With Delaware statutory trusts for 1031 exchanges attracting record levels of investor equity inflows (estimated to exceed $10 billion in 2022), dozens of new sponsors are rushing into the space. In response, ADISA (the Alternative & Direct Investment Securities Association) has published a guide to industry best practices. The DI Wire’s publisher, Damon Elder, interviews three members of the ADISA working group that helped formulate the best practices, including Darryl Steinhause, partner at DLA Piper, Taylor Garrett, managing director at Mountain Dell Consulting and Michael Bendix, co-founder and chief executive officer at DFPG Investments.
Damon Elder 00:00
Hello, and thank you for joining us today. I’m Damon Elder, publisher of The DI Wire.com. Today we’re gonna explore an important topic, the release of ADISA’s, newly published best practices guide for Delaware statutory trusts used in the practice of 1031 exchanges. I’m joined here today by Darryl Steinhouse, partner with DLA Piper, and one of the most respected securities attorneys in the industry, as I’m sure he would agree. We’re also joined by Taylor Garrett, who’s the managing director with Mountain Dell Consulting, and Michael Bendix, CEO of DFPG Investments. All these gentlemen participated in the creation of the best practices, and Darrell was the principal author. So, thanks for joining us, gentlemen. Now as I’m sure most of our audience know, securitized 1031 exchanges became very popular tax advantage investment options in the early 2000’s growing rapidly. By 2006, they had raised nearly 4 billion in that one year, which was the peak under the tenant in common structure, which was the preferred form for 1031’s at the time.
Of course, in the great recession that began in 2008, you really saw the tics and 1031s kind of really go away from the marketplace for some time. By the early 2010’s we saw 1031’s start to reemerge, now utilizing the Delaware statutory trusts structure. 1031’s have grown exponentially in recent years and are far surpassing the peak during the tick era. This year alone, Taylor, correct me if I’m wrong, but I think by the end of this year alone, the DSTs will have raised about 10 billion of investor equity. So, this level of equity, of course, is attracting numerous sponsors to the space, many with long track records, and name brands, but there are also many new entrants. So that I think, leads to my first question, which I’m gonna address to you, Darryl, since you’re the lead author of the best practices, why did ADISA feel compelled to publish the best practices? What is the need, and what’s the intent of these?
Darryl Steinhause 01:53
I think you kind of hit the nail on the head with respect to there being a lot of new sponsors coming into the industry, and as a result, what you have is sponsors and reps and broker-dealers and everyone in the industry trying to differentiate themselves. And some people are differentiating themselves by being what I would consider more aggressive. And there are different views, different techniques, and different structures that are being used. And we tried to come up with a set of best practices that would work or provide advice as to where the middle of the road was. It doesn’t mean that one structure is better or worse than the other, but we tried to stay in an area that protected issuers, broker-dealers, due diligence companies, and investors to the extent we could. And that’s what the best practices kind of, how they work.
Damon Elder 02:53
Well, it’s definitely a topic of a lot of interest because we have well over 400 registrants for this webinar, which surprised me. But clearly, there’s a lot of interest in the space, and I think a lot of people are still actually looking to come in. So, I think this is very timely and I applaud the work that you and ADISA have done to put these together. Now, the best practices, it’s a lengthy document, goes into a lot of detail on every step of the way in the structuring, syndication, marketing, et cetera, of DST offering. So, we’re not gonna just outline and dive through it, we’re gonna go right in and start talking about some of the bigger topics. But you can download a copy of the best practices on the ADISA website, which is adisa.org. I encourage you to do so. It’s very easy to find. And frankly, it’s a very interesting read for those of us in the industry. So, I encourage you to visit the ADISA site to download the best practices. But let’s dive right in. Like I said, we don’t need to go into every point within the best practices. I encourage you all to read them. But let’s talk about some of the things that we often hear in the market. Let’s start with financial engineering, for lack of a better term. We often hear and often witness that some sponsors are being, shall we say, creative with their DST offerings. How do the best practices address this? And what should advisors and investors be wary of in the documents? You wanna start with that one?
Taylor Garrett 04:14
Sure. Yeah. We’re seeing a unique market environment where interest rates kind of increasing and looking for a variety of different ways to provide cash flows and things to the end investor, which is a critical component of the drive towards so much demand in the space. We have seen a lot of different adjustments, right? We’ve seen a lot of what I would consider financial engineering. There’s a good article that was written on this that was posted on The DI Wire a few months ago. Tim wrote a good article on the different ways that financial engineerings happen. I think the best practices really try to do their best to address different things to look out for. A lot of it has to do with just master releases, master tenant, how they’re trying to capitalize those, what they’re trying to do with reserves, underfunding reserves, being aggressive on rental growth is a big one, what we’re seeing right now today. We’re seeing a lot of negative master lease payments in earlier years. We’re seeing bills where they’re not able to cover that, they’re still able to pay that out through some type of reserve account to allow them to generate a more interesting cash flow in certain ways as you’re looking at that, you’re kind of trying to understand, okay, should the program be paying out what the real estate’s generating? What are some of the factors where it might make sense to be able to cover a negative master lease payment in that first or second year? And there’s a variety of ways people are doing that, but in the end, I think it’s a concern that people need to be considering for broker-dealers, for sponsors, for all of us, for investors in an industry to really consider, hey, how much is being funded here?
It’s not always clear in every PPM that’s drafted exactly what’s happening in that component. And it’s a huge question mark that I think could end up having an impact or having a concern for investors down the road if that property doesn’t maintain that, if they chew through some of those reserves and paying for that, that isn’t used for other capital improvements may be done at the property or needed at the property. And so, anytime you’re raising capital to adjust the cash flow upwards and pay that through there, it’s a really important factor. And I think the best practice has done a good job of trying to point to a lot of those things and make sure that due diligence officers and reps, and obviously the investors are critically aware of that because if the industry continues to reward or does reward people for financial engineering, it’s gonna go farther and farther down that way. And I think that’s bad for the industry long term and something I think the broker-dealers need to push back on a lot because they’re doing it and you’re syndicating more equity for it, that could end up being a problem down the road.
