles. Many DSTs met this fate in the great financial crisis. With the ambiguity resulting from COVID-19, the last thing DST operators need is more uncertainty.
So how can DST organizers avoid uncertainty in their acquisitions?
The simple answer is to have intimate knowledge and certainty about the property they are acquiring.
This certainty includes knowledge of:
- The physical characteristics of the asset
- The property management system, team, and staff
- The operational aspects of the property
- Sales and marketing, including branding and effectiveness of digital assets
- Financial systems and controls, and much more
The devil you know…
While intimate knowledge of these issues is important, continuity through the transition from the prior owner to the new one is an essential part of the equation. DST’s thrive on stability. Anyone who has acquired a commercial real estate asset and brought in a new property management team has experienced the operational and resulting financial upheaval that can occur.
When I wanted to fire a multifamily property management firm in the midst of declining performance, a more experienced asset manager cautioned me against it. He said, “That is a good way to lose five more months as you transition to a new (even though better) management team. Better the devil you know than the devil you don’t.”
So what is the optimal way for a DST organizer to obtain intimate knowledge and unbroken continuity?
It’s quite simple.
The best way to achieve both of these key characteristics is to own and manage the property before commencing the DST.
How can that be accomplished?
It’s not complicated. The operator would acquire and stabilize the asset prior to launching the DST.
By undertaking this two-step process, property management, operations, marketing, branding, financial controls, and more would be firmly in place months (or a few years) before launching the DST. I can conceive no better way to provide the stability and continuity that would assure the DST’s smooth transition and predictable outcome.
And there is a significant additional benefit for operators and their investors. It gives them a broader and potentially more lucrative platform to acquire and upgrade assets. Many value-add and even turnaround assets that would never be candidates for a DST could be acquired, upgraded, then later recapitalized through the DST.
In one DST I am involved in, our operating partner acquired a distressed self-storage asset from a mom-and-pop owner for cash. His team upgraded and stabilized the property, adding a number of valuable revenue centers (like truck rentals and showroom retail sales) along the way. The new appraisal came in at 91 percent higher than the purchase price within one year.
He refinanced the property and took almost all of the cash off the table. Within the second year, the operator considered selling the asset. Instead, he recapitalized it by “selling” it to a newly formed DST that he co-managed. This allowed him and his exiting investors to achieve over a 4x return on invested capital in a short time and allowed new 1031 exchange investors to invest in a stabilized asset.
The DST investors knew that after closing, they were investing in a known asset with a known management and operations team. Branding and marketing were already in place, and there were no surprises of any kind.
Downsides and warnings
Every silver cloud has a dark lining, right? (Or something like that!) You may wonder about the potential conflict of interest created by this two-tier structure. I wondered, too. Multiple attorneys assured me it was fine. However, full disclosure is critical for all parties to the transaction, particularly the prior and future investors.
We also got a third-party appraisal on the property by a professional we didn’t know, and that figure was established as the selling price.
And this actually points to another benefit of this structure: zero real estate commissions. Since this was a direct internal sale, the seller (the investment fund) netted more, and the DST buyer may have paid less.
Are you in the business of acquiring assets for DSTs? Hopefully this two-tier structure provides an option you hadn’t considered before.
Paul Moore, managing partner at Wellings Capital, holds an engineering degree and an MBA from Ohio State University. He spent five years at Ford Motor Company in Detroit, and then departed to start a staffing company which was later sold to a publicly traded firm. After a brief “retirement,” Moore began investing in real estate in 2000.
Moore has completed more than 85 real estate investments and exits, appeared on HGTV’s House Hunters, rehabbed and managed rental properties, built new homes, and developed a subdivision. He is the author of The Perfect Investment – Create Enduring Wealth from the Historic Shift to Multifamily Housing (2016) and has a forthcoming book on self-storage investing. He also co-hosts a wealth-building podcast called How to Lose Money.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.
