While real estate investing inherently carries risks, certain asset classes—specifically student housing, senior care facilities, and hospitality properties—are prone to unique challenges. At 1031 Exchange Place, we believe it’s crucial for Delaware Statutory Trust (DST) investors to be aware of these risks when deciding where to allocate their investments.
Understanding Asset Classes in DSTs
When investing in a Delaware Statutory Trust (DST), it’s important to recognize that not all asset classes provide the same level of stability or risk. DSTs often feature core real estate asset classes known for their long-term viability and income-generating potential. Some of the most common and stable asset classes found in DST investments include:
- Retail Properties: Typically anchored by well-known brands or essential services, retail properties can provide consistent rental income. However, it’s important to assess the strength of tenants and the property’s location to ensure ongoing demand.
- Multifamily Apartments: Residential units, particularly in markets with a high demand for housing, tend to perform well due to consistent rental income from multiple tenants. Multifamily housing also benefits from the increasing trend of renting over homeownership in certain demographics.
- Net Lease Properties: These are often commercial properties leased to a single tenant, such as a corporate retailer or fast food chain. Net lease agreements transfer many operational costs (e.g., maintenance, taxes, insurance) to the tenant, making them a lower-risk option for DST investors seeking passive income.
- Industrial Properties: Industrial real estate, including warehouses and distribution centers, has been in high demand, particularly with the growth of e-commerce. This sector typically provides long-term stability due to long-term leases and the essential nature of logistics operations.
- Medical Office Buildings: These facilities are leased to healthcare providers, and with the growing demand for healthcare services, this sector is generally resilient to economic downturns. Long-term leases and essential services make medical office buildings an attractive asset class in DSTs.
- Self-Storage Facilities: The self-storage industry has become increasingly popular as individuals and businesses seek additional space for storage. These properties typically provide steady cash flow and can be considered lower-risk due to their ability to thrive in various economic conditions.
Despite the attractiveness of these core asset classes, it’s vital to understand that some sectors are far more volatile and pose greater risks. While diversification is a key principle in real estate investing, selecting the right asset classes is essential to mitigate exposure to undue risks. When deciding where to invest in a DST or 1031 exchange, it’s not only about choosing what to include but also understanding what to exclude from your portfolio to avoid potential pitfalls.
3 Asset Classes to Avoid in DSTs
When investing in a Delaware Statutory Trust (DST), it’s crucial to recognize that not all asset classes offer the same level of security and income potential. While some asset classes have proven themselves to be reliable, there are others that pose significant risks to investors. At 1031 Exchange Place, we believe that three specific asset classes—student housing, senior care facilities, and hospitality properties—are particularly vulnerable and should be approached with caution, or even avoided altogether, when considering DST investments.
1. Student Housing
Student housing is an asset class that may initially seem appealing, particularly in college towns where the demand for off-campus living is strong. However, this type of investment carries significant risks that may not be immediately apparent to the untrained eye.
Key Challenges:
- Dependence on a Single Demand Generator: The success of student housing relies almost entirely on the nearby university or college. If a school faces enrollment declines, administrative issues, or any disruption in its operations, the demand for student housing can drop dramatically.
- Black Swan Events: The COVID-19 pandemic exposed just how fragile the student housing market can be. As universities across the country closed or shifted to online learning, many students no longer required housing, leading to widespread vacancies and suspended rental income. This left many DST investors in a precarious position, facing diminished or suspended cash flow.
- Limited Marketability: Student housing properties have a very narrow target market—college students. This makes it challenging to pivot the property to other uses should the student population or demand wane, unlike multifamily properties, which can cater to a wider demographic.
The risks associated with student housing can be too great for many DST investors, and we advise extreme caution when considering this asset class.
2. Senior Care Facilities
At first glance, senior care facilities might seem like a sound investment, particularly given the aging Baby Boomer population. The demand for these facilities is increasing year after year, and the sector is expected to grow. However, beneath the surface lies a series of challenges that make this asset class particularly risky for DST investors.
Key Challenges:
- Heavy Regulation: Senior care is one of the most highly regulated industries in the United States. Licenses, permits, and frequent inspections are required to operate these facilities, and compliance with ever-changing regulations can be costly and time-consuming. A failure to meet regulatory standards can result in hefty fines, the loss of operating licenses, or even closure, all of which can decimate an investor’s cash flow.
- Business Risks: Unlike traditional real estate, senior care facilities are more of a business with a real estate component. Running a senior care facility involves managing the day-to-day operations of healthcare and housing for a vulnerable population. This adds a layer of complexity and risk to the investment, as operational issues, staffing challenges, and high costs can impact profitability.
- High Operating Expenses: Senior care facilities have much higher expense ratios compared to traditional real estate. In addition to the typical costs of property maintenance, they require a significant investment in staff, medical care, and compliance with health and safety regulations. Staffing is especially challenging in this sector due to high turnover and the demanding nature of the work, which can lead to operational instability.