Damon Elder 06:59
Well, Mike, you’re a head of a broker-dealer that provides alternatives. What are you looking for? What are the big red flags when you’re looking at an offering?
Michael Bendix 07:08
Kind of the first thing we look at is the assumptions. Taylor mentioned quickly the assumptions for rent growth. And there are three gatekeepers. The first one’s the due diligence community themselves, and then the next one is the rep, and then obviously the third one is the client. we’re not that far removed from a 6% cash-on-cash return year one projection. And now we’re sub-four. So, at point-of-sale things are very different today than they were just a couple of years ago. And Darrell mentioned differentiation a few minutes ago, sponsors are clamoring right now to find out how they can look a little bit better than their competition, because if there’s 10 billion of equity out there, who are the reps gonna choose? And I think right now that the leaning has been toward no matter, what at point-of-sale, what year one cash on cash looks like is what reps are pointing to, to their clients. And that gets into dangerous territory. That smells an awful lot like 2008, 2009, and 2010 when that was sort of the emphasis. So, we look at assumptions, assumptions for rent growth, and some of the other items that are there to figure out if someone who’s saying a 3.9 versus someone else who’s saying a 4.1 But the assumptions on the 4.1 first-year cash on cash are ridiculous. We’ll kind of throw those out and hope that the gatekeeper, that third gatekeeper, which is the client himself, is gonna actually know from the rep, why we think the three nine is better than the four one.
Darryl Steinhause 08:58
I think if you look at this, I break it down into three categories. The first category is the master lease structure. What do you see there? Well, for example, we see some sponsors who have very high projected rents, but there’s no substance behind the master tenant. There’s no economics in the master tenant. It’s an empty shell. And the master tenant has the ability to defer rent if they don’t collect it. So, your first thing, if you’re doing financial engineering at the master lease level, you’ve got two issues. First, economics, am I really gonna get my money? Second, have I blown the whole true lease analysis that’s out there? And if you’ve blown the whole true lease analysis because you don’t have a real lease with substance, then the whole deal is blown up. So that’s the first thing that you’re looking at, at the master tenant level. And by the way, one of the things that recently came out is the IRS provided a private letter ruling and said, you know, we had some early private letter rulings out there with respect to REITs and being able to offset expenses and make other determinations as to what is gross and what is net. And you’re participating rent in these deals has to be based on gross. Some of the sponsors were adjusting the gross for certain expenses. The IRS just came out, like I said, and said, guys, you can’t do that anymore. We made a mistake, and we won’t allow that anymore. So just something else to be aware of as you’re looking at these master leases. The secondary is at the DST level, you see sponsors putting bundles of cash there and using that cash for distributions. And they all have reasons why they have to do it.
But if you read the revenue ruling, which is law because it’s a revenue ruling, it says that you only can retain enough cash for reasonable reserves for operating the property. You’re not supposed to be holding cash for making distributions. So, I’m uncertain whether that alone will have someone from the IRS be concerned about the entire treatment. But you’re violating the revenue ruling. And if you’re gonna do that, we need to make sure that your tax opinion is saying, we’re violated here and we don’t care, and here’s why and your investor needs to understand that you have a violation of the ruling. And the third area is just a practical issue, which is, am I really gonna get the money that they say I’m gonna get? For example, there’s nothing wrong with a interest rate buy-down. We see them, different people, different deals, in DSTs, outside of DSTs where there’s an interest rate buy-down. But your investor has to know that at the end of that deal, the next buyer is not gonna get that interest rate buy down if it’s the end of the term of the loan. So, you maybe think that you have a 5% deal and that when you apply your cap rate, you’re gonna get X dollars out of the deal, but your next investor is only gonna see a 4% cash flow. So, these different mechanisms, how will they impact the overall value of the property? And am I really going to get the money they promised? If they’re starting out with a 6% in a master lease deal and they have the master tenant paying these amounts with no ability to pay them, you’re probably not gonna get the money you think you are.
Damon Elder 12:28
Well, let’s step back on reserves for a second because the best practices specifically caution against offerings that hold reserves for future distributions. But like you said, Darrell, there are all kinds of reasons people give for holding reserves. What specifically should people be looking for? What are those red flags in regard to reserves where you can say, well, that looks fishy, they’re clearly holding them for distributions?
Darryl Steinhause 12:55
Well, some of the sponsors come out and say, we have reserves that we’re holding for distributions. You can look at the master tenant and see how much money is coming from the master tenant. What are my expenses? How much is left? How much should I be getting distributed? So, the other thing to be aware of, by the way, is these reserves are out there and you have limits on how you can invest that money under the DST rules, we see investors placing money in different methods that violate what the revenue ruling says. So, you also have to be aware of if there is extra money being held by the DST, are they investing that money in accordance with the rules? But you can tell by reading the PPM and looking at the projections, whether money’s coming from the DST or from the master leases.
Damon Elder 13:42
Well, why don’t we shift gears a little bit. Mike, I wanna direct this to you. What are your thoughts on quote-unquote cash-out DSTs? One, tell the audience, some of them may not understand exactly what cash out DST is, and then kind of give us your thoughts on those.
Michael Bendix 13:55
Sure. In a cash-out DST, the original offering might be with no debt, someone comes in, he’s got a million dollars of relinquished equity, he puts it into a Delaware statutory trust, subsequent to the initial purchase, the sponsor does a cash-out refinance returns 50% or a half a million dollars of his million dollars, and the client walks away with a half a million dollars in cash. The short answer to my opinion on that is you can’t do it. In something like that, where it is a pre contemplated say, step transaction, I don’t understand how we can say that there is something, there’s a binding agreement that starts off in the beginning as this is what my trust looks like, and then after the fact it changes. I think that that flies in the face of what the IRS has told us all along. It flies in the face of what the Delaware statutory trust rules say. And there have been a few that have run across the bow of our company, and we’ve said no to them based on that. I just think that it doesn’t pass muster with the IRS.
Damon Elder 15:13
Taylor any thoughts on the cash-out DSTs?
Taylor Garrett 15:16
No, that was perfect.
