Delaware statuary trusts—which allow investors to hold title to one or more income producing commercial properties—continue to build momentum, capturing the attention of both investors and big-name sponsors.
The DST structure has been around for about two decades, but interest in the space has notched up to a higher level in recent years. Hines, one of the largest privately held real estate investors and managers in the U.S., is the latest company to throw its hat in the DST ring with the recent launch of its Hines Real Estate Exchange (HREX).
Hines joins a marketplace that has become increasingly crowded with approximately 50 firms offering DSTs, a real estate investment product that provides fractional ownership to investors through the sale of units or shares. DSTs have become increasingly popular among investors seeking to defer capital gains taxes with a 1031 exchange as DSTs are recognized by the IRS as an eligible “like kind” replacement property. It provides an alternative to more prevalent tactic of investing in a single property, often net-leased to one tenant.
Despite volatility in the market this year that has emerged along with Fed rate hikes, DST sponsors have raised nearly $7.8 billion year-to-date through September, according to Robert & Stanger and Mountain Dell Consulting. That volume has already surpassed the $7.2 billion raised last year and is double the $3.4 billion raised in 2019. “The DST space is in its infancy, and the level of activity in real estate markets supports a much bigger DST market,” says Kevin Gannon, chairman and CEO of Robert A. Stanger & Co., a real estate investment banking and advisory firm.
Given the growth trajectory in recent years it’s no surprise that the sector is attracting more institutional sponsors. In the case of Hines, DSTs serves as a good complement to its existing NAV REIT. Hines intends to use its HREX platform to make 1031 exchange opportunities available to investors in the form of interests in DSTs holding assets sourced from Hines Global Income Trust (HGIT), and HGIT will have an option to acquire the properties held by the DSTs. “I expect Hines to do well, and I expect other entrants into the space,” says Gannon.
Growing demand
One of the main drivers behind the surge in capital flows into DSTs is real estate transaction activity from retail investors. Retail investors who are selling appreciated properties and turning to the DST market to both defer taxes and redeploy capital into investment-quality real estate. DSTs can be a convenient and flexible alternative compared to going out and buying a new property that checks all of the rigorous IRS requirements on a 1031 exchange. For example, if an investor collects a $2.8 million gain from the sale of an apartment, they can fully reinvest that $2.8 million into in one DST property or diversify that reinvestment across multiple DSTs.
An important anchor for the DST market these days is the aging population. Aging baby boomers that have been actively involved in buying, selling and managing their own real estate are getting to the point where they want to move out of active management, while still avoiding capital gains taxes, notes Keith Lampi, CEO and president of Inland Private Capital Corp.
Capital Square Founder and co-chief executive officer Louis Rodgers counts himself as one of those aging property owners. “We’re not getting any younger and we’re seeing the ability to sell at what were record prices last year, and this year, are still good prices,” says Rogers. Owners are looking for ways to sell out of assets without recognizing the tax hit, and at the same time get out of the active management of real estate ownership and the tenants, trash and toilets that go along with it, he says.
For Capital Square, 2021 was “off the charts” with $750 million in DST equity investments, and the firm expects sales to reach $1 billion this year. Rogers also attributes part of that activity to the firm’s focus on apartments, which has been performing well and is in high demand among DST investors. “We have grown dramatically in part because we are getting a bigger share of the market, and in part because we are in an asset class that is growing, is more protected against inflation and is generating substantial profits for the owners when we sell,” he says.
Growing sales channels
Rising interest rates could create some speed bumps ahead for sales, which could weigh on demand for 1031 exchanges and DSTs. “I do believe the choppiness in the market will impact the business, and I think it already has. What we have to continue to monitor is at what point does the choppiness offset some of the growth dynamics,” says Lampi.
Some of the forces driving growth in recent years also could help to offset a potential slowdown in sales ahead. What started in the early 2000s as a bit of a cottage industry that appealed to a very narrow subset of investors and financial intermediaries has expanded and evolved. Sponsors are doing a good job of educating investors and advisors, which is resulting in growing awareness of the product and broader sales channels. “As we saw the market make its way through the financial crisis and the Great Recession, and as the market proved itself yet again through the pandemic, we have seen more upstream distribution partners take notice and bring securitized 1031 product onto their platforms. “So, it’s no surprise that sales have started to catapult as a result,” says Lampi.
Another counterpoint in the favor of DSTs is that it is not reliant solely on real estate investors. It sees capital inflows from a variety of business owners, such as physicians, restaurant owners and manufacturers, who are selling real estate along with the business. The business owner can carve out the real estate in the sale and conduct a 1031 exchange into a DST, which offers passive real estate investment. “The DST marketplace is very dynamic, and we appeal to a lot of different types of investors and different types of constituents,” says Lampi.
The entrance of large institutional players also has brought more attention and legitimacy to the space. “What you’re seeing is that the wirehouses, the Merrill Lynch’s and Morgan Stanleys and UBS’ of the world, also are embracing the DST product,” says Gannon.
Tougher competitive landscape ahead
Views are mixed on how higher interest rates are likely to impact the real estate transaction market in 2023. If demand softens it will inevitably stoke competition among the existing field of sponsors and create some shake-out among weaker players. Going back to the ‘80s and ‘90s, new groups often hit the ground whenever there were new real estate investment products. “They would typically get shaken out by the first dip or recession, and I think it will be the same in the DST space,” says Rogers. One of the problems with the outlier firms is that they come and go and when there is a problem they disappear, whereas the more seasoned sponsors and large institutions have more staying power, he adds.
However, Rogers remains optimistic for the prospects ahead in the near term. “I think the DST industry will continue to grow and next year will be better than this year in part because of the aging boomers and transitioning of active property into passive property. But it will be spotty in terms of who’s growing,” he says. Some property sectors also are better positioned to perform in a more challenging economy, such as apartments and self-storage, and therefore are better positioned to capture capital flowing to DSTs, he adds.
“The greater competition forces everyone to elevate their approach and is a healthy tool to push sponsors to improve their products and make them more investor-friendly,” adds Lampi. However, a more challenging investment market will likely separate the stronger and weaker players. “This isn’t just an AUM driven business. It’s investor servicing and soup to nuts from the buy, syndication and the full-cycle liquidity event that has to occur. And that can be a longer term journey that requires good sponsor level commitment over the long term,” he says.