- Legal Exposure: Unfortunately, senior care facilities are often targets for litigation, particularly related to the care of elderly residents. Lawsuits can arise from family members regarding the quality of care, neglect, or other grievances, which can be costly and time-consuming for operators to address.
While senior care facilities may seem attractive due to demographic trends, the operational risks, regulatory challenges, and high costs make this asset class too risky for most DST investors.
3. Hospitality Properties
Hospitality properties, including hotels and resorts, are another asset class that DST investors should approach with caution. While the hospitality sector can be lucrative during economic booms, it is notoriously volatile and susceptible to market fluctuations, making it a risky choice for long-term investment in a DST.
Key Challenges:
- Cyclical Nature: The hospitality industry is highly cyclical and tied to the broader economy. During times of economic growth, hotel occupancy and room rates may be high, but during downturns or crises, occupancy can plummet. The Great Recession and the COVID-19 pandemic are prime examples of how the hospitality industry can suffer severe losses. In 2020 alone, U.S. hotel properties lost billions of dollars in revenue, and many hotel owners defaulted on their loans, leading to a surge in foreclosures.
- Management Intensity: Hotels require constant hands-on management, with operations that include staffing, housekeeping, guest services, and marketing. Unlike other real estate assets with long-term leases, hotels essentially “lease” their rooms on a nightly basis. This means that occupancy must be consistently high to generate returns, and any disruption—whether from poor management, competition, or external events—can severely impact revenue.
- Location-Dependent Performance: Hospitality properties are heavily dependent on their location and proximity to popular tourist destinations or business hubs. Shifts in travel trends, local economic conditions, or even crime rates can drastically affect a hotel’s performance. For example, some major hotel chains have had to close properties in cities like San Francisco due to rising crime and homelessness, which negatively impacted demand.
- Financing and Foreclosure Risk: Many hotels operate on balloon mortgages, which come due every five to ten years. When interest rates rise or market conditions deteriorate, refinancing can become difficult, leading to an increased risk of foreclosure. In 2020, nearly 25% of all hotel loans were delinquent, underscoring the financial instability of the hospitality sector.
Given the volatility of the hospitality industry and its susceptibility to economic swings, DST investors should be wary of allocating funds to this asset class.
The Path to Smarter DST Investing
While real estate investing always carries a degree of risk, certain asset classes pose far more significant challenges that can jeopardize your financial returns. At 1031 Exchange Place, we urge DST investors to avoid student housing, senior care facilities, and hospitality properties due to the unique risks associated with these sectors. Instead, we encourage our clients to focus on more stable asset classes that offer consistent income and long-term growth potential, such as multifamily housing, industrial properties, and net lease buildings.
By avoiding high-risk asset classes and concentrating on proven, resilient sectors, investors can better safeguard their portfolios and enhance their opportunities for success in the ever-changing real estate market.
Prioritizing Stability in DST Investments
At 1031 Exchange Place, we stress the importance of prioritizing stability when selecting investments within a DST. While there’s no such thing as a risk-free investment, carefully choosing asset classes that have demonstrated resilience through economic fluctuations is crucial to building a secure portfolio. Historically, sectors such as multifamily housing, net lease properties, and industrial real estate have shown strong performance during both booming and challenging economic periods.
Why Prioritizing Stability Matters
- Economic Downturns: In times of economic instability, like recessions or black swan events (e.g., the COVID-19 pandemic), certain asset classes are more likely to suffer from sharp declines in value or occupancy rates. Multifamily and industrial properties, on the other hand, often remain in demand due to the essential nature of housing and logistical operations, providing more consistent cash flow.
- Tenant Stability: Asset classes such as net lease properties and medical office buildings often feature long-term leases with stable tenants. This provides investors with predictable and reliable income over time, which can help cushion against market volatility.
- Market Trends: It’s important to consider broader market trends that impact different asset classes. For example, e-commerce growth has boosted demand for industrial spaces, while the aging population creates steady demand for medical office buildings. In contrast, asset classes like hospitality or senior care may be more vulnerable to rapid changes in trends or regulatory environments.
- Risk Mitigation: One of the core principles of DST investing is passive income generation with minimized risk. By avoiding higher-risk asset classes, such as student housing, senior care facilities, and hospitality properties, investors can focus on more stable options that are less likely to face abrupt market changes or significant downturns.
Focus on Long-Term Growth and Stability
While every investment has an element of risk, choosing asset classes with a history of stable performance can help mitigate those risks and create a more secure, long-term investment strategy. DSTs are an attractive vehicle for generating passive income, but investors must exercise caution when selecting the underlying real estate. By focusing on proven, reliable asset classes, you can build a portfolio designed to weather market fluctuations and deliver consistent returns.
At 1031 Exchange Place, we’re here to guide our clients through the complexities of DST investing, ensuring that they make informed choices that align with their long-term goals. Whether you’re exchanging into a DST as part of a 1031 exchange or making a direct cash investment, prioritizing stable asset classes is the foundation for building a lasting legacy with your real estate investments.