Damon Elder 15:17
He pretty much nailed that one. Okay, well what about participating rent? You know, is that beneficial or detrimental to the investors? How does the change in percentage rent matter? I know best practices speak specifically to this topic.
Darryl Steinhause 15:34
I’ll jump in here. So, some of the deals are straight rent, which you just have, Hey, we’re gonna get 5% per year and it’s gonna go up by 3% per year the amount, and there’s no participation. Other deals you have participating rent where there’s a base amount of rent and then there’s a share of gross, and it’s typically over a baseline. And I’m just telling you what the, you know, it could be 20/80 and it could be 80/20 where the investor gets 20% of the upside over a certain limit, or he can get 80% of the upside over a certain limit. And there’s no rule that says you can have it one way or the other. But what investors and reps have to understand is the impact. And traditionally what we see, I think today is anywhere from 50/50 to 80/20 with the investors getting 80% of the upside. If you’re someone who’s giving, for example, 95% of the upside, at a certain point the IRS says you just really have a management contract and the 5% of gross is just your payment for your management fees. So, it’s not really a participating rent. So, you may have a different issue there. But let’s say that you’re at 90/10, so the investor gets 90 cents of every dollar over a certain threshold, which is fine. The investor has to know though if you’re short, so in an inflationary marketplace, the investor wants the higher number, in a marketplace where the expenses are going up and there may be a loss or reduced gross revenues, the investor wants the lower number and it’s vice versa for the sponsor. There’s nothing wrong with any of the numbers, just people need to understand there’s a difference between a 50/50 split and an 80/20 split depending on where the future goes. And it would always be helpful if people understand that if you have 80% of the upside, you have 80% of the downside. And if you have 50% of the upside, you have 50% of the downside. Just really a clarification that would be helpful. And I think that’s what the best practices are getting at there.
Damon Elder 18:04
Well, it’s, you know, mass release, sorry, go ahead Taylor.
Taylor Garrett 18:07
No, I was gonna say, Darrell, there are a lot of expenses there, right? And being on a gross number as opposed to a net number that’s supposed to be, that people need to make sure they’re educated on because… So, it does qualify for 10 31 purposes, you can’t base it on a net result, right? So, this can’t be, hey, above a certain threshold we’re a 50/50 split on net proceeds or something like that. It’s all got to be based on gross, which is where expenses can come in and be a very tricky part to that, especially in a high expense growth or inflationary environment. So, a lot of things for everybody to consider on that and make sure you’re looking at those really closely. But we didn’t talk as much on base rent on that. Darrell, is that something we should also address, or is that more of a different conversation than what we’re gonna go to on that?
Darryl Steinhause 18:51
Well, different people have different views on where the amount of base rent needs to be. I think that you need to have base rent and the lender thinks you need to have base rent that’s gonna cover debt service and expenses of the DST at a minimum. And I think you should have some base amount and my minimum is about half of the anticipated return to the investor where you can show that I’m really paying rent out and this is not just a pure participation transaction. And investors need to know if there’s no percentage, if there’s no base rent at all above the debt service and the expenses of the DST, they may not be receiving any return because the gross rent is not gonna be high enough. So, it’s about an educational issue there, which is not clear. There’s nothing wrong with some of these structures where people have them, I just don’t think it’s clear in the process. But I wanted to raise something. I’m also fully aware that, you know, you said there can’t be any participation in net income. It’s gotta be gross. That’s absolutely true. The sponsor also, and most of us are aware of this, can’t share in net income as a promote in a DST because it turns it into a partnership. But I think most of us are aware that there was actually a deal presented where the sponsor was getting to promote out of the DST and the law firm had, I think given the opinion that that worked and I think you can talk to most law firms, that’s a hundred percent doesn’t work. So, some of the new sponsors coming into the industry are not fully aware and the law firms of how the rules really work.
Taylor Garrett 20:50
Damon Elder 20:51
Let’s go back to master leases a bit, because obviously that’s a key part of the whole structure of the DSTs, and something that the best practices really dive into a bit. So, some master leases don’t clearly differentiate who’s responsible for expense and capital expenditures. How closely do you need to review those leases? Why don’t we start with you Taylor, you’re smirking…
Taylor Garrett 21:12
No, let’s go to Darrell <laugh>. Darrell, that’s a perfect Darrell response.
Darryl Steinhause 21:15
Your master lease needs to specify who’s responsible for capital, which capital items. And it can be all our landing on the DST effectively, or they’re landing on the master tenant, or they’re being allocated some, they’re tenant improvement allowances, but you see some of these master leases and it’s just ambiguous. So economically the sponsor gets to shift between, is it gonna be me who’s gonna pay for this or the DST who’s gonna pay for this? And the DST shouldn’t be paying for any kind of operating expenses. It should be paying for its debt service, it can pay insurance, it can pay taxes, it can pay utilities, but it shouldn’t be paying the person who’s mopping the floors or washing the windows or being involved in the day-to-day management activities and operations of the property. So, you just need to make sure that’s clear. But we do see master leases where that is just, you read it and you just can’t tell which side it’s signing on. So it’s a way that the sponsor can shift economics and no one’s able to really control that.
Taylor Garrett 22:27
Yeah, and using a historical example, there was a deal back in 2000, I don’t know, 2008 or nine got hit by a tornado and the law firm didn’t have great clarification on who needed to pay the deductible on insurance. And the investor fought tooth and nail saying, hey, this is vague. We think this is the sponsor’s responsibility to pay for this. And the sponsor said, this isn’t mine, I don’t own this asset, you go on this asset, so you should have to pay it. But the ambiguity in that PPM created a real challenge for that program and ended up causing significant damage, the relationship between the sponsor and the investors. So critical that everything’s outlined very clearly in the PPM so that there’s no confusion on who’s responsible for what. because it can create different scenarios down the road for sponsors and investors.
Darryl Steinhause 23:21
And I’m gonna make another comment with respect to the reserve issue, and this kind of mixes into here as well. I looked at a PPM and there was a significant reserve. It was over 20% of the value of the offering, I believe. And the only disclosure in the PPM from the law firm was in the generic tax section that says, part of this transaction may result in boot to the investor, didn’t say what issue, what part. They knew how much was in the reserves, they knew how significant that was. And there was absolutely no disclosure of that in the PPM at all.
