Over fifty DST sponsors compete for investor capital at any one time. While often done with good intentions, many DST sponsors are pressured to implement yield enhancement measures to increase their targeted returns. This pressure is particularly notable in the early years of the holding period when a higher targeted yield can significantly improve a sponsor’s ability to raise capital.
More reputable and experienced DST sponsors aren’t pressured to use these measures. These sponsors rely on their reputation for conservative underwriting and their strong track record in raising capital. Newer DST sponsors, however (and even some more reputable ones), may use these measures to remain competitive. Without offering a higher potential return, it is difficult for a newer DST sponsor to raise equity since they lack the track record and experience. Unfortunately, these yield enhancement measures can add risk and may impact the future performance of an investment. Additionally, many investors and their advisors are unaware that these tactics are being used.
One of the most common mistakes DST investors make is focusing solely on the year-1 targeted distribution provided in the offering materials. They fail to research whether the cash flow sought by the property can support these higher targeted returns. Others will be drawn to the potential for future appreciation. They will do this without considering whether the projections used to achieve these results (rent growth, expense growth, future occupancy, etc.) are reasonable or within range. DST investors who chase higher yields from newer less reputable DST sponsors who implement these measures are unwittingly putting themselves at risk and are increasing the likelihood of an adverse investment result.
Agressive Finacial Projections and Assumptions
Using aggressive projections and assumptions is the most common way to enhance the yield on a DST. The sponsor’s proforma should be consistent with the appraisal and the 3rd party due diligence report (hopefully, they get one). If the rent growth in a particular market is forecasted to average 2% over the next five years, but the sponsor is using 4% average rent growth in their proforma, this is an example of an aggressive assumption. If the sponsor has underwritten the offering expenses without considering how these costs could inflate over time, this, too, would be considered aggressive. Underfunding reserve accounts and overestimating market rents and future occupancy are other examples.
Supplementing Cash Flows with Reserves
It is prudent for DST sponsors to set aside reserves for repairs and upgrades. It is more concerning when reserves (especially when they are accountable to investors) are used to pay distributions. This may make a DST’s returns look more attractive initially, but investors should be aware of the long-term impact. For newer properties in their lease-up phase or properties with significantly under-market rents, supplementing distributions with reserves is sometimes needed. For stabilized properties however, investor reserves should normally not be used to help support distributions.
Deferral of Management Fees
Deferring certain management fees (usually in the first few years of the holding period) is another way to inflate targeted distributions. These fees usually need to be paid back at a later date. The more fees that are deferred during the holding period, the more fees that are owed to the sponsor upon sale. This reduces the potential for future appreciation since a portion of the gross sales proceeds will be used to reimburse the sponsor. DST investors should be aware if management fees are being deferred to supplement distribution and if so, whether or not they will need to be paid back at a future date.
Interest Rate Buy-Down
Buying down the interest rate on a loan is another common way to attempt to enhance returns. Many sponsors will bear this cost if it is deemed beneficial. Some sponsors, however, will use investor-funded proceeds to buy down the rate. DST investors should know whether or not the DST sponsor has bought down the interest rate on the loan and who is bearing this cost, the sponsor or the investor.