Are you confused when you work your way through the fee structure on a 1031 DST offering?

Welcome to the club!

There is no one size fits all, even though all 1031 DST must follow the guidance of IRS Revenue Ruling 2004-86. And if the 1031 DST is offered to investors through securities broker dealers, the offering document must also meet the guidelines of the SEC, FINRA, and the NASSA (the various state securities agencies)!

ON THE EQUITY

When you purchased your home for $500,000, assuming your debt level was high (let us use 80%), the commission paid the realtor (6% for this example) was $30,000 (6% of $500,000).

If the commission paid ($30,000) was expressed as a percentage of the equity invested ($100,000), the realtor was paid 30% of the equity!

Since a 1031 DST is sold as a security, the regulators want all fees described as a percentage of the equity!  Therefore, as the percentage of debt varies between offerings, the fees AS A PERCENTAGE of the equity will also vary. 

FIXED VS VARIABLE FEES

Fixed costs of an offering typically are paid to third parties (e.g., lawyer at $250,000, a third-party due diligence report at $100,000 for sponsor and offering, an appraisal for $45,000). 

Variable costs tend to be sales related (typically about 10% of the equity) or for to outside brokers (e.g., mortgage and real estate brokers).

NO PARTICIPATION = FRONT LOADING

A sponsor of a fund can receive a significant payment on eventual sale, depending on the structure of the offering.

A sponsor of a 1031 DST is PROHIBITED from participating in the success of a property! The IRS considers any interest by the sponsor is a REDUCTION in what the 1031 investors bring into the transaction, and therefore the investors fail to gain 100% deferral of their capital gains.

Sponsors of 1031 DSTs charge higher fees upfront – than for a fund where they can participate in the upside – because it is the main way they gain a profit from the activity.

VALUE FOR FEES PAID

What is the investor gaining for the fees paid?

1. The sponsor cost to asset-manage triple net leased single tenant retail locations – where little changes once the property is acquired – will be substantially less than asset managing properties where something is always is changing (e.g., hotels, self- storage, housing).
2. If the sponsor self-manages the property, consider property management and asset management fees as potentially double dipping!
3. Sponsor actual charges for managing renovation should generally be low, as 2004-86 limits what can be done to change a property and the investor demand for cash flow limits the risk the offering can absorb. And exception would be in rebuilding a property after a disaster (e.g., fire, flood, hurricane).

REALITY RULES REALTY

Operating cost for a property in a 1031 DST generally is identical to the same property held directly or in a fund. For example, a new apartment property may only have 30% in operating costs (versus gross income) as rents are high and there is little to repair on the property. That same property at age 25 might be approaching 50% in operating cost, as rents are lower (in comparison to new properties), the tenant mix may be rougher (hence more repairs), and the property has more going wrong (as we do as we age!). 

How the sponsor arrives at their cash flow projections is important to challenge. 

Look for unrealistic annual growth of income (or at a higher percentage than expenses). What might be justified early in ownership, may be due to improvements to management, may not make sense over the term.

BOTTOM LINE

Our analysis, to be fair and effective, between various 1031 DSTs, needs to arrive at an “apples to apples” comparison.  

DSTs over their 20+ year existence have proven to be an effective investment vehicle for those in need of a flexible sized replacement property.

Form, though, does not override the realities of substance!