Damon Elder 24:10
I have one last question on leases and then we’ll move on. But the leases under a DST have to qualify as true leases for tax purposes. So what do you think about deals where there’s a significant ability by the master tenant to defer rent and have no economic backing for the master tenant? I think Darryl you might even touch on this briefly earlier, but let’s dive into it a little bit more.
Darryl Steinhause 24:33
I kind of gave my 2 cents. I’ll let Mike and Taylor jump in here a little bit.
Taylor Garrett 24:40
Yeah, my thoughts on that, going back to the financial engineering side of this, right? There are a lot of deferrals on asset management fees and different things that allow people to generate better returns today for in the future. And what that looks like on boot when you sell the property and how that’s all considered, I think needs to be a really strong understanding of due diligence officers and reps as they’re suggesting different programs to the investors. I mean, as far as, I think base rent my understanding and I’m not an attorney, so I won’t say this is exactly how it is, but my understanding of base rent is that it’s essentially a requirement to be paid, deferring rents inside of that is, I think it’s against what those typically are viewed as. But, I’m not an attorney. I’ve tried to ask a lot of brilliant attorneys on that, and I’ve gotten different responses from some of them in general. But I think that that base rent number is something that’s kind of a requirement of the offering. Typically to pay property taxes, insurance, and debt service if they have debt service but even if they don’t have debt service, the ability to defer some or all of that is my understanding is it may require to bring into an LLC. Did that answer the question, Damon?
Damon Elder 25:57
Yeah, I mean, I think that’s great getting lots of colors, which I think is fantastic for everyone. But let’s move back to another aspect of a DST offering, which of course comes with the tax opinion. Mike, your firm obviously looks at a lot of these offerings and what do you look for there? I mean, some of the tax opinions don’t consider the applicability of the loan terms. Is that a requirement for your firm when you’re looking at one of these DST offerings?
Michael Bendix 26:21
Yeah, it’s funny, when we were preparing for this, I looked into that to find out. We haven’t seen ones that don’t. So, the good news is, is that yeah, we would require it. I can’t imagine an opinion that doesn’t discuss the loan terms themselves and how they’re applicable. It would be an absolute requirement of us that that happened. And short of that, we would probably require some sort of an additional disclosure internally where we actually talked about it ourselves. It seems to be a no-brainer what we would need in the opinion.
Damon Elder 26:57
Darryl, what are your thoughts there?
Darryl Steinhause 26:59
I’ve seen some of the PPM’s that don’t talk about the loan terms, they don’t consider it, and don’t even know if they’ve been reviewed by the tax folks. But again, there’s a ppm I just saw that they didn’t have a loan, and yet there was a tax opinion saying that the deal work in the transaction. So, I’m sitting there thinking, how did you put that together when you didn’t have the loan yet, but you still rendered the opinion?
Damon Elder 27:30
Bit of a red flag for you, Darrell?
Darryl Steinhause 27:31
Damon Elder 27:33
Taylor, do you want to add anything on this topic?
Taylor Garrett 27:35
No, I think you get what you pay for in certain attorneys. I’m not an attorney, so I can’t speak to that with too much intent, but I do believe as we look at an Orchard Securities as a managing broker-dealer and as we’re considering all these deals, there are some important parts to it that would be something really important, I thin. Make sure when you’re looking at these PPM’s when you’re looking at the tax opinions, as my business partner would say, you’re gonna pay for it once front and three, four times on the back end if you don’t get the right type of legal advice, you wanna make sure that you have a very strong tax attorney that’s given that tax opinion to make sure it qualifies. Cause the last thing you want is to get down the road and find out the tax opinion and consider all the elements into an offering,
Darryl Steinhause 28:24
I’d like to raise one transaction that’s out there and you know, on all these things, investors can make choices. You can make a choice to invest in something that is a 1% likelihood of success if that’s your choice and you understand the issues. So, we’re not saying don’t, we’re saying make sure people understand. But some of these are very aggressive. There are a number of deals in the marketplace where you have the sponsor buying a piece of dirt, then the sponsor is selling that piece of dirt and leasing the property back, and then they’re constructing a building on that property. There is an early private letter ruling from the IRS that says, if the master tenant in that situation is the sponsor and that sponsor is building that building, we think that you have to look at all parties as one agreement. So, you have a joint partnership here, you have the trust being engaged in prohibited activities, and the whole transaction fails. We have seen that deal out there with numerous sponsors, and we have not even had people reference the fact that there’s a ruling by the IRS that says, this doesn’t work. If you’re going to put out that transaction and you’re not gonna reference and provide the investors the knowledge that you’re going against an existing ruling, that’s what I think is problematic. So, we see these deals, we see these construction deals where the sponsor is the one that’s actually doing the construction, and there’s no mention of the early ruling. And in some of these cases, like I said, it’s newer sponsors or it’s newer law firms, and they may not be aware, but it’s about an educational process.
Damon Elder 30:32
Well, let me throw a curve ball real quick into the panel because I know you’re not gonna name names, although I encourage you to do so. But what should investors and broker-dealers, what should they be looking for in a sponsor in this quickly growing marketplace? Again, we have dozens of new people rushing in. What do you need to look for? What should be your loadstone?
Darryl Steinhause 30:52
Well, I’m gonna jump in first because one of the real important things about the best practices is and I’m just being blunt here, when this started, it was, oh, let’s tell the sponsors what they have to do. And that was not the right path. The right path is this is a multi-headed monster. This involves issuers, this involves broker-dealers, this involves RIAs, this involves the law firms, and this involves the due diligence companies. And when an issuer puts out the PPM, first, the law firm is supposed to be the first governor. What are you doing? Does it work? Does it not work? Second, the due diligence companies need to be the next governor. Is there a problem? Is there an issue? They have to have the knowledge, and they have to have the tax knowledge to be able to say, there’s a problem here, or there’s not a problem here.
And then lastly, you’ve gotta look at the reps. When something comes across that seems too good to be true, it probably is. And the reps have to be aware, the broker-dealers have to do their due diligence to make sure that they’re comfortable. So this is aimed at all that entire channel. And we have problems like we had an issue with respect to a sponsor effectively allowing a mess lender to get in and taking all the investors’ money and selling the project. Well, the issuer put it out, their law firm didn’t probably have the knowledge, the due diligence company led it through, and the broker-dealer sold it. But if you put it in front of many people, they would’ve said, you shouldn’t be here. So, no one was willing to put the stop sign up to say, this is problematic. And that’s why we’re trying to put these best practices out to allow people to say when you see these problems, there’s a red flag, and someone’s gotta look at it.
Damon Elder 32:59
Mike, what are you looking at when you’re evaluating sponsors to do business with?
Michael Bendix 33:02
We’ve been talking about financial engineering, but what Darrell’s talking about right there is really structural engineering. One of my pet peeves is when a sponsor wants to do something that maybe is not allowed or out of the ordinary and tells the law firm… And that firm may or may not be one that’s been in the space, tells the law firm what they’re trying to achieve, and then they work backwards to do so. Whether they have knowledge that what they are allowing is okay, is not okay, or not, I don’t know. But the answer is, Darrell talks about all the different constituents that are involved here, and that no one raised a red flag. Well, people did raise a red flag. It’s those broker-dealers who said no to that offering. So, it goes down the line and we try really, really hard to make sure that we know what is allowable in a Delaware statutory trust and what’s not and be able to identify in a PPM that may have been created by an attorney on direction from a sponsor to do something. We talked a little bit about the cash-out transactions, there were deals out there, right? We made a decision not to do those deals, so it stopped at our broker-dealer level. But they were broker-dealers who signed off on it, and that was out there, and they raised it and you can sell out of transaction. So, the gatekeeper really to the investor is the retail broker-dealer who needs to take a stance and say, no. And hopefully, we talk with our dollars so that sponsors who are not able to raise the equity that they anticipated because the broker-dealer community says, no, you can’t do that, then the behavior will change at that point.
Damon Elder 35:01
What about the third part? Go ahead, Taylor. Sorry.
Taylor Garrett 35:04
Yeah, so it’s funny because all of us have different ways that we look at this space, right? Darryl is an Attorney; Mike Bendix is a broker-dealer. Our primary job, although we have Mount Dells, is Orchard Securities as a managing broker-dealer. And we’ve helped dozens of different groups under the space and raised several billion dollars in 10 30 ones over our lifetime. So, we get to get calls all the time, as I’m sure both Darrell and Mike do as well from groups that are interested in entering the space. And our first job is to try to scare the hell out of them and say, you don’t wanna be here, it’s really hard to enter the space. Why would someone wanna work with you when they could work with a group, they’ve been working with for 10, 20, 30, or 40 years? You have to come out with a better product, a cleaner product. You have to know all this stuff. There are investor relations, there are all of these things that are working around it. And I think all of us collectively here, as well as the hundreds of people that are on this webinar, have done a good job at trying to keep the riff raft out, right? I mean, it’s a lot easier for people to get into the space back in the early two thousand doing TIC deals. It’s really hard to enter the space. And there are a lot of things to be considered when sponsors are looking to enter the space. There are a lot of things to consider for a broker-dealer as they’re considering which groups, they wanna work with. And the first deal is really hard and the second deals really hard.
And you’re dealing with people that have done a hundred different offerings and been around for dozens of years 20, 30 years, and longer. And there are a lot of things to try to figure out as a new entrant into the space. And as broker-dealers are looking at them, they’re looking at, Hey, it’s not just what’s your industry expertise. What’s your understanding of this specific asset type? Why would we give you money? It’s who are the principles. How well capitalized are you? What’s your track record outside of this space? What are the fees that you’re gonna be charging on this kind of an offering? Who are you using for your third party? Who are you using for your attorney? Are you using your buddy down the street that’s been writing your PPM’s forever? Are you using a high-quality law firm that really understands the space and understands all the private letter rulings and everything that’s involved in the intricacies of a DST? What’s your underwriting standards? What kind of growth are you putting on this? So many different things. And then there’s the, after the closing, the investor relations. What kind of portal do you have? Do you have a portal? What kind of communication are you getting? Who’s in charge of that? Am I gonna be calling and having someone answer the phone when you get there? And then what does this look like long term? How are you gonna act when things get tough? And that’s a tough thing for everybody to underwrite. How are you gonna act when deals aren’t working? And are you gonna answer the phone?
Are you gonna be doing calls? Are you not gonna respond? And are you gonna do what’s right for you? What’s right for the investor? How’s this gonna look? And so, so many things for sponsors to consider as they’re entering the space. And I feel like we have a really good stable of sponsors. I’m excited by the level and the quality of people that are calling us today. And we kind of ignore the people that are calling that we don’t think make a good fit for the long-term viability of an industry we hope is around for 10, 20, 30, or 50 more years.
Darryl Steinhause 38:16
Just to add on there, it’s really important for everybody to buy in all the categories that we talked about because the goal here is we don’t want anybody to pee in the pool so we all have to get out. And that’s really what we’re looking for. And if we have some sponsor who does something crazy and it draws the attention of Congress or some other thing that says, you know, we don’t like this industry, we’re gonna shut it down. Everybody should be interested in making sure that we play within the lines.
Damon Elder 38:54
So, we’ve talked, I think obviously there’s a lot of layers to the industry, a lot of gatekeepers as you’re all referencing. But of course now in recent years we’ve seen the emergence of the 506 C structure, which you know, is increasingly popular in the DST space and we’re seeing more and more of those offerings C’s sold through exclusively through BDC’s and RIAs, but they’re not required to 506 C can generally solicit to the public and can raise dollars directly from an investor, which would eliminate a lot of those layers of diligence that we’ve been talking about. What are your thoughts on the 506 C versus the traditional 506 B structure?
Taylor Garrett 39:31
No, let’s have Mike start
Damon Elder 39:32
<laugh>. Go ahead, Mike.
Michael Bendix 39:33
When 506 C was first proposed, I was really excited about it and I remain optimistic that it’s where we’re gonna end up going. One of the issues that we have at the broker-dealer level is kind of the creation of a Chinese wall. And a generally solicited investor versus one that would go into a B offering. So, I send out something that is a general solicitation because I’ve got a 506 C offering that a sponsor has out there and I take that equity in and I put him into a B offering, I’ve got a problem. So that’s one of the things that we’ve had to sort of address internally because we have both B and C offerings on our platform right now. So, we’ve had to kind of make sure. It does go a bit to contemplation, but it also really is mostly about a substantive relationship with a client. It’s great to be able to have a 506 C offering with a client that I already have in the fold. The broker-dealer already knows them, so I’m able to put them in. And that’s great so that some of the verification of the accreditation issues don’t exist. If I have a generally solicited deal, so that’s gonna go into 506 C, but I got that client yesterday, I have to do additional verification of accreditation. So, it puts a little bit more of the onus on me. My competitor
Damon Elder 41:04
But isn’t it the requirement of the sponsor, though?
Michael Bendix 41:06
It’s a requirement of the sponsor who for the most part sends that down to the broker-dealer because my representative does not want to give the sponsor the responsibility, and the contact information to collect the data. My rep is out there saying, he’s my client, so I’ll get his tax returns, or his asset verification sheets. And so, it’s, for the most part, a relatively easy process on 10% of the transactions, it’s not easy. And there are additional steps that are required. We’ve got a fairly concise now list of things that we need from our reps on a deal that is a 506 C offering. And the buy-in has been actually a lot better than I thought it was going to be as we introduced the C’s. Again, when this was first starting, I thought the entire world was gonna go to C because one of the things that really scares me is a 506 B offering where another selling group member’s representative is doing something to blow an exemption. And I, as a selling group member whose reps did it exactly the right way, am going to have a problem because now I’ve got an offering in 1031 exchange where they potentially could lose the 1031 because they lose the property exemption from reg’s. So, I’d love it to go see in its entirety. We have a few bugs we gotta kind of clean up.
Damon Elder 42:44
Darrell, what do you think there, I know you think quite a bit about 506 Cs and Bs.
Darryl Steinhause 42:47
I think you should go to Taylor next, and I’ll wrap it up. Cause I think has a lot more energy on this and emotion than I have.
Taylor Garrett 42:57
I feel like someone has to stand up for 506 B because we’ve been doing it this way forever and now all of a sudden they’re taboo. But I mean my biggest… There are a few things on it, right? Contemplation is what Mike was talking a bit about, I think that rule is an antiquated rule. I wish we would spend time as an organization trying to go after that because I think the idea that I’m gonna generally solicit on my website, not even about the offering, just about my services, and on my website it says, I say, Hey, I can help provide solutions for 1031 exchanges and someone sees my website and sees the experience that I have and it’s like, Hey, I wanna work with you on this offering. The idea that an offering that launched yesterday that is the perfect offering for them but because I talked to them for the first time today and was able to create a substantive relationship with them, I can’t offer that to them.
I think the mid-1970s ruling for contemplation, what its intended use was back then compared to where the world is at today, I think is logically, I just don’t think that makes a lot of sense to take it to that level. And I wish we’d push back on that a lot. The idea between 506 B and 506 C, I agree with what Mike’s saying, I like the idea that we could generally solicit, I don’t want an exemption to be blown. I’m not aware of any time if there has ever been a general solicitation, which I assume there has been, I’ve never heard of a time where if general solicitation took place and the contemplation happened there and an offering was sent. I’ve never heard of an exemption being blown in the DST space. But I’m not an expert on that. But that’s not to say we should do it. I think that absolutely a 506 C is a better way to go for protecting the exemption based on where the world currently is and how things are marketed. But I also, the same broker-dealers that Mike’s worried about doing the right thing and make sure they’re doing it right and you have no control of them. I think a lot of sponsors right now are saying, hey, I’m not gonna allow broker-dealers to market this offering, or generally solicit this offering. Those are the same broker-dealers we were worried about doing the wrong thing last time. I’m not sure why they can enforce that heavily, especially if everyone goes 506 c.
And most importantly though, with all of this though, I think 506 C does a lot to help protect this exemption, which helps everyone, helps the sponsor, and helps the investor, but I’m also trying to consider the end investor and what’s best for them. My nightmare scenario in this world is that I have a client, not as a retailer rep, if a rep has a client, a great client, have been working with them for a long time. They’ve got $2 million to exchange and at their broker-dealer, they’ve vetted of the 84 offerings that are currently available in the marketplace, they’ve vetted a lot of them, and they feel really good about six of those deals. And so, they approve six of them and they don’t approve the other 78 programs that are available in the market. They go through a big process, understand that client’s financial situation and circumstances, and they lay out, hey, I think you should go into these four different offerings, put $500,000 each in all of them. Then they go around, and they find a 506 C deal that’s being generally solicited and it’s a 10% cash flow, or 8% or 6% like it used to be.
And that’s heavily financially engineered. And that broker dealer’s firm didn’t approve the deal because they didn’t think it was a viable deal. They call the sponsor because they see the offering on their website. Wow, I love this deal. I wanna go into it. And that sponsor who doesn’t have the same requirements the broker-dealer RIA has says, you know what? I think you should put all 2 million into this one program because this is the best deal I’ve ever seen. That investor leaves that rep that looks at their full financial picture and thinks this is the best solution for them, and instead invests all $2 million in that one program. I think that’s my concern. I think those are some of the bugs that need to be played out. But I think there are a lot of things that 506 C solves. I like the idea of being able to get more exposure to DSTs in general and have more people interested in them. But I think there are some unattended consequences that come from 506 C that aren’t necessarily always in the investor’s best interests. Maybe I’m wrong, but those are just some of the things that keep me up at night as I consider both 506 B and 506 C.
Damon Elder 47:43
Darryl, we’ll refer to you. We talked a bit about contemplation. Let’s build into your response something on contemplation. Give us a little 101 on what contemplation is and how it applies to the 506 Cs, 506 B discussion.
Darryl Steinhause 47:57
Sure. And first I’m gonna kinda respond to Taylor, listen, I really hate income taxes, but I have to pay them because that’s the law, right? And I understand you hate 506 C because…
Taylor Garrett 47:14
No, I hate contemplation. I hate…
Darryl Steinhause 47:16
Okay, you hate contemplation, but you also seem to hate 506 C because investors can go to other places outside the broker-dealer network as a possibility. Now I think most of the issuers who are doing 506 Cs are saying, I’m not gonna do that and are not going outside. But they can. But the problem is Congress wanted to give the investors the option to find access or to have access to these other investments. That’s why they put out 506 C. So, you’re gonna under your ladder kind of argument, you gotta get Congress to change the law. So that’s where we are. And contemplation is also the law. And I understand you hate it, but it’s there. So, I’m not disagreeing with you that you hate it because I believe you do based on our conversations <laugh>. But I still think it’s the law. What contemplation is, the rule is put in place so that broker-dealers who are agents of the issuer can’t generally solicit for investors when the issuer can’t generally solicit. So, the issuer under file 506 B can’t go out to the marketplace and say here’s my investment, come and invest. So, what the contemplation rule is out there as for is that the broker-dealer can’t go out and say, here are these potential investments, and then bring in a new investor who invests in the deal that was either existing or contemplated. That’s where the contemplation rule comes from.
The hardest thing is it takes two issues. It requires some type of general advertising, and it also takes an offer. And the definition of an offer is the most difficult thing because an offer is you have to do something that entices or excites the person who receives it to want to make an investment. And that’s the most unspecific rule known to man. Where is that line of what’s an offer and what’s not an offer? If you say you’re the orange squirrel on TV and you say, come invest with us, I don’t think you’ve made an offer probably in most cases, because you’re not saying anything. If you’re saying, I’m XYZ company and I do DSTs and ten thirty-one products, come call me. You probably have made an offer under the definition of offer. And the court cases say, guys, offer doesn’t mean the same thing as offering, it’s a much broader spectrum. It’s anything that may excite an investor to wanna make an investment, that is an offer. So, they’re just trying to block the indirect general solicitation that the issuer can’t use by blocking the broker-dealer, who’s the issuer’s agent from doing the same thing. That is the sole purpose of the rule. And by the way, you can be walking down the grocery store and you can crash into the cart of someone else and your PPM can fall on the ground, and you can pick it up and they can invest because there was no general solicitation. It’s not new investors, it’s only the general solicitation that gets you into trouble.
Damon Elder 51:48
Which of course, (Inaudible)
Taylor Garrett 51:50
To clarify that point, Darryl, because we talked a little bit about this and you said it, but I’d want to put light on it. If you have a website and you say, hey, I provide all these services, I provide a hundred different services, I can do taxes, I can do your financial advice, I could do variable annuities, mutual funds, ETFs, bonds, oil and gas, 1031 exchanges and a million other things. Then you could, if someone found you through your website and said, hey, I like this guy, I wanna work with him and happen to have a 1031, there’s gray area on whether that’s general solicitation and that if contemplation involved. If you have a website and you say, I do 1031 exchanges, that’s my sole focus and I’m the best on the planet for it, you should call me if you have a 1031 exchange and want to go do a DST, that would be a general solicitation or an offer of that. And it’s still gray, but would likely be that (Inaudible) solicitation for the offer
Darryl Steinhause 53:01
That’s my (Inaudible), the website becomes a general advertising, right? And then the “I sell DSTs, come invest with me” is the offer. And it’s still not a hundred percent, it’s just an opinion, but that’s where probably the line is drawn. And by the way, we asked the SEC to give us more clarity on where that line is, and they did not. They said facts and circumstances.
Damon Elder 53:27
That’s one of the most frustrating things about this industry, right? It’s the most regulated industry in the world, and yet there’s no specific definition of general solicitation or offering.
Taylor Garrett 53:36
Yeah, don’t screw it up.
Michael Bendix 53:37
What’s really crazy is that it happens all the time. I mean, I see it multiple times. I was gonna say multiple times a week. I probably see it multiple times a day that people are out there generally soliciting based on the definition, Darrell, that you just laid out. So, the problem is, I mean, look, a smart investor, he’s gonna just invest on any deal that was 506 B that was generally solicited because he’s gotta put option to get all of his money back by being able to say later, this deal was generally solicited way back in the day, I want my money back because that deal should have been blown. And it’s happening all the time. And the hardest part right now that I think we have to kind of figure out is what we as a community can do to put a stop to that, whether it’s portals and platforms or individual registered representatives, their websites, what we can do to put a stop to it because when this comes crashing down and, you know, Taylor, you mentioned wanting to go and get contemplation stricken. I don’t think you want to prick the regulatory bear and get it on their radar. Because as soon as they start to realize the extent to which these things are being violated GS and contemplation, we got a world of hurt in the 506 B world.
Taylor Garrett 55:07
Yeah, I mean, we were talking about that in best practices 2006, right, for TIC and contemplation. I’m only familiar aware of the very limited amount of times that’s been discussed, but it sounds like it already is on their radar. So, I mean, it’s a good point. Do we wanna fight it? And all of a sudden, they’re like, I’m sorry, what is contemplation? You’re like, you know, in the 1970s you guys wrote this in, right? And so, we don’t necessarily wanna do that by any stretch. But I mean, as I’m looking at all this, the best practices, clearly the end for all of us is to try to make sure we’re protecting investors. We don’t want to, like Darryl said, piss in the pool and make it bad for anybody doing these things wrong. I just wanna make sure that they’re getting the proper advice to make good decisions. And I hate to take out people that have fiduciary responsibility or securities level responsibility to make sure that an investor has a fair, balanced approach to how they’re investing in these things. And I think the broker-dealer and or channel and others do a great job of helping them understand all the circumstances. And these are very complicated documents that Darrell and others write PPM’s in. And I think it’s valuable to have assistance in that. Just like I don’t do my own taxes, I wanna make sure that someone that understands the sophisticated investment is helping me make the best decision possible. The unattended consequence is all I’m referring to. I’m great with 506 C Darryl. I don’t have a fight with that.
Darryl Steinhause 56:38
So, the best practices list some of the recent contemplation enforcement actions for people who want to take a look at them as to what FINRA has been doing in that area.
Damon Elder 56:51
So, we’re running out of time and this as we’ve referenced multiple times, this industry’s growing by leaps and bounds and it’s an ever-evolving thing. You’ve got 506 Cs emerging, which is the 506 C constant conversation. So, these best practices, Darrell, that again, you played a heavy hand in creating, how often should we expect them to be updated? Are they going to change? Is this a living document or is this, here’s how you do it, guys, follow the rules. Let’s all benefit.
Darryl Steinhause 57:19
Well, obviously if I help put them together, they can be improved. So <laugh>, when people have good ideas, we will revise them, we will adjust them, we will keep them changing, and try to stay up with the market on these issues.
Damon Elder 57:40
Okay, so let’s wrap up quickly with a round table question for all of you. What keeps you up at night, Mike, why don’t we start with you? In regard to this, of course. Let’s stay on track.
Michael Bendix 57:48
So, I mentioned earlier about sort of maybe things beyond my control, our competitors, registered reps that might blow an exemption by their actions, that’s probably primary. Our industry is sort of on an honor system at this point, right? And I talked earlier about the fact that I wish that we could just talk with our dollars and that sponsors would not be able to sell a deal if they didn’t do it the right way. But the truth is, is that there are selling agreements that are signed minutes after the due diligence materials arrive at the broker-dealer. Subscription documents are being executed hours after that. And there’s no way in the world that the due diligence department of that broker-dealer, the register would have time to have reviewed it. The registered representative would’ve had time to review it to make sure that it was suitable for his client and that the client would’ve been able to review it. So, what’s keeping me up at night is the reality is that we’re on an honor system where relatively shortsighted people are going out and skirting the issue because of competition to get equity. That may be changing a little bit because we’ve had a little bit of slowing here over the last 60 days. But I wish we could find a way to somewhat police each other to say, hey, let’s do it the right way and take extra time to make sure that the due diligence people, their reps, and the eventual client has a chance to really take a look at something before they invest.
Damon Elder 59:39
Taylor, what’s keeping you up at night?
Taylor Garrett 59:42
I mean, I like that the three of us here are really involved in this space. And I think all of us try to do our best to try to keep our (Inaudible) badges on <laugh> badges on and try to help as Mike’s alluding to keep the bad actors out and keep the vibrant industry. I think we earned our stripes on going through where we were in the early two thousand to where we’re at today. The quality of sponsors that are coming is phenomenal, getting a lot more exposure to the space and more people are understanding this as a very viable investment for investors that are before where they sell a fourplex, they’re 70 years old, they sell a fourplex and they go to their real estate agent, they buy another fourplex right down the road. I think for what this vehicle is, the ability to invest a smaller amount into institutional quality real estate managed by phenomenal professional sponsors that know what they’re doing. I think this industry could be around forever because I think there’s a huge demand for that. I don’t think everyone wants to continue to manage the real estate that they own forever. I think the idea of being able to the potential for passive income and meaningful upside opportunity with an investment and investing in different geographic locations and different asset types, the different sponsor is huge.
So, I think we’re gonna be around for a really long time. I really hope that all of us will do our best to keep bad practices and bad sponsors out. Don’t let them get off the ground, make sure that they don’t know what they’re doing and they’re not using the right groups to be able to come out with high-quality product that follows the guidelines that are set forth by the IRS and by the SEC and FINRA that we don’t let them be successful in the space. Because I think that will hurt us long term if we have bad actors or bad groups that come in and ruin it for everybody. One, a few times people are gonna be on the front page and if it’s in a bad light, then DSTs are gonna get more and more attention in the wrong way. But if we keep doing what we’re supposed to be doing and keep doing quality real estate with quality groups, I think this will be a very successful industry for many, many years to come.
Damon Elder 1:01:55
Darryl, aside from the overconsumption of Mountain Dew, what’s keeping you up at night?
Darryl Steinhause 1:02:00
<laugh>, that’s the main thing. I think there are three areas. One, we have to have the courage to put the stop sign up, all the different groups instead of taking the money. Because as Mike said, it’s a long play. It’s not a short-term play and everybody’s gotta get to that point. The second thing that keeps me up is if we have too much commotion, how does that impact 1031 overall? We don’t want to have people get angry over 1031 or get governmental concerns over 1031. We want 1031 to be just keep plotting along as it has. And if 1031 gets eliminated, obviously this industry is gone. So, we need to make sure that we all kind of play in the sandbox nicely in that area. And the last thing is, and I don’t know if a lot of people are aware of this, the SEC has changed its position.
The SEC used to say, we’re only gonna look at matters that we think we can win. And they’ve had a change in direction under this administration that even if they don’t think they can win, they’re still gonna pursue people. And if you look at the amount of enforcement actions that the SEC has come out with and by the way, once they get you in their grips, it’s hard to get out. If you look at the level of enforcement actions that are out there by the SEC, it’s fairly significant and it’s usually about disclosure issues. So, people need to be thinking about, am I disclosing this properly. And it’s not just public deals. They’re hitting Reg D deals as well, saying you did not properly disclose this and we’re coming after you. And that’s a major issue, especially when they’re coming after you, even if they don’t think they can win, but they don’t like what you did.
Damon Elder 1:04:06
Well, thanks gentlemen, appreciate all of your insights and hopefully, the publication of the best practices is gonna be a big step forward for the industry and help again, making sure it stays on the right path.
So again, for all of our watchers, and listeners, you can download those best practices on the ADISA’s website at adisa.org. And this webinar will be available for rebroadcast on the diy.com within the next… Hopefully by the end of today, but certainly by tomorrow. So, thanks for watching. Thanks for reading. Thanks again gentlemen, for all of your help. Appreciate it very much.
Darryl Steinhause 1:04:36
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